The Behavioral Revolution in Economics
Prof. Richard Thaler, The Recipient of The Nobel Prize in Economics, 2017
When I first started studying Economics in college, I naturally assumed that economics is behavioral. In fact, that’s how I learned and internalized the concepts of diminishing returns, diminishing marginal utility, economies of scale, the laws of demand and supply et al. Of course at the time I didn’t know that such concepts fuelled a deeper purpose, of concave functions in convex sets being open to well behaved mathematical analysis. In hindsight, I do remember things which flummoxed me at the time, when I really thought, who really equates marginal revenue with marginal costs in a business? I’ve never heard of someone run a business like that! But of course, since I was an Indian student, and a fresher in Economics, I cast the thoughts away and thought well, this is how it must be and the businesses are naïve, after all, they haven’t done formal training in Economics!
After about seven years since those days, now well settled into my Ph.D. in the subject, I have really come a long way in thinking about things. The evolution has been bumpy, and now I can say that my puberty is over regarding the field. I’d like to think it works for all students the same way. You start with your own intuitions about the field at the start. The introductory textbooks restrict your domain so that you are ashamed of your earlier ideas, and lack of confidence in saying that this theory doesn’t make any sense. I mean look at the mathematics! They must be right. It’s me who’s stupid, and we start speaking in the language of the textbooks.
However, when this period is over if one is brave enough to consider graduate school, you start deconstructing the subject according to your own ways. After formal methods become second nature to you, you start gaining more and more confidence, until you someday are able to say. ‘The mathematics is fine. But why would someone put such conditions as to expect the answer?’. It’s kind of like driving. It just makes sense after a particular point of time, and though you still argue in your head that ‘I know nothing.’ The fact is that you do know now, and soon you’ll become that author other students would balk at.
An interesting part here is that when this evolution takes place, the learning consists of many elements. You start appreciating as to why that author made those unintuitive assumptions. Tractability, feasibility and the application of models start making sense to you. A certain philosophical understanding accompanies the technical understanding, and as you read more and more, the jigsaw puzzle starts solving itself, and one can see that puzzle from micro specificity to at the broadest possible sense. But still, one thing remains unchanged. That curious intuitive child who questions, like he did seven years back, although now with better tools and formal methods as ammunition.
This leads me back to my example of Behavioral Economics. The first question that bothered me were certain assumptions which made no sense. So now you saw work which actually challenged those assumptions, and won a Nobel Prize for that. But it is important and liberating to know that Economics was at a time the most open field for all sorts of ideas. In fact, the first Behavioral Economist was none other than our own Mr. Adam Smith, with his somewhat lesser known title, The Theory of Moral Sentiments. Not just Smith, other intellectual titans such as F.A. Hayek, who published again a lesser known work called The Sensory Order, and another titan, John Maynard Keynes, whose lack of formal economic training meant that most of his perspectives on economic thought were intuitive. Animal Spirits, Liquidity Trap, The Beauty Contest Games, and so much more. We were all behavioral until we decided to become Scientists and not Social Scientists, which happened mostly in the second half of the twentieth century onwards.
Coming to the Nobel winning Behavioral Economist who started a new revolution. No, I’m not talking about Richard Thaler, who won this year’s prize, I am talking about a genius by the name of Herbert Simon, who won the prize in 1978, for attacking the most controversial and important assumptions Behavioral Economics owe their career to, Rationality. Any academician apart from economists will laugh at the assumption so fundamental to economic analysis that humans behave rationally in markets, at least statistically. That means, we see our lifetime’s worth of benefits from one good when buying it. That given the same option again and again over time, there is no option that we should change it. That we perfectly calculate each extra benefit from the good to each dollar paid for it. Of course, this is horseradish. We basically need this assumption to perform mathematical analysis with good continuous functions and an equilibrium point. Simon worked on what we call Bounded Rationality.
Maurice Allais worked on the consistency axiom and showed us how the framing of choices can deceive us. Vernon Smith helped develop the field of experimental economics, where microeconomic axioms could be tested under controlled settings. Alvin Roth worked on the market design, where not everything depends on prices. (Price gouging makes perfect sense to an economist, but would never be legally justified, rightly so). Kahneman and Tversky worked on Prospect Theory, that depending on the amount of reward or punishment, our valuation, and expected utility changes, and is not constant, of course, we don’t all have iron hearts!
So far so good. These gentlemen gave us great works and deservedly got published in the top journals, and won a Nobel prize at that. But they weren’t a threat to the established industry. These analyses were great for a moment’s reflection and then getting back to work. Until the tide grew larger and larger, and Richard Thaler was one of the few forerunners of this new wave. This needs to go mainstream these forerunners thought, which had genuine scholars as well as opportunists who’ll get a wealth of new research to publish. Thaler’s work on Mental Accounting and other behavioral anomalies and collaboration with Kahneman and Tversky, and upcoming students who wanted a more psychological approach to economics struggled for almost two decades until the line of work got its own handbook, it’s own journal and its own foundation. It helped that this community was tightly knit, unlike the dispersed nature of the neoclassical school, which was divided on matters of how much should the markets be free. The Harvard-MIT intellectuals versus the Chicago School.
Behavioral Economics gained its biggest breakthrough in the financial crisis when according to me, this subfield gained the most acceptability and was much more attractive than Marxian critiques of the crises, and suddenly Behavioral Economics became the rage. Together with Behavioral Finance, which challenged the rational Efficient Market Hypothesis, the popularity of Behavioral Economics skyrocketed, and though Behavioral Economics gained the name, the popularity had its own trade-off, and one aspect shined brighter than most: – ‘Nudging’. Thaler got his own cameo in the movie ‘The Big Short’, other behavioral economists were called into policy making to make simple nudge incentives, which on accord of their own incentives they most definitely complied. Behavioral Economics as a buzzword became more and more obscure and handed an opportunity for the criticizers on a golden plate. It’s easy to see whenever a research framework clicks, opportunists jump at making all sorts of theories and predictions, just as econometrics is currently struggling. The abuse of that framework makes us ask, is it the theory at fault? No! It’s human behavior! Econometrics and Behavioral economics if done robustly are extremely useful to develop precise descriptions and predictions. It is unto the academic community and those stakeholders at peer-reviewed journals to face this monumental task of sifting through the hay to find the needle.
The future of economic theory depends much on how computing technology updates and allows us to perform trillions of calculations so that models need not be so restricted anymore. Agent-based simulations with multiple assumptions in base could be tested for innumerable parameters again and again with varied assumptions on behavior. It’s time to keep the future in mind in how economics would be done, and my wishful thinking gains confidence by the decision of the Nobel committee to recognize the role Behavioral Economics would have in the future.