Today I went back to work on my dissertation. When researching more about reference-dependent preferences and reference-dependent risk attitudes, I stumbled across an interesting lecture of the economist Matthew Rabin, held at ITAM in 2011. Rabin is the Pershing Square Professor of Behavioral Economics in the Harvard Economics Department and Harvard Business School. Together with Koszegi, Rabin published an alternative model of reference dependent preferences in 2006. Furthermore, Koszegi and Rabin used this alternative model in 2007 to look at reference dependent risk attitudes and this is how I took notice of Rabin’s lecture at ITAM in the first place.
What I want to talk about in my post today is how Matthew Rabin described the evolution of behavioural economics in his lecture at ITAM (Galvan, 2011a, 2011b, 2011c). In particular, he argues that behavioural economics has emerged in three waves:
- Identifying anomalies,
- Formalising alternatives and
- Fully integrating behavioural economics into economic theory.
What he calls the ‘first wave’, was the time in which behavioural economics was mainly concerned with describing anomalies in actual human behaviour which does not fit into the standard economic model and does not correspond to ‘homo economicus’ (economic man). During that period, Richard Thaler, for example, published a regular column entitled ‘Anomalies’ in the Journal of Economic Perspectives.
In the ‘second wave’, behavioural economics reverted to formalising alternatives and empirical tests of the alternative models. This was the time of extensive experimental research on concepts like loss aversion, present-bias and social preferences and in some respect this experimental research continues.
However, Rabin argues that we are now in the stage where behavioural economics starts to become fully integrated into the field of economics. In this ‘third wave’, the insights of behavioural economics now improve the realism of economic models. Furthermore, Rabin argues that behavioural economics today enables us to reintroduce theory into empirical economics, which has taken over in recent years after abandoning standard economic theory due to its major shortcomings. In the ‘third wave’, behavioural economics is now merging with empirical economics. This is why these are exciting times for aspiring economists: On the one hand, we have empirical economic research which can capture actual human behaviour and, on the other hand, we have behavioural economics which provides the theoretical backbone for explaining the data. This merger is crucial for understanding the driving forces of human behaviour and for better policy making as well. Empirical economics in itself – without the necessary theory – is of limited value for policy makers if it remains unclear what the underlying systematic mechanisms of behaviour are. As far as I understand, the combination of behavioural economics and empirical economics is what Rabin envisions the ‘new economics’ to be: Having both the mathematical formalism and rigour in behavioural economics as well as empirical evidence for explanatory power.
Another interesting point raised by Rabin is that behavioural economics is actually not arguing against ‘rationality’; rather it is arguing against the stereotype of the self-interested ‘homo economicus’ and the unrealistic assumptions that accompany this stereotype. Rabin argues that behavioural economics is not about people systematically making ‘errors’ because they exert bounded rationality. On the contrary, it allows for ‘rationalisable behaviour’. People may be perfectly rational in not acting in a purely self-interested manner. If they have, for example, social preferences then they actually act rational by being altruistic, fair etc. because they derive pleasure from doing so. Hence what Rabin argues is that behavioural economics has not ruled out rationality per se. In fact, behavioural economics shows that people behave ‘rational’ or ‘rationalisable’ most of the time when accounting for their preferences and other factors. As Dan Ariely (2009) put it, we are predictably irrational; ‘predictably’ implying that there are systematic forces that can explain the behaviour we observe.
I encourage you to have a look at the lecture (it is split into three parts; see references below uploaded by J.M. Galvan). After the overview on behavioural economics, Rabin continues to talk about the concept of ‘present bias’ and, in particular, his research in the field, including examples of procrastination and time inconsistency. It is inspiring and exemplifies how this emerging field is revolutionising the study of economics.
Many thanks for reading!
Ariely, D. (2009). Predictably Irrational: The Hidden Forces that Shape Our Decisions. London: Harper Collins.
Galvan, J.M. (2011a). Matthew Rabin ITAM I [Video]. Available from: https://www.youtube.com/watch?v=O2ORi5Oxzaw [Accessed 08/10/2016]
Galvan, J.M. (2011b). MAH06418 [Video]. Available from: https://www.youtube.com/watch?v=_qYCPcxUB98 [Accessed 08/10/2016]
Galvan, J.M. (2011c). Matthew Rabin ITAM III [Video]. Available from: https://www.youtube.com/watch?v=vX23nwR_Eoo [Accessed 08/10/2016]
Koszegi, B.R., Matthew (2006). A Model of Reference-Dependent Preferences. The Quarterly Journal of Economics, 121(4), pp.1133-1165.
Koszegi, B. and Rabin, M. (2007). Reference-Dependent Risk Attitudes. American Economic Review, 97(4), pp.1047-1073.