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Momentary Lapses of Reason: The Psychophysics of Law and Behavior

39 Pages Posted: 30 Oct 2015 Last revised: 19 Aug 2016

James Ming Chen

Michigan State University - College of Law

Date Written: October 29, 2015

Abstract

The conventional capital asset pricing model (CAPM) remains the preferred approach to risk management in a wide range of economic settings. At the same time, the neoclassical assumptions underlying the CAPM have come under severe attack by behavioral economics. In sharp contrast with the purely rational agents of neoclassical economics, real humans make decisions under the constraints imposed by their innate heuristics. The tension between conventional asset pricing theory and behavioral economics puts particular pressure on law. As an applied branch of social science, law purports to subject human conduct to rules that should optimize objective well-being as well as subjective satisfaction.

This paper proposes a mathematically expedient method of alleviating this tension. A four-moment capital asset pricing model captures the emotional impact of odd and even moments of statistical distributions. Critically, a four-moment CAPM transcends the limits of financial models that consider nothing beyond the mean and variance in the distribution of returns. At an absolute minimum, four-moment CAPM gives mathematical voice to one of the key findings of prospect theory: the preference for skewed, lottery-like returns from actuarially unfavorable gambles.

Suggested Citation

Chen, James Ming, Momentary Lapses of Reason: The Psychophysics of Law and Behavior (October 29, 2015). Michigan State Law Review, Vol. 2016, No. 2, pp. 607-642. Available at SSRN: https://ssrn.com/abstract=2683557 or http://dx.doi.org/10.2139/ssrn.2683557

James Ming Chen (Contact Author)

Michigan State University - College of Law ( email )

318 Law College Building
East Lansing, MI 48824-1300
United States

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