Emotions and Economics

In today’s post, I want to review the role of emotion in economic behaviour as emotions used to play an important part in Economics. Jeremy Bentham, for example, who is regarded as the founder of modern utilitarianism, gave emotions a prominent role in the decision process and viewed the concept of utility as the sum of emotions. Yet neoclassical economics abstracts utility from its psychological foundations (Loewenstein, 2000). Undergraduate students of Economics, in particular, familiarise with the representative economic agent as a rational and self-interested individual who deploys pure logic to maximise her utility. Insights from behavioural research rarely make it into an Introductory Microeconomics course. Yet more descriptive realism – particularly at undergraduate level – might help to arouse the students’ interest in the field.

economics-and-emotions
Figure 1. Consequentialist model of decision-making (Source: Rick and Loewenstein, 2008, p.139)

So, let’s start with the neoclassical view on emotions in economic behaviour. Standard economic models are consequentialist in nature (figure 1), meaning that choice is modelled as a cognitive process of utility maximisation. This does not rule out the influence of emotions in the decision process as consequentialist models can account for expected emotions, i.e. emotions which the decision-maker anticipates to experience because of her decision. Emotions experienced at the point of decision-making, however, are difficult to capture in these models as the decision-process itself is some form of expectation-based calculus.

Type

When Scope

Expected emotions

After making the decision

Related to the decision

Integral emotions

At the point of decision-making

Related to the decision

Incidental emotions At the point of decision-making

Unrelated to the decision

Table 1 The different types of emotions in decision-making

In contrast, behavioural research has identified two types of immediate emotions which are important for understanding an individual’s choice but which are typically neglected in the neoclassical view (see table above). First, there are integral emotions. They are related to the decision at hand and arise from thinking about the decision’s consequences. As shown in figure 1, consequentialist models can, in fact, be extended to incorporate this type of emotions as there is a causal link between the decision and this type of immediate emotions. Second, there are incidental emotions which are also experienced at the point of decision-making but which are unrelated to the decision, arising from situational influences and visceral factors (Rick and Loewenstein, 2008). Yet because incidental emotions are irrelevant to the decision, they are difficult to capture in the consequentialist perspective. What is more, economists tend to refrain from incorporating visceral factors in their analyses as (1) “visceral factors often drive people to behave in ways that they view as contrary to their own self-interest” and as (2) “people tend to underestimate the impact of visceral factors on their own current and future behaviour” because these complications run counter to the view that decision-making is a cognitive process (Loewenstein, 2000, p.428). Fortunately, with the rise of behavioural economics, integral and incidental emotions re-enter economic analyses. Starting with counterfactual emotions such as regret, more realistic models of behaviour emerge which re-connect emotions and utility. In the last few years, in particular, one can see a rethinking in economic modeling, for example, with the risk-as-feelings hypothesis by Loewenstein, Weber, Hsee and Welch (2001).

In sum, expected, integral and incidental emotions play an important role in economic behaviour and with a shift towards more psychologically realistic assumptions, they re-enter economic models.

Many thanks for reading; I hope you enjoyed today’s topic!

Jasse


References

Loewenstein, G.F. (2000). Emotions in Economic Theory and Economic Behaviour. Preferences, Behaviour, and Welfare, 90(2), pp. 426-432.

Loewenstein, G.F., Weber, E.U., Hsee, C.K. and Welch, N. (2001). Risk as Feelings. Psychological Bulletin, 127(2), pp. 267-286.

Rick, S., and Loewenstein, G.F. (2008). The Role of Emotion in Economic Behavior. In: M. Lewis, J.M. Haviland-Jones, L.F. Barrett (Eds.). Handbook of Emotions (3rd ed.). New York: Guilford Press.

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The Economics of Deception and Manipulation

I recently finished George Akerlof and Robert Shiller’s latest book Phishing For Phools. While I also enjoyed their earlier book Animal Spirits I have to say that Phishing For Phools is a hidden gem. So I decided to devote today’s post to the book and why every student of Economics should have a copy of it.

What makes Phishing For Phools different?

Phishing for Phools is different because Akerlof and Shiller give the reader a new perspective on Economics. It is not a re-iteration of New Behavioural Economics because it addresses:

  1. The Role of Equilibrium in Competitive Markets,
  2. The Difficulties with ‘Revealed Preference’ and
  3. Story Grafting.

