The Beginnings of Behavioral Economics

Katona, Simon, and Leibenstein's X-Efficiency Theory

Roger Frantz

• Publisher: Academic Press
• Year: 2019
• Print ISBN: 9780128152898
• eBook ISBN: 9780128157053
• Topic: Economics
• Subtopic: Microeconomics
• Index: Economics

The Beginnings of Behavioral Economics: Katona, Simon, and Leibenstein's X-Efficiency Theory explores the mid-20th century roots of behavioral economics, placing the origin of this now-dominant approach to economic theory many years before the groundbreaking 1979 work on prospect theory by Daniel Kahneman and Amos Tversky. It discusses the work of Harvey Leibenstein, Herbert Simon, George Katona, and Frederick Hayek, reintroducing their contributions as founding pillars of the behavioral approach. It concentrates on the work of Leibenstein, reviewing his nuanced introduction of X-efficiency theory. Building from these foundations, the work explores the body of empirical research on market power and firm behavior – XE relationship.This book is a tremendous resource for graduate students and early career researchers in behavioral economics, experimental economics, organizational economics, social and organizational psychology, labor market economics and public policy.- Reviews the powerful, but neglected contributions of mid-20th century scholars, like Leibenstein and Katona in building the roots of behavioral economic theory- Amalgamates and reviews 50 years of empirical research and over 200 empirical papers on X-efficiency theory- Establishes how X-efficiency can aid modern behavioral economics in further developing firm theory and understanding efficiency wages

1

Introduction

Abstract

This book argues that there were two beginnings of behavioral economics. The first beginning started in the 1940s and was led with the works of George Katona, Herbert Simon, Harvey Leibenstein, and others. The second, the one that truly revolutionized (behavioral) economics, was led by Kahneman, Tversky, Thaler, and George Akerlof. These two groups are the “old” and “new” behavioral economics, respectively. Or, if you prefer, the first-generation behavioral economics and the generations, which came after. This book will try to show the relationship between these two beginnings and groups, their important similarities, and their obvious differences. There are separate chapters on the work of the “Big 3,” Katona, Simon, and Leibenstein, and; another on other first-generation behavioral economics. There are two chapters on Leibenstein’s research, one that covers the period 1950 to 1960, and the other on his 1966 seminal article on X-efficiency theory. There are then six chapters on the approximately 200 empirical studies on X-efficiency theory using evidence in every continent and many industries. The average level of X-inefficiency worldwide is approximately 20%. The final chapter summarizes the chapters.

Keywords

Old behavioral economics; New behavioral economics; First-generation behavioral economics; Later generations of behavioral economics; X-efficiency theory; The door

The Boston Celtics of the National Basketball Association won NBA titles in 1959–66, 8 years in a row. They also won the title in 1968 and 1969. They were led by their 6′9″ Center, Bill Russell, a man considered the greatest defensive player in his or any time. But he hardly ever shot the ball more than 10 or 12 ft from the basket; he wasn’t a good shooter. And, he wasn’t very good at “free throws” 15 ft from the basket. Most tall players of his day weren’t good at either of those skills. The Celtics’ starting line-up was Russell, 6′9″, K.C. Jones, point guard, 6′1″, Sam Jones, shooting guard, 6′4″, Tom Sanders, power forward, 6′6″, and Tom Heinsohn, shooting forward, 6′6″. Average height 6′5″. Consider the current Golden State Warriors. They have won NBA championship is 2015, 2017 and 2018. Their starting line-up averages almost 6′7 1/2″. Their 6′11″ center, and their 6′9″ shooting forward both shoot well from 25′ to 30′ from the basket. With the possible exception of their power forward, the other four starters all shoot “lights out” from 25 to 30 ft. They are good “free throw” shooters.

Current NBA players are taller, in better physical condition, they jump higher, they run faster, and they “fly through the air with the greatest of ease,” spin around 360 degrees while in the air and jam the ball into the basket. There are 6′10″ point guards in today’s NBA. Watch some NBA games from the late 1950s and the 1960s and if think that you are watching a high school basketball game then it would be understandable. The game is that different in 2019 from “back-in-the-day.” But regardless of how different it looks, the Celtics then, and the Golden State Warriors today are playing the same game: basketball. The Celtics were the best in their day: 10 championships in 11 years. Today, they probably would not make the playoffs.

