Posts Tagged ‘descriptive theories’

Behavioral Economics

August 29, 2015

A number of previous healthy memory blog posts have been on the topic of behavioral economics. Mainstream economics is based on the idea of the rational man.  In 1978 the psychologist Herbert Simon was awarded the Nobel Prize in Economic Science for his research showing that human beings do not, and often cannot, evaluate all available information before making a decision.  He found that people satisfice, that is, use only enough information they think they need to make a decision.  In 2002, the psychologist Daniel Kahneman shared the Nobel Prize in Economic Science for his work with Amos Tversky showing the relevance of psychological research on human judgment and decision making under uncertainty to economics.  Kahneman and Tversky formulated Prospect Theory that showed how human behavior deviated from the economic norm.  Unfortunately, Tversky had passed away, so he was ineligible to receive the Nobel Prize.

Misbehaving:  The Making of Behavioral Economics by Richard H. Thaler provides a well-written and informative discussion of the development of behavioral economics.  Although he is an economist he had the good fortune to be able to work with Kahneman and Tversky early in his career.  So he was an early, perhaps the earliest, economist to come into the behavioral economics fold.  The book unfolds in chronological order so you are able to follow the development of Thaler’s career along with the development of behavioral economics.  His writing is quite entertaining.

Misbehaving: The Making of Behavioral Economics covers the course of the development of behavioral economics up until current times, so the coverage of material is quite large. The book begins with the discussion of SIFs (supposedly irrelevant factors).  These are factors that classical economics wave off as being irrelevant, but which are most certainly not irrelevant.  Early in his career Thaler began making his list of phenomena which were relevant to economics, but which were waved off as being irrelevant.  There are two types of theories:  normative and descriptive.  Normative theories inform us the right way to think about some problem.  Right here refers logical consistency.  Descriptive theories explain how problems are handled.  That is, what people actually do.  This differences is central to the difference between classical and behavioral economics.  Classical economics explains how logically people should be  behave, and behavioral economics explains how people actually do behave.

Perhaps the most dramatic example of this distinction can be found in the recent economic crash.  According to the rational model of man, this crisis should not have happened.  And, indeed, it was predicted by very few economists.   The crisis was due to the irrational, emotional nature of human beings.  The economics Alan Greenspan had a sign reading “Greed is Good” on his door.  Greed is also one of the Seven Deadly Sins.  I remember thinking that adjustable rate mortgages were a big mistake.  People tend to be overly optimistic and often overlook misfortune in their future.  This combined with increases in interests rates could cause many too default on their mortgages.  I had no idea of the extent of shenanigans  that were taking place.  Optimism regarding the never ending increase in real estate values precluded any rationality or safeguards.  Unfortunately, the changes in financial regulation were woefully inadequate, and another market crash looms in the future.  That is unless more attention is paid to behavioral economics and appropriate legislation is passed.  Unfortunately, although the influence of behavioral economics has grown, I was pleased to learn that Thaler had been elected President of the American Economics Association, it has yet to become mainstream.  Until it does, we remain at risk as the rational model of humanity is flawed.  Economics needs to be based on what humans do, not on a theoretical model based on rationality.

Misbehaving: The Making of Behavioral Economics is a real gem.  Unfortunately it presents me with a real dilemma.  I could easily spend several months writing posts based on this book.  However, I fear that some readers would not appreciate the emphasis being placed on economics and become bored.  Moreover, focusing on Thaler’s book would force me to neglect some needed topics.  So, what I shall do is to occasionally reach back to this book for posts that seem especially relevant.

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