First, Akerlof and Shiller in their perspective on Economics endorse that economic systems converge towards a general equilibrium, albeit a phishing equilibrium. In contrast, work in Behavioural Economics tends to centre on shrouded markets and economic actors having certain weaknesses (e.g. present bias). While these assumptions make phishing undeniable, the results of these studies are not generalisable. Shiller and Akerlof level criticism at Behavioural Economics in its current form because it misses the generality of phishing for phools in our economy. They describe a range of examples in the book with their favourite probably being Cinnabon® bakeries in airports and shopping malls to show that when “people have informational or psychological weaknesses that can be profitably exploited” (p.170), then we can be certain that phishing for phools is going to happen. Hence phishing for phools is a general feature of our economy rather than an externality of shrouded markets or biases of non-rational economic actors.

phishing equilibrium.png
A Phishing Game

I am thinking of Akerlof and Shiller’s phishing equilibrium in the Cinnabon® example as a Pareto-inferior equilibrium in a simple two-player “Phishing Game” with a consumer (C) and a firm (F). Here the consumer, that is the row player, has some true preferences and some monkey-on-the shoulder tastes. Both preferences map into some choice. However, the choice based on the consumer’s true preferences yields a higher payoff for her than her choice based on her monkey-on-the-shoulder tastes (assuming that the firm simultaneously chooses to provide her with that specific good and not the alternative). The column player, that is the firm, has two profit opportunities. It can open a healthy shop or a sweet & tasty shop in the airport or shopping mall where the consumer can easily be phished for a phool. I have arranged the firm’s and consumer’s payoff similar to the Battle of the Sexes game with the modification that the consumer receives a payoff of 3 and not 2 in the optimal equilibrium. This allows us to distinguish the two equilibria into an equilibrium which maximises social welfare (Healthy Shop | True Preferences) and a Pareto-inferior one, i.e. a phishing equilibrium (Sweet & Tasty Shop | Monkey-on-the-Shoulder Tastes). Both the consumer and firm want to coordinate in the sense that the consumer wants to consume and the firm wants to sell. However, the firm wants to maximise profits by selling its sweet and tasty products rather than selling a healthy product (which might allow for a lower mark-up).

Crucially, Akerlof and Shiller argue that such a ‘general equilibrium’ perspective with phishing for phools as a general feature of the economy gives an answer to why economists did not see the financial crisis coming: they did not look for phishes stemming from the informational and psychological weaknesses of economic actors and the counterparts that profitably exploited them.

Moving on to the second argument; the book is also not a re-iteration of Behavioural Economics because it challenges Revealed Preference. The authors criticise this concept and the general acceptance of it in Behavioural Economics. As mentioned above, Akerlof and Shiller distinguish between what people really want and what they think they want, i.e. their monkey-on-the shoulder tastes (and hence the book’s caption The Economics of Deception and Manipulation). Akerlof and Shiller criticise that both standard economic theory and Behavioural Economics assume that people optimise and therefore make choices which maximise their utility. Both fields tend to assume that people reveal their preferences if free to choose and given all the necessary information. This allows for the simple assumption that, in theory and practice, people’s choices reflect their true preferences. However, this is not what we observe: Akerlof and Shiller give plenty of examples in their book which they call the NO-ONE-COULD-POSSIBLY-WANTs. They categorise them into the areas of (1) personal financial security, (2) the stability of the macroeconomy, (3) health, and (4) the quality of government in order to highlight how prevalent they are. The book therefore challenges both standard economic theory and Behavioural Economics for overlooking this subtle but important difference between true preferences and what people think they want.

Third, Story Grafting makes the book different from Behavioural Economics. Akerlof and Shiller make the case for a new variable in Economics, that is the story that people are telling themselves. While Behavioural Economics has come up with a choice menu of psychological biases to explain non-rational behaviours, it has often eschewed the underlying mental frames of decision-making. Daniel Kahneman (1999, in Kahneman and Tversky, 2000, p.xiv) once said that we

apply the label “frame” to descriptions of decisions at two levels: the formulation to which decision makers are exposed is called a frame and so is the interpretation that they construct for themselves.

