Apparently it’s biology and economics week for me because after Andrew Caplin finishes his fantastic series of lectures here at NU tomorrow, I am off to LA for this conference at USC on Biology, Neuroscience, and Economic Modeling.

Today Andrew was talking about the empirical foundations of dopamine as a reward system.  Along the way he reminded us of an important finding about how dopamine actually works in the brain.  It’s not what you would have guessed.  If you take a monkey and do a Pavlovian experiment where you ring a bell and then later give him some goodies, the dopamine neurons fire not when the actual payoff comes, but instead when the bell rings.  Interestingly, when you ring the bell and then don’t come through with the goods there is a dip in dopamine activity that seems to be associated with the letdown.

The theory is that dopamine responds to changes in expectations about payoffs, and not directly to the realization of those payoffs.  This raises a very interesting theoretical question:  why would that be Nature’s most convenient way to incentivize us?  Think of Nature as the principal, you are the agent.  You have decision-making authority because you know what choices are available and Nature gives you dopamine bonuses to guide you to good decisions.  Can you come up with the right set of constraints on this moral hazard problem under which the optimal contract uses immediate rewards for the expectation of a good outcome rather than rewards that come later when the outcome actually obtains?

Here’s my lame first try, based on discount factors.  Depending on your idiosyncratic circumstances your survival probability fluctuates, and this changes how much you discount the expectation of future rewards.  Evolution can’t react to these changes.  But if Nature is going to use future rewards to motivate your behavior today she is going to have to calibrate the magnitude of those incentive payments to your discount factor.  The fluctuations in your discount factor make this prone to error. Immediate payments are better because they don’t require Nature to make any guesses about discounting.

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