Monday, May 14, 2012

Behavioral Economics

A recent story on National Public Radio ( link) gives an overview of a subfield of economics called behavioral economics. Behavioral economics incorporates elements of psychology into economic theory. Some people believe that behavioral economics will improve economic models because it makes a correction for what they believe are errors in the assumptions of classical economics. As a result many people have come to think that behavioral economics may even justify the unprecedented amount of government intervention in the economy and improve our lives. 
First, I would say that the term 'behavioral economics' is very misleading from the start. I don't doubt that there may be ways that concepts from psychology could improve certain aspects of economic models. However, a better term would be psychological economics, cognitive economics, or psychonomics. Economics in general is the study of choices, and how they are made compatible in a world of scarce resources. It is already all about behavior. To name a subfield 'behavioral economics' is redundant and confusing.

Secondly, a major criticism of classical economics is the assumption that people are perfectly rational and perfectly informed. As the article states:

"Economists literally assume that the agents in the economy are as smart as the smartest economist," Thaler says. "And not just smart: We're not overweight; we never overdrink; and we save just enough for retirement. But, of course, the people we know aren't like that.......An imperfectly rational human being challenges a really important idea: the notion that markets work well because individuals can be counted on to make the best choice for themselves."

  One problem is that people get too excited about behavioral economics and over exaggerate the fact that people are not perfectly rational. We all know that people don't always appear rational, and don't always make the best decisions. Some people make very bad decisions. When people learn that economic 'theory' assumes that people are perfectly rational, a naive reaction is that economics has to be wrong.  That is a huge mistake.

As an example, we might learn in science class that the earth is not perfectly round and smooth, but we still use perfectly round smooth globes to learn about geography. We all know that most pool players don't do physics and calculus in their heads for every shot they take, but the shots can be easily modeled using the laws of physics. We don't trash globes or stop teaching physics in schools just because these 'models' aren't exactly like the real world. In fact these models are useful only because they are not exactly like the real world. They approximate the real world just enough to be useful. To make these models match the real world exactly would make them so complex that they wouldn't be easy to use.

In fact, one of the major criticisms of behavioral economics is that it makes models too complex to be useful. From a the Economist's View blog David Andolfatto writes:

"There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner."

A lot of people are holding out hope that 'behavioral economics' will save us from ourselves. That it will allow us to break a basic law of nature: that people own themselves and that you as an individual are the best person to decide what is best for you. If behavioral economics allows this, then there is no limit to what government can do. Suddenly there is no limit to how high taxes can be raised. We can raise the wages for the poor and cap the wages of the rich with no consequence. We can print as much money as we want and not worry about inflation. We can ignore large budget deficits. We can tell car companies what kind of cars to build and return them to profitability. We can tell farmers what kind of crops to grow and how to raise their livestock and still feed the world.

Even if behavioral economics were to offer great breakthroughs, another subfield of economics called Public Choice casts doubt on whether our elected leaders would actually put better policies ahead of their own personal and political party's gain, or that they would have sufficient knowledge to do it. Perhaps, as mentioned in the article, government officials don’t have to be hyper rational or perfectly informed to paint words on sidewalks, but when it comes to a very complicated world, and the billions of decisions made every day (even to make something as simple as a pencil), governments are not immune to the fundamental problem of economics.  

With the basic assumptions of economics, we've seen that people do appear to respond to incentives. We see that tax cuts can lead to job creation and economic growth. We see that minimum/living wages lead to decreased opportunities for the most disadvantaged. We see that printing large amounts of money leads to inflation. People don't have to be perfectly rational for the most basic principles of economics to be relevant, and behavioral economics likely won't change this. ( see Gregory Mankiw's 10 Principles of Economics ).

I, Pencil and I, Smartphone