New Behavioural Economics has very much focused on the latter. It is the frame which decision-makers have control about. In contrast, the frame which decision-makers are exposed to is much broader and in some sense out of their control. Akerlof and Shiller’s stories describe these broader frames which are shaped in great deal by the media and our environment and peers. Rather than having a choice menu of psychological biases, Akerlof and Shiller argue for recognising these broad mental frames that influence individuals’ decisions. Stories, like phishes, are a general feature of our economy. Economics as a study of society needs to go beyond the analysis of the exchange of scarce resources. It needs to become more inclusive. In particular, Akerlof and Shiller argue that “we should be inclusive of whatever thinking, conscious or subconscious, is the basis for people’s decisions” (p.172).

In my opinion, Akerlof and Shiller have crafted a hidden gem with their book Phishing For Phools because it really offers a new perspective on Economics which goes beyond recent work in New Behavioural Economics. It makes the case for phishes and stories as a general feature of our economy and makes the subtle but important differentiation between true preferences and monkey-on-the-shoulder tastes. This New Economic perspective is more inclusive and much needed to understand how people make decisions.

So I hope that my post today has inspired you to give the book a chance. Many thanks for reading,

Jasmin


References

Akerlof, G.A., and Shiller, R. (2015). Phishing For Phools: The Economics of Deception and Manipulation. Princeton: Princeton University Press.

Kahneman, D. (1999). Preface. In: Kahneman, D., and Tversky, A., eds. (2000). Choices, Values and Frames. Cambridge: Cambridge University Press, pp. ix-xvii.

The Behavioural Shift

While taking a break from studying and researching for my Honours Economics thesis, I came across an inspirational talk on The Behavioural Shift by Colin Camerer, Andrew Caplin, and David Laibson – all of whom are leading behavioral scholars. They were invited to discuss how their research has given valuable insight into economic models of human behavior at the Becker Friedman Institute located at the University of Chicago in the United States.

I must say that especially Harvard Economist David Laibson inspires me to learn more on Behavioural Economics and pursue research in the area myself in the future! What is more, Camerer’s, Caplin’s and Laibson’s discussion about new cutting edge research and the future of Behavioural Economics reassures me that my dream of graduate studies in Economics is not only personally fulfilling but it is also going to be an exiting area to specialise in.

While the panel is lengthy, it is more than worth it. After presenting their research, the behavioural scholars Camerer, Caplin and Laibson engage in an insightful discussion with their two hosts and also answer questions from the audience.

So don’t miss out on this inspirational talk if you are interested in the behavioural shift…

Jasse

David Kreps on Dynamic Choice

While researching and preparing for my applications for graduate studies in Economics, I came across a highly inspiring lecture by David Kreps who is the Adams Distinguished Professor of Management as well as Professor of Economics at Stanford. Under the heading “Choice, Dynamic Choice, and Behavioral Economics” Kreps contrasts how the discipline of economics models choice and, in particular, how the discipline models dynamic choice with more realistic models which draw on behavioural economics. Thereby Kreps’ research program is at the forefront of this with Kreps’ mission being:

To provide economists with “better” (more realistic, more consistent with observed behaviour) models of dynamic choice.

As an introduction to the lecture, Kreps first discusses how the discipline of economics works. Kreps argues that the bedrock of standard economics is that: (1) people make consistent choices and (2) these choices are equilibrated in markets and other institutional settings. Note here that some economists say that people make ‘rational choices’ rather than ‘consistent choices’. However, Kreps reverts to the wording ‘consistent choices’ to circumvent calling choices ‘irrational’ which do not conform with the standard economic model. Having laid out the basics, Kreps exemplifies what consistent choice in economics means in reality. It prohibits any situation like the following:

David Kreps.png
(Kreps, 2015, 2:37-3:12)

The situation in the roadside diner is the typical example of inconsistent choice. Why? Because the customer prefers the apple pie initially when having the choice between apple and peach pie. We could say that the individual maximises his utility by purchasing the apple pie. However, when confronted with a seemingly irrelevant third alternative, that is banana crème, his preference changes. He now chooses peach pie over both apple pie and banana crème. In the world of standard economics this cannot happen because economists assume that the customer will stick to his preferences no matter what. If he chooses apple pie and not peach pie if both options are available to him, then he will never choose peach pie over apple pie when both options are available to him. In short: He will always choose apple because he prefers apple pie. Besides consistent choice theory being the bedrock for economics, this assumption is also necessary for maximising utility. We need this independence of irrelevant alternatives/ preference stability in the choice of an economic agent to conclude that individuals are utility maximisers. Otherwise we cannot model the decision-making process as one of maximising utility with a simple numerical function as commonly done in utility theory, expected utility theory and subjective expected utility theory.

