Behavioral Economics--What's the Big Deal?
Behavioral Economics—What’s the Big Deal?
October 1, 2020
Each of my monthly newsletters deals with a specific dimension of Behavioral Economics (BE) with some—hopefully—useful applications.(1) What I’d like to do in this month’s newsletter is take a step back and discuss the purpose of economics, the rise of BE, and my perspective on both.
Economics is a social science, and economists like to emphasize “science”. As such, Economics, to be useful, must help us understand how the world works and maybe even allow for some reasonably accurate predictions about economic outcomes. Accurate – or as accurate as possible – descriptions and predictions are the generally accepted raisons d’être of the discipline.
One can make a case that “modern” Economics started in 1776 with Adam Smith’s The Wealth of Nations, yet there were clearly economic thinkers well before that. But let’s skip to 1946 when Paul Samuelson’s Foundations of Economic Analysis turned the discipline in a strongly mathematical direction. As the title suggests, it laid the foundation for graphical and mathematical models of behavior, markets, and economic systems.(2)
But models are unrealistic, by their nature. That is, they focus on a few key variables and ignore others. Modelers attempt to identify the most important variables and omit variables that are largely irrelevant to the question at hand. A rather extreme example to illustrate: In trying to model consumer purchases, an economist might look at household income but ignore the hair color of the primary bread winner of the house.
What I will call “conventional economics” or “Econ 101” focuses on the models that derive from a graphical or mathematical description of behavior. An important underlying assumption in these models is that people are rational. “People” includes consumers as well as decision makers in companies and government. “Rational” can be a bit tricky, but one dictionary defines it thusly: “based on or in accordance with reason or logic.” The radical and revolutionary step taken by the pioneers of Behavioral Economics was to generally discard or at least significantly modify that assumption of rational behavior.
My view is that Econ 101 models can be useful in the sense defined above—they do help us understand the world and sometimes provide reasonable, even accurate, predictions. For example, Econ 101 models predict that if you raise the price of a product, people will buy less of it. They predict that if you change incentives, behavior often will change in a predictable direction (the magnitude of the behavioral change might not be predictable, however).
Often, perhaps but not always, not by a long shot – not if how people actually behave is the primary focus, rather than how they “should” behave according to previous models. That was the initial insight of Behavioral Economics researchers. This led many of them to start looking at the work being done in psychology, which provided (and continues to provide) clear evidence that people do not always act rationally – when making decisions about money or just about anything else. In fact, Daniel Kahneman, a psychologist, won the Nobel Prize in Economic Sciences in 2002 for his many studies—with co-author Amos Tversky—that showed behavior that does not conform to the notion of rationality that underlies conventional economic models. I think of Kahneman as the grandfather of BE.
If Kahneman is the grandfather of BE, the father is arguably Richard Thaler.(3) If you have the slightest interest in BE and how it developed, I strongly recommend his book Misbehaving. It is very readable and offers many amusing examples of seemingly irrational behavior. Thaler won the Nobel Prize in 2017. I found especially amusing the “Stop me before I eat [nuts] again” story that helped provoke Thaler’s awareness of nonrational behavior.
Do models based on the recognition of various types of irrationality help us understand the world better and make better predictions? As you might expect, the answer is Yes, in many circumstances. For example, individual investors trade (buy and sell) more often than rationality-based models. Why? Probably overconfidence (especially on the part of men, and the subject on my September newsletter) and self-attribution bias (perhaps the subject of a future newsletter), which BE academics have widely researched.(4)
Is BE a big deal? It has its detractors, and I’ll investigate some of their criticisms in a future blog or two. Conventional economics does have descriptive capability and predictive power. Does BE add much to that?
My view is that Econ 101 has not completely run its course, but that there’s relatively little left to squeeze from models based on rationality. In contrast, as a relatively new subdiscipline, BE has more potential for furthering our understanding of economic phenomena than conventional economics. To be sure, it is still in its formative stages. But so far it has given us new and deeper ways of understanding how we actually interact with others, not to mention the various parts of ourselves, when making economic decisions. Any area of social science that can actually deliver that is a (big) deal I want to be part of.
If you click on “View this email in your browser”, you will see “Past Issues” in the upper left-hand corner.
Samuelson was the first American to win the Nobel Prize in Economic Sciences (1970).
I would be remiss if I did not mention Robert Shiller, who won the Nobel Prize in 2013. His work focuses more on behavioral macroeconomics. For example, he predicted the housing bust of 2008. He has written several books but is probably best known for Irrational Exuberance. And how could I ignore Herbert Simon, winner of the Nobel Prize in 1978? Wow, who am I going to offend by not mentioning them? There are an increasing number of outstanding behavioral economists.
If you are interested in personal financial planning from a BE viewpoint, I recommend my book, The Foolish Corner, available on Amazon.