After studying this chapter you will:
• Know the difference between descriptive and normative theories of decision
• Understand how behavioral economics differs from standard (neoclassical) economics – and why
• Appreciate the variety of methods used by behavioral economists
1.1 Economics: Neoclassical and behavioral Economics: Neoclassical and behavioral
This is a book about theories of decision. To use the language of the epigraph, such theories are about the negotiation of “the thorny career of life”: they tell us how we make, or how we should make, decisions. Not that the Marquis de Sade would have spoken in these terms, living as he did in the eighteenth century, but the theory of decision seems to be exactly what he had in mind when he imagined “the master-piece of philosophy.”
Developing an acceptable theory of decision would be an achievement. Most human activity – finance, science, medicine, arts, and life in general – can be understood as a matter of people making certain kinds of decisions. Consequently, an accurate theory of decision would cover a lot of ground. Maybe none of the theories we will discuss is the masterpiece of which de Sade thought so highly. Each theory can be, has been, and perhaps should be challenged on various grounds. However, decision theory has been an active area of research in recent decades, and it may have generated real progress.
Modern theories of decision (or theories of choice – I will use the terms interchangeably) say little about what goals people will or should pursue. Goals may be good or evil, mean-spirited or magnanimous, altruistic or egoistic, short-sighted or far-sighted; they may be Mother Teresa’s or the Marquis de Sade’s. Theories of decision simply take a set of goals as given. Provided a set of goals, however, the theories have much to say about how people will or should pursue those goals.
Theories of decision are variously presented as descriptive or normative. A descriptive theory describes how people in fact make decisions. A normative theory captures how people should make decisions. It is at least theoretically possible that people make the decisions that they should make. If so, one and the same theory can simultaneously be descriptively adequate and normatively correct. However, it is possible that people fail to act in the manner in which they should. If so, no one theory can be both descriptively adequate and normatively correct.
Exercise 1.1 Descriptive vs. normative Which of the following claims are descriptive and which are normative? (Answers to this and other exercises can be found in the Appendix.)
(a) On average, people save less than 10 percent of their income for retirement.
(b) People do not save as much for retirement as they should.
(c) Very often, people regret not saving more for retirement.
It can be unclear whether a claim is descriptive or normative. “People save too little” is an example. Does this mean that people do not save as much as they should? If so, the claim is normative. Does this mean that people do not save as much as they wish they did? If so, the claim is descriptive.
Example 1.2 Poker Suppose that you are playing poker, and that you are playing to win. Would you benefit from having an adequate descriptive theory, a correct normative theory, or both?
A descriptive theory would give you information about the actions of the other players. A normative theory would tell you how you should behave in light of what you know about the nature of the game, the expected actions of the other players, and your ambition to win. All this information is obviously useful when playing poker. You would benefit from having both kinds of theory.
Some theories of decision are described as theories of rational choice. In everyday speech, the word “rationality” is used loosely; frequently it is used simply as a mark of approval. For our purposes, a theory of rational decision is best seen as a definition of rationality, that is, as specifying what it means to be rational. Every theory of rational decision serves to divide decisions into two classes: rational and irrational. Rational decisions are those that are in accordance with the theory; irrational decisions are those that are not. A theory of rational choice can be thought of as descriptive or normative (or both). To say that a theory of rational decision is descriptive is to say that people in fact act rationally. To say that a theory of rational decision is normative is to say that people should act rationally. To say that a theory of rational decision is simultaneously descriptive and normative is to say that people act and should act rationally. Typically, the term rational-choice theory is reserved for theories that are (or that are thought to be) normatively correct, whether or not they are simultaneously descriptively adequate.
For generations now, economics has been dominated by an intellectual tradition broadly referred to as neoclassical economics. If you have studied economics but do not know whether or not you were taught in the neoclassical tradition, it is almost certain that you were. Neoclassical economics is characterized by its commitment to a theory of rational choice that is simultaneously presented as descriptively adequate and normatively correct. This approach presupposes that people by and large act in the manner that they should. Neoclassical economists do not need to assume that all people act rationally all the time, but they insist that deviations from perfect rationality are so small or so unsystematic as to be negligible. Because of its historical dominance, I will refer to neoclassical economics as standard economics, and to neoclassical economic theory as standard theory.
This is an introduction to behavioral economics: the attempt to increase the explanatory and predictive power of economic theory by providing it with more psychologically plausible foundations, where “psychologically plausible” means consistent with the best available psychology. Behavioral economists share neoclassical economists’ conception of economics as the study of people’s decisions under conditions of scarcity and of the results of those decisions for society. But behavioral economists reject the idea that people by and large behave in the manner that they should. While behavioral economists certainly do not deny that some people act rationally some of the time, they believe that the deviations from rationality are large enough, systematic enough, and consequently predictable enough to warrant the development of new descriptive theories of decision. If this is right, a descriptively adequate theory cannot at the same time be normatively correct, and a normatively correct theory cannot at the same time be descriptively adequate.
