Nature of Behavioral Economics
2016 was a calamitous year for experts and their opinions. Two events happened that defied these opinions and have caused chaos and volatility in various markets all over the world. In June the Brexit referendum in the UK caught most experts, including economists, by surprise. Many of them had publicly expressed views that, in their assessment of evidence, lent support to a Remain position. The chairman of the Bank of England, Mark Carney, was one of many to have done this, in terms of forecasting the effects on the UK economy of leaving the EU. Various other institutions, including the International Monetary Fund and the European Central Bank, had made similar statements, thereby supporting the stance of the UK prime minister and chancellor. Michael Gove, a prominent supporter of Brexit, responded by saying ‘We have had enough of experts’.
Donald Trump’s victory in the US election in November came as even more of a surprise to many. At the beginning of the year he was not even expected to feature well in the election primaries, let alone be a viable candidate for president. In the run-up to the election and during the pre-election debates he stumbled repeatedly, continually making factual errors and gaffes. Not least, he received highly unfavorable publicity regarding his attitudes and behavior towards women. At the date of the election he had 75 lawsuits outstanding against him and his business concerns. Trump garnered many votes from immigrants, Muslims and other minorities, women, and unionized workers, in spite of the fact that in previous months he had behaved or advocated policies against their interests. One commentator likened the situation to turkeys voting for Christmas.
Following these two history-changing events, the political climate in Europe is undergoing significant change. Some of the underlying developments were evident before 2016, such as the rise of xenophobic far-right, or alt-right, parties, but this trend has gathered considerable momentum since then. For many years, questions of European integration seemed to turn on economic issues: trade liberalization, convergence to common standards, and monetary union, to name just some of the more prominent ones. What we are seeing since 2016, however, is the return of fundamental political concerns regarding the European Union, with many expecting significant changes in the political and economic map of Europe over the coming years.
The issues raised by Brexit and the Trump victory reach beyond the traditional domain of economics, certainly if seen through the eyes of the economic mainstream. And yet, many of the concerns that people were voting on were economic in nature: trade, jobs and social policy, and increasing income inequalities in particular. At the heart of all this lies a fundamental question which mainstream economics struggles to answer:
Why did voters behave the way they did in both the US and the UK, seeming to vote against their own interests?
We will argue that this question can only be answered by applying the principles of behavioral economics, which involves an interdisciplinary approach. Economists have spent too much time focusing on what people do and trying to understand empirical patterns of behavior through analyses that, at their heart, lack a behavioral approach, making implicit assumptions related to rationality. In doing so, they have avoided examining why people do what they do. Only by considering the ‘why’ question, which means incorporating psychology and related disciplines, can we develop a deeper understanding of economic behavior that at first sight appears irrational and beyond the remit of economic analysis. As we will see, much of our day-to-day behavior proceeds along lines quite different from those of a putative homo oeconomicus. It is only through an appreciation of this richer perspective on economic behavior that we can hope to arrive at better predictions.
1.1 Behavioral economics and the standard model
What is behavioral economics?
Economic phenomena relate to any aspect of human behavior that involves the allocation of scarce resources; thus economics is very wide-ranging in its subject area. For example, all of the following can be described as economic phenomena, although they may also of course involve other disciplines of study: searching for a future spouse on the internet, watching a documentary on television, making a charitable donation, giving a lift to one’s neighbor in order to make it easier to ask them for a favor later, deciding to take a nap rather than mow the lawn, teaching one’s child to play tennis, and going to church.
Economics, like any other social science, is concerned with developing theories whose ultimate aim it is to help us better understand the world we live in. Economic theories attempt to describe and explain relationships between economic phenomena. In order to do this they need to proceed on the basis of a number of assumptions or premises. Sometimes these assumptions are made explicit, but in many cases they are implicit, and it is often important to tease out these implicit assumptions: if a theory proves to be inaccurate in its empirical implications this tells us that if we have deduced these implications correctly from the underlying assumptions of the theory, we should query those themselves.
This is where behavioral economics is relevant. As Camerer and Loewenstein (2004, p. 3) succinctly put it:
Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations.
Hence, behavioral economics is not seeking to replace the standard framework of analysis. It seeks to add to this framework:
It is important to emphasize that the behavioral economics approach extends rational choice and equilibrium models; it does not advocate abandoning these models entirely. (Ho, Lim and Camerer, 2006, p. 308)
In order to understand these claims, and also to understand various critiques of behavioral economics, we must examine the major assumptions underlying the standard model that Ho, Lim and Camerer allude to in the quotation above, and then consider various important and widespread phenomena where this model has run into some difficulty to explain – which are frequently referred to as anomalies.