Even when things look different, there are similarities among them. Basketball is basketball. And, behavioral economics is behavioral economics. The 1950s and 1960s version, “old” behavioral economics, may look different from the 1974–2019 version, “new” behavioral economics, just as the 1965 Celtics look different from the 2019 Golden State Warriors. But along with the rather obvious differences there are similarities. This book is about some of the obvious differences and some of the important similarities. Maybe more than this, this book will try to get more well-deserved recognition for those who came before the truly momentous years in the history of (behavioral) economics: 1974 and 1979.

I What this book is about and what it is not about

This book is about the pre-Kahneman and Tversky behavioral economists, and the relationship between their behavioral economics and that of the behavioral economics beginning with Kahneman and Tversky. These two groups are the “old” and “new” behavioral economics, respectively. Or, if you prefer, the first generation behavioral economics and the generations which came after. The “old” group includes Herbert Simon, George Katona, Harvey Leibenstein, who I refer to as the “big 3” of the “old” group. It also includes Boulding, March, Cyert, Scitovsky, Shackle, Nelson, Winter, Duesenberry, Rheinhard Selten, and an early 20th century French Judge and sociologist Gabriel Tarde. Tarde is a forerunner of behavioral economics because he wrote about behavioral economics in the early years of the 20th century. The others are first gen behavioral economics because they started writing about it in the 1940s.

Paul Samuelson in 1949 wrote about the “sophisticated-anthropomorphic sin.” This “sin” is not realizing that the content of those who came before is equivalent to those who came later because the earlier group does not use the same terminology or symbols as the later group. Equivalent is too strong a word in this case. But what I will try to show in this book is that the ideas and topics written about by the “old” group was also in the writings of the new behavioral economists, in substance if not in style.

One of the most important aspects, if not the most important aspect of their common interest/substance was to show that homo economicus was, to use a term used by Richard Thaler, a unicorn. So long as homo economicus, the unicorn, was the model human, behavioral economics would not exist. Homo economicus is a fully rational maximizer. His behavior is based on certain rules, similar with the way gravity “behaves” according to certain rules. He can’t act in any other way because he does not have free will. Homo economicus is, therefore, a robot, a machine which acts according to the “software” programs placed in its “hardware.” Kahneman, Tversky, and Thaler wrote about the gap between full rationality and human rationality, but Katona, Simon, and Leibenstein wrote about this gap as much as 30 years before Kahneman, Tversky, and Thaler. The other first gens also wrote about this gap.

Below is a quote from each of Katona, Simon, and Leibenstein. The quotes indicate their research agenda. The quotes do not sound similar with the “new” behavioral economists. They do sound more the way economists wrote in the 1950s and 1960s.

Unlike pure theorists, we shall not assume at the outset that rational behavior exists or that rational behavior constitutes the topic of economic analysis. We shall study economic behavior as we find it

Katona (1951, p. 16).

…replace the global rationality of economic man with a kind of rational behavior that is compatible with the access of information and the computational capacities that are actually possessed by organisms, including man, in the kinds of environments in which such organisms exist

Simon (1955, p. 99).

At the core of economics is the concept of efficiency. Microeconomic theory is concerned with allocative efficiency. Empirical evidence… suggests that… allocative efficiency is trivial…microeconomic theory focuses on allocative efficiency to the exclusion of other types of efficiencies that, in fact, are much more significant in many instances

Leibenstein (1966, p. 392).

The “old” group developed larger themes, they did not do experiments. The larger themes included the nature of human rationality and non-allocative efficiency. The new behavioral economists do experiments about the nature of human rationality, to name but one theme. Both the old and the new behavioral economists reject the characterization of human rationality being that of homo economicus. The styles of the “old” and the “new” differ from each other, but the substance, I assert, is very similar with respect to perhaps the most important topic in behavioral economics: the nature of human rationality.

This book is not a platform for whining. Whining is making a sad, often nasally sound, expressing discontent, disappointment or unhappiness. There will be no whining in this book. What would I whine about? First, an opinion piece published in the New York Times on February 11, 2001. The authors is Louis Uchitelle, the title, “Some Economists Call Behavior a Key.” The sentence which sent many behavioral economists of my age group, 55 in 2001, into a total tizzy was, “In the histories of economics still to be written, the spring of 1994 will almost certainly be flagged as momentous. That is when… David Laibson… received his Ph.D. in economics” (Uchitelle, 2001). The tizzy followed a sense of being diminished, rejected, and ignored. Some number of these behavioral economists of my age never accepted the changing nature of behavioral economics, from the approach of Katona, Simon, and Leibenstein, and others, to that of Kahneman, Tversky, Thaler, and others who came after them. The complaint was that behavioral economics seemed to have begun with a set of big ideas which ran contrary to neoclassical economics. It then shifted into a newer version of neoclassical economics which “captured” every aspect of human nature and behavior which seemed contrary to neoclassical economics. Many members of the “old guard,” those around age 55 in 2001, were furious, saying, “You can’t turn neoclassical economics into behavioral economics by adding a parameter to your model.”

