Advanced Introduction to Behavioral Economics
John F. Tomer
This book covers the key areas of behavioral economics, including Herbert Simon’s bounded rationality, Daniel Kahneman and Amos Tversky’s psychological economics, behavioral finance, nudging and public policy, behavioral macroeconomics, law and behavioral economics, neuroeconomics, and empirical methods of behavioral economics. It features a very interesting chapter on behavioral finance that highlights the contribution of Robert Shiller. The author also explores how and why behavioral economics emerged and differs from neoclassical economics.
Economics is a science, a social science. It is a science whose practices have for a number of decades been contested. The dominant paradigm in economics has for more than sixty years been neoclassical economics (NE). At the heart of NE are 1) the assumption that humans are rational, maximizers of their individual well-being and 2) the proposition that economic behavior can be described very well using mathematical models without the use of psychology or other social sciences. In opposition to the main tenets of NE, behavioral economics (BE) began to emerge in the 1950s. Behavioral economists have sought to create an economic science that has a more realistic conception of human behavior. Moreover, many behavioral economists have worked to create an economics whose methods are less narrow, rigid, and mechanical than those of NE. In the 1950s through the 1970s, BE had relatively few adherents, but over the years as BE theory and methods advanced, the ranks of behavioral economists have grown greatly. This growth occurred as more and more economists came to recognize that the scientific methods of BE depart substantially from those of NE and that BE explanations of economic behavior are more realistic owing to the fact that BE combines important insights from psychology and other social sciences with sound economic principles. In recent years, BE has become very prominent and respected and has gained many adherents. It is noteworthy that BE has gained considerable favorable attention as a consequence of the number of behavioral economists who have won the Nobel Prize in Economics for their research. At the same time, more and more economists were coming to the recognition that NE models fail to explain important aspects of how humans behave. Another part of the story is that a great many leading young economic researchers now recognize the value of combining a variety of behavioral insights, not just those from psychology, in their theoretical models. They realize that the actor in behavioral economics is not a perfectly rational machine but is a realistic human being who is often predictably irrational. And increasingly, empirical research in economics utilizes methods pioneered by behavioral and experimental economists.
Today, if you are an economic researcher, teacher, or student or are a user of economic research, you need to know about BE. This is very much true even if you are not a specialist in BE. Without sufficient BE knowledge, you will be at a disadvantage unless you are able to understand the most important BE theories and perspectives. In other words, today you need to acquire BE literacy. If becoming literate in BE is your goal, I believe this book is what you need. This book is designed to explain carefully and simply about the most important BE theories and perspectives. It is also designed to explain about important BE trends and recent developments. If after reading this book you gain a reasonable understanding of BE, it will be much easier for you to go on to acquire greater BE knowledge from texts, references, research articles and books, and intelligent discussions of BE phenomena. Accordingly, this book should be particularly useful for advanced undergraduate students, graduate students, government policy makers, and other professionals who participate in discussions about economic related matters.
Chapter 2 raises the question of whether behavioral economics (BE) is a new paradigm, possibly a superior paradigm, that might succeed neoclassical economics (NE), the current paradigm. Chapter 2 also considers how the scientific practices of BE differ from those of NE. Clearly, there are fundamental differences between BE and NE. There are, for example, sharp differences between the NE behavioral assumptions and those of BE. And the scientific methods of BE and NE are also very different. NE emphasizes a positivistic philosophy and rigorous mathematical methods. BE, on the other hand, rejects positivism, strongly accepts interdisciplinary social science, and finds much less use for mathematics. In general, NE is much more narrow, rigid, intolerant, mechanical, separate, and individualistic than BE. Based on this comparison, there is a strong argument that the scientific practices of the emergent BE constitute a new paradigm.
Toward its end, the book considers the overall situation regarding the scientific changes that have occurred in economics and seem to be occurring. Based on a review of all that has been happening in recent years, the prospect for paradigm change does not seem clear at all. To get a better idea about this, it is useful to think about arraying all behavioral economists along a spectrum. On the low end of the spectrum would be economists who have adopted only a relatively small amount of the scientific practices associated with BE. On the high end would be economists who have adopted a very large amount of the scientific practices of BE. One of the economists on the low end of the spectrum would surely be Matthew Rabin (2002), a leading behavioral researcher. He has expressed the view that the main difference between NE and BE is that the assumptions of BE have greater psychological realism than those of NE. Rabin is for the most part not critical of NE methods. Economists such as Rabin like their psychological realism with a large dose of NE methods. Others like the followers of Herbert Simon are in favor of a BE that is fundamentally different from NE, i.e, a BE that is different along many dimensions. These days there clearly are many varieties of behavioral economists. Most behavioral economists, of course, would be located somewhere in the middle of the spectrum. Two examples follow.
Consider the BE orientation of Raj Chetty, the young Harvard economics professor. As mentioned in chapter 13, Chetty has a pragmatic perspective regarding the difference between BE and NE. His view is that “BE represents a natural progression of (rather than a challenge to) NE methods” (Chetty 2015, p. 1). He believes that “BE is better viewed as a part of all economists’ toolkit (like other tools in applied theory) rather than as a separate subfield [or paradigm]” (p. 37). Chetty finds BE very useful “to the extent that … [it] improves empirical predictions and policy decisions” (p. 1). Despite his use of BE tools, Chetty believes that “the neoclassical model remains the benchmark for most economic applications” (p. 1).
Richard Thaler (2016, p. 1) is a more thorough going behavioral economist than Chetty, but he does not believe that BE represents a “paradigm shifting revolution.” In his view, “the methodology of BE returns economic thinking to the way it began with Adam Smith” (p. 1). Thaler emphasizes that there are “historical precedents for utilizing a psychologically realistic depiction of the representative agent” (p. 1). In his view, the significance of BE is that it considers the important role of the “supposedly irrelevant factors” (factors typically deriving from noneconomic social science) in its models, whereas NE does not. According to Thaler, if everyone [all economists] were to include all the factors [including the supposedly irrelevant ones] that do determine economic behaviors in their models, then the field of BE would no longer need to exist (p. 1). In this event, economics would then be “the kind of open-minded, intuitively motivated discipline that was invented by Adam Smith” (p. 19).
As suggested by the above, BE as it exists today may no doubt have some potential for giving birth to a new full-fledged paradigm, but it does not seem close to realizing that potential in the near future. The great diversity of opinions and scientific practices among all economists would seem to rule out a scientific revolution for now.