We will also see that unrealistic assumptions as such may still yield useful empirical insights. It is difficult to conceive of economic theories that are not built on some kind of abstraction from the rich complexity of economic phenomena. This means that there will always be a trade-off situation between highly abstract but general behavioral assumptions, such as they can be found in the standard model, and empirically better grounded yet often quite context-specific assumptions as we find them in behavioral economics, an issue that was recognized as far back as 1991:
It is in the nature of economic anomalies that they violate standard theory. The next question is what to do about it. In many cases there is no obvious way to amend the theory to fit the facts, either because too little is known, or because the changes would greatly increase the complexity of the theory and reduce its predictive yield. (Kahneman et al., 1991, p. 205)
Standard models and economics
The term ‘standard model’ has been used in the previous two paragraphs to indicate a contrast between behavioral economics and what might be called ‘mainstream’ economics. However, as mentioned in the preface, this distinction has been losing its validity over recent years, particularly since the financial crisis in 2007. In order to understand this dynamic it is really necessary to consider ‘standard models’ in other areas of science. Perhaps the most fundamental, at least in a reductionist sense, is the standard model of particle physics, which seeks to describe and explain the elementary particles and forces in the universe. This theory coalesced in the 1970s and has had great success in predicting the existence of new particles, notably the Higgs boson in 2012. However, it is acknowl-edged that the theory is incomplete, since it does not give an account of gravity, nor does it account for either dark matter or dark energy, which cosmologists estimate constitute about 96% of the mass-energy in the universe. As a result, some might say this means that the ‘standard’ theory is highly incomplete. Cosmologists have developed the model further in the 1990s, referring to a lambda-CDM model, which does take into account dark matter and dark energy, but this is also incomplete and is more speculative.
Both of the above models have certain aspects in common with what has been called the standard economic model, but there are some differences also. Both have coalesced into a generally accepted standard model much more recently, and for that reason can be claimed to have fewer anomalies. As a consequence scientists expect further observations to result in minor modifications of the models rather than a drastic overhaul. However, caution is needed here, since physicists had the same attitude at the end of the nineteenth century, believing classical physics was more or less complete, and then came the revolu-tions of quantum mechanics and general relativity which dramatically altered the previous ‘standard model’.
Perhaps the ‘standard model’ closest to economics is in evolutionary biology, with the neo-Darwinian synthesis. As in economics, the main foundation was laid in the nineteenth century, but fundamental modifications to the model were made in the twentieth century to take into account discoveries in genetics, and then molecular biology. It wasn’t until the discovery of DNA in 1953 that this model moved close to being regarded complete. It can be claimed that the ‘modern synthesis’ has fewer anomalies than most other standard models in the sciences, and again biologists expect future observations to only yield minor modifications. Nevertheless, alternative models, most recently emerging from the so-called Evo-Devo literature in evolutionary biology, for example, out of attempts to better account for the morphogenetic development of organisms, proceed from different assumptions and the underlying debates are far from resolved. This aspect of theory development is discussed further in the next chapter.
Where does this all leave us as far as any standard model in economics is concerned? As we will see in the following section, the standard model in economics has its intellectual origins in the neoclassical tradition of economic thought, and is therefore more appropriately referred to as the neoclassical model (NM). By the end of the 1970s it was clear that there were numerous fundamental anomalies in this model, and these accounted for the emergence of behavioral economics. For some decades there was an uneasy tension in the economics discipline, with behavioral economics being regarded as an unruly offshoot from the mainstream, consisting of a number of often conflicting and ad hoc hypotheses, with no coherent body of theory. This situation has gradually changed since the millennium, with more behavioral aspects becoming incorporated into the mainstream of the discipline. As mentioned in the preface, this may ultimately lead to the death of behavioral economics, in terms of its current status as a collection of separate approaches: if its main precepts all become absorbed into a revised standard model that is commonly
accepted then the distinction will cease to be meaningful. For this reason we regard it now preferable to benchmark behavioral economics against a static ‘neoclassical model’ rather than against a dynamic, constantly changing ‘standard model’.
In many ways, debates in economics on the strengths and weaknesses of a standard model are debates on useful and less useful ways of arriving at economic concepts and theories through abstraction from concrete phenomena. Methodological considera...