With hindsight, it was naïve to think that as behavioral economics became more intriguing to economists that it would not be incorporated as much as possible into neoclassical economics. At the same time, the “old” groups, the first gen behavioral economics—Simon, Katona, Leibenstein, Boulding, March, Cyert, Scitovsky, Shackle, Nelson, Winter, Duesenberry, Rheinhard Selten, Gabriel Tarde, and others—have to various degrees been discounted, under-appreciated, forgotten by the “new” behavioral economists. I am not going to whine about this. I am only going to try to explain why the “old” group laid some of the ground-work for the “new” group. And hence why they deserve a better treatment than they have received. Kahneman and Tversky, and Thaler all deserved the Nobel Prize, so did Herbert Simon and Reinhard Selten.

II Two beginnings, one door

Behavioral economics had two beginnings. The famous beginning, the truly revolutionary beginning, was in the years 1974 and 1979. The first year, 1974, was when Tversky and Kahneman published their article in Science, “Judgment Under Uncertainty: Heuristics and Biases.” The second year, 1979, was when Kahneman and Tversky published their article in Econometrica, “Prospect Theory: An Analysis of Decisions Under Risk.” Shortly after was the beginning of a long “train” of important publications by Richard Thaler. The other beginning started in the 1940s with several publications by George Katona and Herbert Simon, followed in 1950 and then 1966 by Harvey Leibenstein. There was also Shackle beginning in the early 1940s, Duesenberry in 1949, March and Simon in 1958, Selten in the mid-1960s, and others. There can be two beginnings in behavioral economics because the first one, the one beginning in the 1940s, was been discounted. Some believe that there was only one beginning, but it is a major contention of this book that there were two.

As a way of thinking about the beginnings and the “old” and the “new” behavioral economics, I divide behavioral economists into three groups. The first gens consist of those who began writings before 1974 and include Katona, Simon, Leibenstein, and the other names already mentioned. The second group, includes Kahneman, Tversky, Thaler, and Akerlof. The third group, also part of the “new” behavioral economists consists of those who began publishing beginning around 1985 or later. This group is also a very illustrious group, including George Lowenstein, Andrei Shleifer, Colin Camerer, David Laibson, Mathew Rabin, Sendhil Mullainathan, and Raj Chetty. To illustrate what each group did in the history of behavioral economics, I use the metaphor of a door. The first gens built a door and on the front placed a sign, “Behavioral Economics. Enter Here.” The second group opened the door. The third group walked into the room. The first and second group had two and three Nobel Prize winners, respectively. Many would not be surprised if this third group has at least three winners. The topic of the two beginnings, and the door are part of Chapter 2.

Chapter 3 is about the “Big 3”—Simon, Katona, and Leibenstein. Simon, the polymath, Nobel Laureate, received his PhD in political science from the University of Chicago at age 27. Katona received his PhD in psychology at the University of Gottingen at age 20. He then studied with the founders of Gestalt psychology before moving to the United States, eventually to Ann Arbor, Michigan where he spent the remainder of his professional life at the University of Michigan. In 1951 his book, Psychological Analysis of Economic Behavior, was published. It was an early major statement about economics and psychology, a.k.a., behavioral economics. Rabin (2002) sa...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Dedication
• Acknowledgments
• 1: Introduction
• 2: Two beginnings
• 3: The “Big 3.” Simon, Katona, Leibenstein
• 4: It didn’t just happen overnight
• 5: Leibenstein before X-efficiency theory
• 6: X-efficiency. An intervening variable
• 7: Empirical research on XE: c.1967–1990
• 8: XE among US financial institutions: c.1991–2017
• 9: XE among financial firms in Asia: c.1991–2017
• 10: XE among Asian non-financial institutions: c.1991–2017
• 11: XE in Europe: c.1991–2017
• 12: XE in Australia and New Zealand, Latin America, the Middle East, Africa, and the world: c.1991–2017
• 13: Conclusions
• References
• Index