After having set the scene what consistent choice is in economics, Kreps looks at empirical evidence. He argues that empirically the assumption that people make consistent choices does not hold. There is watertight evidence that the environment and other seemingly irrelevant alternatives available to you change the ‘frame’ of the choice. One of the examples is marketing which relies heavily on manipulating the frame of a decision, inducing individuals to buy their products. Hence, compared to economists, marketers have long recognised that people fall prey to inconsistent choices, for example depending on which products they advertise simultaneously. In contrast, economists still go with ‘consistent choice’ because otherwise their decision theory breaks down. Conventional economists tend to ignore the ‘frame’ of the decision.

Next Kreps looks at dynamic choice. The situation of the apple and peach pie is an example of static choice. Kreps, however, is more interested in dynamic choice; that is, choices that have implications for the future and influence future choices like education or savings decisions. Again, standard economics looks at dynamic choice problems through the lens of utility maximisation. It assumes that economic agents act ‘as if’ they could figure out the set of strategies and the outcomes of each strategy in a dynamic choice problem and hence could plainly act ‘as if’ they maximised their utility subject to their ‘budget constraint’. According to Kreps, utility maximisation and the ‘as if’ assumption are not a good model of dynamic choice due to the following three reasons:

  1. Tastes change.
  2. People know that the future is highly uncertain and often unpredictable and they take this into account in the decisions they make today.
  3. People rely on heuristics when it comes to complex dynamic choice problems.

In the remainder of the lecture Kreps looks at all three reasons in more detail. In terms of changing tastes, he argues that people have three basic options. On the one hand, individuals can acknowledge that tastes changes but do nothing. On the other hand, if they wanted to take some action, they could either constrain themselves via a commitment device or deliberately choose to remain flexible and choose not constrain themselves.

In relation to the second reason, Kreps takes a closer look at what motivates people. Conventional economics models individuals as homo economicus; that is consistent (or rational) and selfish. Under these assumptions incentives are guaranteed to work. Economics has a complete theory of incentives. An example is the simple principal agent model: In order to incentivise the agent, the principal can pay the agent a monetary bonus. This is sufficient for compensating the agent for the risk of putting in high effort but just being unlucky and ending up with an unsuccessful project. On the other hand, social psychologists take a rather different stand on motivation. Kreps points towards the concepts of self-determination and self-perception in social psychology. He sees both as superior to the standard economics stories and argues that social psychology needs to be incorporated into economics if we want to build theories approximating real-world behaviour.

In terms of the third reason for why the ‘as if’ model is unlikely to be a good one for dynamic choice problems, one needs to acknowledge that most of the dynamic decision problems like how much to save for retirement, which school to go to or which career to pursue are far too complex. What is more, in the real world individuals tend to choose by trial-and-error. The only way to find out which option is the best one is often merely to try or alternatively simplify the problem and then use some rule of thumbs, i.e. certain heuristics.

The bottom line of David Kreps’ lecture is that dynamic choice problems matter. They are among the most important ones in terms of their impact on individual’s economic well-being, the economic well-being of society and in aggregate the macroeconomic outlook. However, standard economics, by modeling individuals as utility maximisers, abstracts from how actual individuals behave in our economy. In contrast, what economics really should do is modeling actual human choice using proper assumptions which necessarily move away from “rational decision making” because our world is complex, risky and uncertain. Acknowledging that people do the best they can, given their cognitive limitations, paves the way to a superior theory of choice and, in particular, theory of dynamic choice.

If my short discussion of David Kreps caught your interest; then you should check out the full lecture available from here! Kreps is an amazing speaker and his way of presenting makes the topic – which is fascinating in its own right – even more captivating!