1.2 The origins of behavioral economics
Behavioral economics can be said to have a short history but a long past. Only in the last few decades has it emerged as an independent subdiscipline of economics. By now, top departments of economics have behavioral economists on their staff. Behavioral economics gets published in mainstream journals. Traditional economists incorporate insights from behavioral economics into their work. In 2002, Daniel Kahneman (one of the most famous behavioral economists) won the Nobel Memorial Prize “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” And then, in 2017, Richard Thaler (another leading figure) won the Prize for his contributions to behavioral economics. In spite of its short history, however, efforts to provide economics with plausible psychological foundations go back a long way.
The establishment of modern economics is marked by the publication in 1776 of Adam Smith’s The Wealth of Nations. Classical economists such as Smith are often accused of having a particularly simple-minded (and false) picture of human nature, according to which people everywhere and always, in hyper-rational fashion, pursue their narrowly construed self-interest. This accusation, however, is unfounded. Smith did not think people were rational:
How many people ruin themselves by laying out money on trinkets of frivolous utility? What pleases these lovers of toys is not so much the utility, as the aptness of the machines which are fitted to promote it. All their pockets are stuffed with little conveniences … of which the whole utility is certainly not worth the fatigue of bearing the burden.
Smith wrote these words 200 years before the era of pocket calculators, camera phones, iPads, and smartwatches. Nor did Smith think people were selfish: “[There] are evidently some principles in [man’s] nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.” Smith and the other classical economists had a conception of human nature that was remarkably multi-faceted; indeed, they did not draw a sharp line between psychology and economics the way we do.
Early neoclassical economics was built on the foundation of hedonic psychology: an account of individual behavior according to which individuals seek to maximize pleasure and minimize pain. In W. Stanley Jevons’s words: “Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics. To satisfy our wants to the utmost with the least effort … in other words, to maximise pleasure, is the problem of Economics.” The early neoclassical economists were inspired by the philosopher Jeremy Bentham, who wrote: “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure … They govern us in all we do, in all we say, in all we think.” Because it was assumed that individuals have direct access to their conscious experience, some economists defended the principles of hedonic psychology on the basis of their introspective self-evidence alone.
After World War II, however, many economists were disappointed with the meager results of early neoclassicism in terms of generating theories with predictive power and so came to doubt that introspection worked. Similar developments took place in other fields: behaviorism in psychology, verificationism in philosophy, and operationalism in physics can all be seen as expressions of the same intellectual trend. Postwar neoclassical economists aimed to improve the predictive power of their theories by focusing on what can be publicly observed rather than on what must be experienced. Instead of taking a theory about pleasure and pain as their foundation, they took a theory of preference. The main difference is that people’s feelings of pleasure and pain are unobservable, whereas their choices can be directly observed. On the assumption that choices reflect personal preferences, we can have direct observable evidence about what people prefer. Thus, postwar neoclassical economists hoped to completely rid economics of its ties to psychology – hedonic and otherwise.
In spite of the relative hegemony of neoclassical economics during the second half of the twentieth century, many economists felt that their discipline would benefit from closer ties to psychology and other neighboring fields. What really made a difference, however, was the cognitive revolution. In the 1950s and 1960s, researchers in psychology, computer science, linguistics, anthropology, and elsewhere rejected the demands that science focus on the observable and that all methods be public. Instead, these figures advocated a “science of cognition” or cognitive science. The cognitive scientists were skeptical of naive reliance on introspection, but nevertheless felt that a scientific psychology must refer to things “in the head,” including beliefs and desires, symbols, rules, and images. Behavioral economics is a product of the cognitive revolution. Like cognitive scientists, behavioral economists – though skeptical of the theories and methods of the early neoclassical period – are comfortable talking about beliefs, desires, rules of thumb, and other things “in the head.” Below, we will see how these commitments get played out in practice.
To some, the fact that behavioral economists go about their work in such a different way means that they have become economists in name only. But notice that behavioral economics is still about the manner in which people make choices under conditions of scarcity and the results of those choices for society at large – which is the very definition of economics. Behavioral science refers to the scientific study of behavior, which makes behavioral economics a kind of behavioral science.
Psychology and economics is also a broader category, referring to anything that integrates the two disciplines, and which therefore does not need to be about choice at all.
Before we explore in earnest the concepts and theories developed by behavioral economists in the last few decades, I want to discuss the data that behavioral economists use to test their theories and the methods they use to generate suc...