May 29, 2015 by Darius
Last week, I saw noted economist Richard Thaler discuss his new book Misbehaving: The Making of Behavioral Economics.
Thaler began with an example: at an after-dinner discussion with graduate students at his house, Thaler put out a bowl of cashews. Quickly, though, everyone agreed the cashews were a problem and asked Thaler to take them away. The kicker, though, is that according to conventional economic thinking, you cannot be worse off having a bowl of cashews present than not; you cannot be made better off having had options eliminated. You simply eat the cashews if doing so would be in your self interest and otherwise ignore them. It was obvious, though, that in real life, everyone indeed felt better off without the bowl of cashews.
The bowl of cashews was one of Thaler’s moments of epiphany. He likened his cashews to Newton’s apple.
He started asking people, for fun, while working on his dissertation, how much they would pay for the cure to a fatal disease they had a one in 1000 chance of having already contracted. Then he asked the same people how much money they would need to be paid in order to participate in a medical study that would entail a one in 1000 chance of exposing them to the same fatal disease. The amount people demanded to voluntarily be exposed to the disease was far higher than the amount they were willing to be paid to potentially be rid of it. From an economics standpoint, of course, this makes no sense: the risk of the disease should be worth the same amount of money to a given individual in both cases.
Thaler used these points to illustrate the crux of behavioral economics: the standard economic practice of today – reflected in teaching and policy recommendations alike – is based on assumptions that people always act rationally in their self-interest. In the real world, though, people do not act rationally.
According to Thaler, mainstream economic thought was originally behavioral. Adam Smith himself was a behaviorist, and behaviorism was regarded as economic common sense for more than a century. Beginning in the 1940s, however, mathematics chased behaviorism out of economics. Why? According to Thaler, the easiest mathematical economics problems to solve are optimization problems, so economists looking to burnish their mathematical credentials turned to the issue of optimization. This led to an increasing generalization that economic models would assume optimization. As Thaler put it, over the next 40-50 years, the “agents” of economic models got smarter and smarter. Actual people did not.
Thaler felt it is vital to put behaviorism back into economics. Specifically, he said realistic assumptions in economics are critical because economists have the monopoly on social science advice to heads of government and policymakers. Having unrealistic models makes for bad policy. Thaler hopes that one day there will be no need for “behavioral economics,” that all economics will again be infused with a better understanding of human behavior. But for now, it seems that economics desperately needs the injection of realism provided by behaviorism.
I look forward to reading Misbehaving: The Making of Behavioral Economics.