A Little Psychology Does Economics Some Good

Understanding behavior isn't a way to justify government intervention.

So you think people are rational?

Source: Ullstein bild via Getty Images

In Chapter 17 of his new book, "Misbehaving," behavioral economics founder Richard Thaler describes a conference that was held at the University of Chicago in 1985 solely for the purpose of debating the value of the new field. That’s a pretty remarkable event -- new areas of economics research usually get lots of buzz, but a special conference like that is rare. It shows that behavioral econ didn’t just generate excitement; it also generated a sense of threat. 

The threat was that of a paradigm shift. This term, coined by philosopher Thomas Kuhn, refers to the dread moment when scientists learn that up is down, black is white and everything they thought they understood about the world is wrong. Kuhn said that paradigm shifts happen when enough “anomalies” are found in the existing theory that a reconsideration becomes unavoidable. It's probably not a coincidence that Chapter 18 of Thaler’s book is called “Anomalies.” 

The fear of a paradigm shift also explains the strong negative reactions to Thaler’s new book among certain tradition-minded economists. For example, John Cochrane, Thaler’s colleague at Univerisyt of Chicago’s Booth Business School, recently delivered a long blast against behavioral econ on his blog:

[Thaler] spends [a lot of time] complaining about homo economicus, the dispassionate rational maximizer of economic theory...This is a straw man, and we all know it...All sciences and engineering make simplifying assumptions appropriate to the problem at hand. If you want to figure out the effect of prices on tomato demand, the absurdly simplified rational maximizer approach gives a darn good answer. If you want to figure out where to put the signs advertising a tomato sale, or what color to draw them, let me suggest some psychology... 

Psychology has a lot to say about how people make quick decisions in environments of information overload and scarce time...Traditional economics ignores information gathering and processing costs, because they are usually [small]..."behavioral" approaches study small-potatoes effects.

Cochrane goes on to complain about the “nudge”-type paternalism advocated by Thaler. I already defended that flavor of soft paternalism in a previous post

Anyway, Cochrane definitely seems to think that the aim of behavioral economics is to replace the assumption of rationality with specific kinds of irrational thinking derived from psychology experiments. If that could be done, that would truly be a massive paradigm shift in economics. 

But it won’t happen -- at least, not in our lifetimes. This is because psychology itself has no unified theory, at least not yet. Cognitive and social psychology are basically pre-paradigmatic sciences -- they produce a huge amount of experimental results, but they don’t fit together into any coherent whole. Social psychologist Walter Mischel jokes that “psychologists treat other people’s theories like toothbrushes – no self-respecting person wants to use anyone else’s.” 

Psychology, therefore, will be able to furnish econ with a large grab bag of anomalies, but there’s a good chance it will never provide a grand unified theory that will render the rational maximization of classical economics entirely obsolete. 

I think behavioral economists almost universally recognize this fact. Matthew Rabin, a behavioral economist at the University of California-Berkeley, put it very well in a 2013 essay in the American Economic Review Papers and Proceedings, entitled “An Approach to Incorporating Psychology into Economics.” Rabin doesn’t speak of paradigm shifts or throwing out rationality. Instead, he talks about “improving the psychological realism of economics while maintaining its conventional techniques and goals,” and “extensions of existing models.” 

In other words, Rabin is talking about evolution, not revolution. The idea is that sometimes, psychology matters. In other situations, it doesn’t. Economists looking to explain a phenomenon should always be open to the possibility that psychology might be important, even though that will only sometimes turn out to be the case. 

So Cochrane’s idea of behavioral econ is also a bit of a straw man. Thaler teases homo economicus, but in the end, homo behavioralis isn't going to look radically different.

Why all the fuss, then? I suspect that the rancor that surrounds this topic -- and the alarm demonstrated by the organizers of the 1985 Chicago conference -- is rooted in politics. Not academic politics, but good old right-left, free-market-versus-state-intervention politics. Opponents of behavioralism seem to worry that it represents the thin edge of a socialist wedge. I think this also explains the outsized fear of soft paternalism and “nudges.”

That’s a shame. Behaviorism isn’t about providing a justification for government intervention; it’s about finding a more useful explanation of economic phenomena. Nor would perfect rationality be a defense against government intervention. There are plenty of potential reasons for government to intervene in an economy -- externalities, public goods, asymmetric information and incomplete markets -- that are perfectly compatible with homo economicus.

So I think the whole brouhaha surrounding behavioral econ is overblown. Bringing psychology into economics was an important scientific advance -- one more useful tool in the toolbox. It isn't going to turn economics into a vehicle for promoting socialism. 

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