War and Peace in Economics

The discipline of Economics has some pretty tough problems to solve. Psychology can lend a helping hand.

Economics as a discipline carries a two-fold burden: that of ensuring that there is enough for everybody, and that everyone gets what they deserve, keeping in mind the common knowledge that resources are limited and trade-offs are inevitable. Both economists and non-economists realise that this lofty purpose can only be achieved through an interdisciplinary approach, impelling oneself to move outside of the realm of economics. Interdisciplinarity is not new, with theories and methods from statistics, mathematics, physics, sociology and psychology regularly permeating the study of economics. Since the 1970s, two psychologists, Daniel Kahneman and Amos Tversky, have laid the foundation of Behavioural Economics, attempting to redress what they thought were some fundamental issues with how economics views human decision-making.

As with any “shiny new idea,” economists appear polarised on how to integrate insights from behavioural science into their work. They are sometimes prone to an outpouring of emotion, when defending what they learnt as graduate students and consider as gospel. On the other hand, some economists tend to view new systems as a golden bullet while dismissing the old ones as Sisyphean. However, all economics modeling will be imperfect if seen in silos, and the different schools have to interact with each other to meet the burden the discipline sets for itself.

The big change from mainstream neoclassical economics to behavioral economics is the “rationality assumption.” To clarify, rationality as defined in economics is different from everyday parlance — a person is called rational if her preferences are monotonic, transitive and complete. Under the rational behavior assumption, an individual weighs costs and benefits which are informed by known preferences, and understands the payoffs of the transaction (Thorsten Veblen famously described the ‘econ’ as a lightning calculator of pleasure and pains”), making the choice the most optimal decision. As studies starting in the 1970s consistently began to show, some assumptions about these preferences were repeatedly violated.

This is where behavioural economics came in. It argues that (among other things) even minor changes in how choices are presented to an individual have a considerable impact on an individual’s decision. This could have implications for a range of economic decisions: everything from what to eat to how to save. Neat ‘rationality’ models don’t empower economics to answer questions like, “Do consumers dislike losses more than liking an equivalent gain?” Psychology, however, does — and it certainly holds implications for economics as well.

Despite its critique of conventional economics, behavioral models remain rooted in the rational model of decision making. The key assumption still remains that human beings always maximise their welfare, subject to some constraints. When economists observed deviations from this behavior, they were asked to “do their best to make a correct prediction.” Such deviations in behaviour, when systematically shown to violate essential tenets of rational decision-making, form a core part of the behavioural critique of mainstream economics. Herbert Simon first raised this in the 1950s. In what is one of the best papers of the 20th century, Simon argued that humans often can’t compute information fast enough to display maximising behaviour. They just cannot process the vast amount of information to make a best possible decision. He also tweaked the fundamentals by changing ‘rationality’ to ‘bounded rationality’. It would only be several decades later that economists would consider modeling individuals as boundedly rational.

To us, two things stand out at a fundamental level, driving the difference between various schools of economic thought. The first is the very conceptualisation of an economy, which further forms the basis of what is prescribed as “good economics.” The Classical Economists — David Ricardo, Thomas Malthus and Adam Smith — conceptualised society as formed of ‘classes’. The mechanisms of price stability and the power structures among the Royalty, Clergy, Bourgeoise and Workers led them to the Free-Market system as one where everyone will be the most well-off. Today, the world is modeled on individuals, not classes, leading to other free-market schools (Neoclassical, Austrian etc). However, this is not to say that Ricardo, Malthus and Smith are not important anymore. Be it Hayek’s enchantment with “unintended but realized effects,” or Hirschman’s analysis of “unrealized but intended effects,” the dominant worldview of the economist plays a role in shaping assumptions that inform what the economist or policy maker should do. Each may be different from the other, but the existence of one doesn’t make the other obsolete.

The second is how (and to what extent) do humans beings respond to economic, social, or cognitive stimuli, given a particular context. Will giving more choice to individuals be better for them or worse? Further, how much choice is optimal? Such stimuli have traditionally been assumed away to be ceteris paribus in mainstream economics. Almost all economic modelling is done making certain assumptions, most of them around human behaviour. The proofs of the widely known Arrow-Debreu theorems on efficiency and Pareto optimality of competitive equilibria are based on ruling out externalities altogether (eg: altruistic behaviour). Even when such externalities are accommodated, as in Gary Becker’s model of rational allocation where altruistic behavior is modeled, it is done modelling only one aspect of altruistic behavior. Becker assumes that altruistic actions will only be undertaken if the actor is benefitting from altruistic behaviour by gaining others’ sympathy, leaving no room to model persuasion of a selfless objective, and good behaviour for its own sake. Thus, it is important, nay imperative, that the veracity of these assumptions be tested, and their imperfectness be perfected.

Raj Chetty at Harvard University argues for a pragmatic approach to the usage of behavioral economics in a paper titled Behavioral Economics and Public Policy: A Pragmatic Perspective. He says:

Instead of posing the central research question as “are the assumptions of the neoclassical economic model valid?”, the pragmatic approach starts from a policy question – for example, “how can we increase savings rates?” – and incorporates behavioral factors to the extent that they improve empirical predictions and policy decisions.This approach follows the widely applied methodology of positive economics advocated by Milton Friedman (1953), who argued that it is more useful to evaluate economic models on the accuracy of their empirical predictions than on their assumptions.

It isn’t a triumph of one school of thought over another that is important, but the end goal and result leading to a more coherent understanding of how the world works.

Recent advances in economic theory have indeed involved elegant yet robust modeling of behavioural assumptions (for example, present bias and reference-dependent preferences). Having a closer look at the psychology of homo economicus is perhaps beneficial for the discipline, without discarding the rigor of neoclassical economics. To go back to Colin Camerer and George Loewenstein, “…behavioral economics simply rekindles an interest in psychology that was put aside when economics was formalized in the latter part of the neoclassical revolution.”

About the author

Prakhar Misra

Prakhar Misra is an Associate with IDFC Institute, a political economy think/do tank in Mumbai. Previously, he was a Chevening Scholar reading for a Masters in Public Policy at the University of Oxford. He was also a Chanakya Scholar at the Meghnad Desai Academy of Economics from where he earned his post-graduation in Economics and Finance. He has been a fellow with Teach For India and with the Swaniti Initiative.