Thanks for reading,

Jasse

 


References

Kreps, D. (2015). Choice, Dynamic Choice, and Behavioral Economists [Video]. Available at: http://www.gsb.stanford.edu/insights/david-kreps-choice-dynamic-choice-behavioral-economics [Accessed 22 October 2016].

David Laibson on Behavioural Economics and Public Policy Design

At the Behavioural Economics Symposium in Singapore in 2013 David Laibson, who is Robert I. Goldman Professor of Economics at Harvard University, gave a lecture on how behavioural economics is changing public policy making in the 21st century. Under the heading Towards Better Policy Design and Evaluation: Behavioural Economics and Randomised Controlled Trials Laibson (2013a, 2013b) looked at the growing importance of behavioural economic concepts as well as randomised control trials.

Laibson introduces the lecture by contrasting mainstream economic assumptions with the assumptions in behavioural economics. Standard economics assumes rationality and optimising behaviour while behavioural economics recognises that people are often confused or do not follow through on their plans. Laibson then continues with the example of savings behaviour to contrast effective policy making based on classical economic assumptions with effective policies based on behavioural economic assumptions. In particular, he shows that under the assumption of rationality and optimisation (‘homo economicus’), incentives and education should prove powerful to induce people to make use of their 401(k) savings plans. Yet the randomised control trials which Laibson conducted together with Choi and Madrian in 2010 suggest the opposite: incentives and education about the benefits of enrolling in a 401(k) savings account to maximise income (targeted at workers of age 59.5 and over) did not lead to the desired effect. It raised participation by only 5 to 10 percentage points (Laibson, 2013a, 2013b).

Hence Laibson suggests that we have the ‘classical economics view’ on the one hand and the ‘behavioural economics view’ on the other hand. While the former relies on incentives and education as the most important tools for public policy making, the latter recognises that incentives and education have a rather small effect on their own. Laibson argues that the solution to such failure of incentives and education is to find “interventions that channel good intentions into action” (2013a, p.13). One example of an intervention which channels good intentions into action is a change of opt-in enrolment to opt-out enrolment. Alternatively, one could also implement ‘active choice’, meaning that an individual is required to make a choice. In terms of the 401(k) savings account, this would mean that individuals would be required to make a choice upon the start of her job with a new firm.

Finally, Laibson turns to the domain of health where he sees significant similarities to saving behaviour and where the challenge is also to channel good intentions into action. For example, he argues that individuals often want to change their behaviour in the future by improving their diet, working out more, quitting smoking or other activities beneficial for health. Yet informing people (for example about their caloric intake) does not have the desired effect either. Information and education on its own are shown to have little effect in a range of randomised control trials. What works, according to Laibson, is to align intentions and actions. One example is a flu shot communication which at basically zero costs to society can be enhanced by adding a date and time plan. His second example is a colonoscopy communication which again at basically zero costs to society can be enhanced by adding a sticky note and an action prompt (Laibson, 2013a, 2013b).

So Laibson (2013a, 2013b) summarises his short lecture on Behavioural Economics and Public Policy Design as follows: The emerging field of behavioural economics sheds light on the failure of standard economic assumptions (rationality, optimising behaviour). Simultaneously, its insights prove valuable for public policy making because they can help to design more effective interventions which nudge people into the right direction at virtually no extra costs to society. Poster children for good public policy design based on behavioural economics are saving behaviour and health decisions.

I recommend you to watch the complete lecture by Laibson, which can be found here. The slides are available from here. In my opinion it is a highly inspirational lecture and gives a good overview on the wide range of applications of behavioural economics and how it transforms public policy making in the 21st century. What is more, Laibson is a highly engaging speaker and great to listen to!

