/Lessons from Behavioral Economics

Lessons from Behavioral Economics

I returned from Morocco, where I was asked at a conference, “Does behavioral economics make optimization models obsolete?” The message of some publications may be that behavioral economics is a substitute for ‘traditional’ economics and that it more accurately resembles humans rather than ‘econs’ that are the subject of traditional theory. Some may infer that behavioral economics suggests minimal reliance on optimal decision rules and all we need to do is to identify and classify behavioral rules. Indeed, if you look at the literature, many interesting patterns have already been discovered. On the surface, one implication of this suggestion is true. Traditional economic models, with firms maximizing profits, consumers maximizing enjoyment from goods they buy in the market, and all participants knowing exactly what they are doing (i.e. having full information), are out of fashion. In fact, their relevance has been in decline for years.

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I thought about this question during the few days I spent at an exquisite hotel in Morocco for a workshop, visiting a bazaar and trying to charm a snake. My thoughts are presented in this blog, where I would like to argue that traditional models are evolving and that behavioral economics is another important effort to make micro-economic analysis more realistic and relevant. We will see several areas where economic research has been advanced and enriched. So behavioral economics is one of the main forms of modification of the economic canon. Behavioral economics augments, rather than replaces, traditional economics. Furthermore, like other economists, I really believe that the broader paradigm, where people, organisms, and organizations optimize subject to constraints, remains as valid as ever.

The challenge to economics and other sciences is to better identify the objectives (what do people and organizations pursue?) and constraints. Traditional economics started from a perspective where consumers maximize utility subject to a budget constraint and producers maximize profit. This simple model results in some important hypotheses, but it was obvious that it is far from perfect – and traditional economists have slowly augmented this model to make it both richer and more realistic. Behavioral economics is another step in this ongoing improvement.

Figuring out the actual objectives and constraints individuals face is a tall order. It requires a comprehensive multidisciplinary effort and will take many years. Economists need other social and natural disciplines to collaborate in this effort and, as technology improves, we will do a better job. It is a long-term quest, but as long as the world doesn’t come to an end anytime soon, we don’t have a deadline. Open-ended, perpetual search is a driving force for science.

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While finding the optimal framework that can explain human behavior is a major long-term challenge, economists need to develop solutions to immediate problems. As the poet says, “forget your perfect offering.” Economists have long been approximating given their own (limited) cognitive skills and the technology of the day. Thus each era’s models were appropriate for their time, whether Adam Smith’s or Milton Friedman’s. Much of the economic research in the 21stcentury aims to expand our understanding of consumers’ and firms’ objectives and the constraints that they face. Lancaster and Becker recognize that consumers don’t get enjoyment directly from the goods they buy in the market, but from the attributes that they provide (for example nutrients, flavors, aesthetic values, etc). These attributes are generated combining market goods and labor within household production processes. For example, a nutritious meal is produced combining purchased vegetables and meats with the effort of cooking. Many Nobel Laureates including Arrow,Sliglitz, and Akerlof developed a better understanding of consumers’ and firms’ choices under risk and uncertainty recognizing that imperfect information and lack of knowledge may affect many consumer choices and business practices.

The pioneer of behavioral economists was Herbert Simon, who developed the notion of bounded rationality, namely that an individual is rational, but that their ability to compute, assess, and decide are limited especially given constraints on time to make a decision. Therefore, people develop ad hoc decision rules that oftentimes perform quite well. Another pioneer of behavioral economics was Richard Day, who showed that many of the key variables in economics, like supply and demand, can follow from ad hoc behavioral decision rules.

Modern behavioral economics was inspired by Kahneman and Tversky, who documented that individual choices are impaired by cognitive limitations. Individuals may have imperfect perceptions of reality and precise calculation is tiresome and time consuming, so people develop heuristic decision rules. Thaler consolidated behavioral economics and identified many heuristic rules followed by people. The quest to understand the factors that affect behaviors took many paths, and economists have continued to update its frameworks and concepts over time. Schultz introduced the notion of human capital, recognizing that individuals’ decision-making are changing over time and may improve with education and experience. Recent studies introduce the notion of self-efficacy where individuals’ beliefs in their own capacity affects their choices. Moreover, individuals are diverse,  and sources of heterogeneity must be considered in assessing and predicting behavior.

Traditional economic frameworks are limited not only in explaining individual behavior, but also in explaining the behavior of institutions. In traditional economics, markets are king and prices and quantities of resources are determined by markets. But again, economic research has recognized limitations in these frameworks. Nobel Laureates Coase and Williamson showed that profitability and the costs of transaction will affect when firms will rely on markets to allocate resources and  when they allocate them internally. Scholars including Mirrlees,Vickery, and Tirole have studied modern economies with the challenges of coordination, heterogeneity, and asymmetric information, and have developed a better understanding of the role of contracts and auctions as mechanisms for resource allocation.

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While behavioral economics introduced insights from psychology to economics, economics research was also enriched by insights from political science leading to the field of political economy. Its basic premise is that economic decisions are affected and affecting the political reality. Political economic research identified voting and other political processes as major mechanisms affecting the roles and performance of markets and resource allocations. Political economic research analyzes politicians as agents who pursue self-interest subject to their own constraints, and it analyzes how the economic and political systems co-evolve.

Another direction of the evolution of economic analysis is the growing emphasis on dynamic processes and systems. While initially traditional economic models were mostly static, economists are paying growing attention to dynamic processes and the evolution of technology, industries, and even natural resources. It has been realized that innovations are outcomes of economic activities and affected by incentives and policies. There is growing analysis of the “educational-industrial complex” and how ideas that originated with researchers have transformed to become commercial technologies. This type of analysis doesn’t assume perfect profit-maximization and recognizes cognitive limitations that may result in political economy choices that affect the direction of change. Furthermore, there is a growing emphasis on the evolution of entrepreneurial behavior and the resulting supply chains. Entrepreneurs pursue self-interest subject to government policies and other constraints. They design supply chains to implement innovations that may introduce new products and markets, contributing to processes of “creative destruction” where the new replaces the old. Research on these dynamic processes also recognizes some of the risks and other challenges associated with these evolutionary processes and the need for an effective regulatory system that will allow progress while preventing undesirable consequences.

As we can see, economic understanding of individual and group choices is a work in progress, and economic frameworks dealing with practical situations at a given moment are shaped by the best knowledge at the time, recognizing that it is imperfect and will improve in the future. The discoveries of behavioral economics are important steps forward in our evolving discipline, contributing to better understanding of choices, objectives and constraints facing decision-makers, the resulting outcomes, as well as to provide avenues for improved policy-making. For example, behavioral economists introduced nudging as a new policy mechanism. While more basic economic research emphasizes the long game, applied economists have to focus on more immediate challengeshow to control climate change in a conflicted world, how to deal with polarization among nations and between the have and the have-nots within nations, how to address issues of food security and health, and how to manage the evolution of technology to benefit humans and not to harm them.  In the face of all these challenges, the basic tenets of economic theory still provide a solid foundation. It is up to each of us to adapt our thinking and tools to effectively engage an ever-changing reality.

Behavioral economics doesn’t present a new alternative, but rather is a state in the evolution of economic thinking. I find it significant because it allows injecting knowledge from cognitive psychology into economics. And it’s a contributor to the emergence of an integrated social science to understand human decision-making. The beauty of economics is that it is always changing and I find the introduction of behavioral sciences into economics as an opportunity, rather than a threat.

richard day