Economist Brian Easton says behavioural economics challenges our assumptions about the relevance of rational economic man

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Paul Krugman tweeted that ‘behavoural econ[omics] is the best thing to happen to the [economics] field in generations’. For the last 150 years much economic analysis has been based on homo economicus, an ‘economic’ man who is rational and narrowly self-interested and who pursues his subjectively defined ends optimally. (Women were hardly thought about.)

In the last 30 odd years that assumption has been undermined by the systematic evidence from psychological experiment, that humans do not act as rationally and optimally as the theory assumed. I am not surprised. Introspecting, I never thought my personal behaviour was particularly homo economicus. The problem has been what theory could replace it. I don’t think we have quite reached the stage of a coherent replacement. (I’ll explain the current ad hoc approach shortly.) What is clear is that the old theory of rational economic man is untenable, a nice mathematical abstraction only tenuously connected to the real world.

Any column is going to have to be very selective explaining the issues involved, especially as there are so many diverse research findings. I’ve written on many aspects, which are listed here. The writers I have most admired are Daniel Kahneman and Richard Thaler. I add David Orrell’s Behavioural Economics: Psychology, Neuroscience, and the Human Side of Economics which I recommend.

Does it matters? Whatever economists think, economies broadly work. But if we assume that each of us is a homo economicus and develop policy on that basis, our economies are not going to work very well. At the very least we need to understand the weakness of the foundations of our thinking.

For instance, it turns out that individuals are not very good at resolving logical problems especially if they involve probabilities. If the same problem is stated in two different ways, individuals often respond differently. If a question is about a choice between two treatments which save lives with the different probabilities people tend to give one answer. If the same underlying choice about the two treatments is framed in terms of the deaths, they are likely to give the opposite one.

In one experiment the individuals were given two versions of a similar choice problem while their brains were scanned by an MRI. It turned out they used different parts of the brain to respond to the two versions. A subgroup whose brains in those areas had been affected by strokes or other injuries were found to respond in a logical manner. Perhaps to be a rational economic man you have to be brain damaged.

Do we need to bother? One reason is that marketing is well aware of these issues and uses them to shape your responses. The default choice on a website is almost always the one which favours the seller of the service because people tend to use the default. How often have you grumbled that an ‘independent’ political survey frames its questions to favour particular answers?

The public sector learned similar lessons from the research and so we have ‘nudging’, where the default to a question gives what is judged a socially favourable outcome. (Austrians had an opt-out provision for organ donations; Germany had an opt-in. Almost all (99%) Austrians agreed to donate after their death, but only 12% of Germans. Nudging would favour the opt-out.) Fortunately, public action is subject to greater scrutiny, so we know more about what those with public power are up to than we know about private sector marketing.

Even if you do not care about being pushed around, you may find some mastery of behavioural economics helpful for introspection or better understanding of your fellow humans. It will be only about how they make choices though; your insights will not be the stuff of Listener cover stories.

You may also find it useful to understand particular social stories like public debates. In his opening chapter, Orrell describes the British Brexit campaign in terms of concepts such as ‘risky decision making’, ‘present bias’, preference reversal’, overconfidence effects’, ‘nudging’, ‘framing’, ‘loss aversion’ and ‘status quo bias’, which come from the research which behavioural economics is based on. All effective political campaigns use such approaches.

There is also a substantial and thriving literature applying behavioural economics to financial markets. Behavioural economics adds to the richness of Minsky’s account of the cycle of boom and bust. Next time you are looking at an account of a financial market ask yourself to what extent the writer assumes that all the participants are behaving with the precision of a rational economic man. In reality they do not. Where do you think irrational exuberance comes from? An investor in speculative markets would be unwise to bet on each fellow investor being homo economicus,

Prospect theory, for which Kahneman was awarded a Nobel Laureateship, needs its own column. I am also fascinated by his ‘thinking fast; thinking slow’ which suggests, we may have two decision centres in our brain (as that experiment reported earlier found). Thinking fast is attractive because it is energy saving, but it does lead to speaking before one’s brain is in gear. That’s another column too.

I do not want to imply that economics is unaware of behavioural economics. At least seven Nobel Laureates in Economics have contributed to the field. The problem is how to incorporate its insights. In science bad theories don’t get dropped; they get replaced by better theories.

The closest we currently have to a ‘better’ theory is based upon the notion that people’s decisions use heuristics – rules of thumb and decision-making shortcuts. They are not always a bad idea. (When I cross a road, I automatically look right, left and right.) But they can lead people astray. (The heuristic does not work so well in a left-hand-drive country.) Over the years there has been assembled a long list of such decision-making flaws.

My impression is that people’s heuristics work reasonably well most of the time in most places. (I have yet to be run over.) But in some places they don’t work too well at all – speculative markets would be an example. The important conclusion is to check that your analytic and policy conclusions are not dependent upon an assumption of the super-rationality of rational economic man. That is an irrational assumption.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.