Many thanks for reading,

Jasse


References

Laibson, D. (2013a). Behavioural Economics and Public Policy Design. Slides presented at the Behavioural Economics Symposium 2013, Civil Service College, Singapore. Available at: https://www.cscollege.gov.sg/Knowledge/Documents/Events/BE%20Symp%202013/David%20Laibson.pdf [Accessed 15 October 2016]

Laibson, D. (2013b). Behavioural Economics and Public Policy Design [Video]. Available at: https://www.cscollege.gov.sg/Knowledge/Pages/David_Laibson-Behavioural_Economics_and_Public_Policy_Design-Part1of2.aspx [Accessed 15 October 2016]

The Winner’s Curse: Paradoxes and Anomalies of Economic Life

Having read the books Nudge (2009) and Misbehaving (2015) by Richard H. Thaler, I decided to get a copy of his book The Winner’s Curse: Paradoxes and Anomalies of Economic Life recently. At first sight, the book seems a bit dated because it was already published in 1992. Yet, the content of the book is as relevant today is it was in the nineties.

The title of the book already implies that it is about economics anomalies, where Thaler defines an anomaly as a “fact or observation that is inconsistent with the theory” (p.2). In order to come across a cogent anomaly, Thaler argues that one needs:

  1. A theory which allows for clear predictions and
  2. Observations of actual human behaviour which are inconsistent with the predictions of the theory.

With these two basic ingredients Thaler succeeded in composing a book of 13 anomalies in total. His main intention at the time of writing was to raise awareness of economics anomalies. His vision, however, went beyond this: he envisioned the development of an improved economic theory which is consistent with actual human behaviour. For him, the cornerstones of this new theory would need to comprise optimising behaviour coupled with bounded rationality and social preferences. In Thaler’s words:

This new theory will retain the idea that individuals try to do the best they can, but these individuals will also have the human strengths of kindness and cooperation, together with the limited human abilities to store and process information. (p.5)

In the introduction to the book, Thaler gives a good overview on the model of rational choice on the one hand and actual choice on the other hand. Rational choice models are based on the assumptions of (1) rationality and (2) self-interest. This allows for the well-known ‘homo economicus’ (rational man) in standard economic theory. He (or she) maximises his (her) utility by making optimal choices, knowing his (her) preferences and planning well ahead. Then there is actual human choice with anomalies like the winner’s curse, under-saving for retirement or a significant gap between the willingness to accept (WTA) and the willingness to pay (WTP) for a good.

Despite considerable evidence for the incompatibility of rational choice and actual human choice, proponents of the rational choice model provide a range of reasons for why rational choice should be retained. Thaler lists the following four as examples:

  1. People act ‘as if’ they possessed the knowledge necessary for making a rational choice.
  2. The shortcomings of the rationality and self-interest assumptions do not matter (“it does not matter if the assumptions are wrong if the theory still makes good predictions” (p.4)).
  3. The mistakes of individuals cancel out in aggregate.
  4. Strong incentives for optimal choice, for example transaction costs, will induce people to behave rationally and in self-interest.

Having described the proponents’ strongest arguments for rational choice models, Thaler continues to refute each of them. For example, mistakes are unlikely to cancel out in aggregate because they are likely to be in the same direction. This might be due to confounding factors. Imagine that the individuals in an economy base their investment decisions on the news and forecasts available to everyone. Then, over-optimistic or over-pessimistic news will likely bias individuals in the same manner. As a result, individuals as collective will likely be over-optimistic or over-pessimistic in their investment decisions. Hence the argument that mistakes are irrelevant to aggregate behaviour in the economy and therefore the conclusion that rational choice is the golden rule for economic theory is rather weak.

I am in the midst of reading Thaler’s book. However, the inspiration and motivation behind The Winner’s Curse as well as Thaler’s vision of economic theory in the future makes me keen to read more on the 13 anomalies. I love his writing style; it is engaging and challenging your mind at the same time. It also makes you aware of your own biases and from an economist point of view, it challenges your conventional training. In sum, if you enjoyed Thaler’s books Nudge and Misbehaving as much as I did, then you should not miss out on The Winner’s Curse.

Many thanks for reading,

Jasse


References

Thaler, R.H. (1992). The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton: Princeton University Press.

Sunstein, C.R., Thaler, R.H. (2009). Nudge: Improving Decisions About Health, Wealth and Happiness. London: Penguin Books.

Thaler, R.H. (2015). Misbehaving: The Making of Behavioral Economics. New York: W.W. Norton & Company.

The Evolution of Behavioural Economics

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:

  1. Identifying anomalies,
  2. Formalising alternatives and
  3. 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!

Jasse


References

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.