Economics focus

Behaviourists at the gates
May 8th 2003
From The Economist print edition

How economists are using psychology to question orthodox policy prescriptions

ANYONE who has read even a bit of economics knows how arid it can be. Pages filled with squiggly equations describe a world occupied not by fallible, generous people like you, your family or your friends, but by “agents” and “actors”, all as rational as Star Trek's Spock and as greedy as Gordon Gekko.

Yet most economists rather like the dryness of the dominant, neoclassical strain of their discipline. Its lack of detail about how people behave in the real world, much bemoaned by its critics, is actually a strength. It gives economic theory great flexibility, especially when mathematical techniques are brought to bear. Starting from the idea that people are rational—meaning, in essence, that their tastes and therefore choices are consistent—economists can examine a huge array of theories and policies. Neoclassical economics tends often, though not always, to conclude, much like this newspaper, that the best policies tend to be liberal ones: free trade, a limited role for governments, lower taxes. The flexibility of neoclassical economics has also allowed its techniques and prescriptions to infiltrate other social sciences, such as sociology, political science and anthropology.

Neoclassicism and its discontents

For years, some dissident economists have been quietly chipping away at the micro-foundations of the neoclassical edifice and the policy conclusions built upon them. Now their efforts seem to be gathering force on American university campuses, where most American students meet Homo economicus for the first time. Although the dissidents' methods might one day lead to a clearer understanding of the basics of economics, the results so far have been of limited value—judged at least against the dissidents' grand ambitions.

The most striking development has been a move at Harvard, which has one of America's biggest and most influential economics faculties, to offer an alternative to the basic undergraduate economics course taught by Martin Feldstein, a former economic adviser to Ronald Reagan. Mr Feldstein's course is typical of the neoclassical approach.

The new course is being proposed by Stephen Marglin, a tenured professor who earned his chair largely for research that attempted to square a Marxian approach with Keynesian demand theory. One basis of the proposed course and others like it, however, is the rapid uptake of the ideas of behavioural economics. This uses lessons from psychology to undercut the idea of Homo economicus as a rational being. Many of these ideas are based on the work of Daniel Kahneman, a psychologist and winner of last year's Nobel prize in economics, and his collaborator, Amos Tversky, who died in 1996. They highlighted, through a number of experiments, the various ways that people perceive and misperceive risks.

Behavioural economics is a fascinating field. On its face, moreover, it seems to undermine the neoclassical orthodoxy. It suggests that people, contrary to the basic assumptions of the standard approach, do not always behave rationally. They may avoid slight risks, and yet take wild gambles. They may fail to save for the future, although they have the means to do so and a good prospect of a long life. They may not be able to choose how to spend their money in a way that maximises their “utility”, economists' jargon for happiness. They may have no idea how to attain happiness. More than this, people are not entirely selfish. Parents seem to give up a lot for their children. People give money to charities, churches and buskers with no apparent gain to themselves.

What are the implications of these ideas for policy? According to Mr Marglin, they are profound. What if people cannot even calculate the amount they are willing to pay for a pound of butter or a haircut, or have any idea what prices will be in the future? In such a world, such basic constructs as demand and supply curves—which show the quantities that people and firms would be willing to demand or supply at given prices—lose their meaning. The normal economic calculations of costs and benefits—for example, of the costs created by a tax increase or the imposition of a tariff—depend on estimates of these curves. These calculations, and the policy conclusions that follow from them, may therefore be threatened by the behavioural approach.

This helps unorthodox economists in a range of debates with those in the mainstream. Support for school vouchers, for example, relies crucially on the notion that people know what is best for them, or at any rate for their children. Free trade relies on the benefits that occur to many from lower import duties, set against the costs suffered in the form of lost jobs in industries competing with imports. But if these things cannot be measured, or even theorised about sensibly, the rationale seems to melt away. Mr Marglin would have students read about the travails of unemployed textile workers in the American South who have lost their jobs thanks to NAFTA, rather than wade though econometric studies of the net benefits of the trade agreement to the American and Mexican economies.

So is Homo economicus doomed to be toppled? Not yet. There is no clear evidence that people's failure, at least some of the time, to behave rationally should be a bar to the neoclassical model. As Milton Friedman noted decades ago, it is enough that people behave more or less “as if” they are rational. And people's mistakes might all come out in the wash: for every one who saves too little, someone else might save too much. Supply and demand curves are still informative devices.

The heterodox economists, however, deserve credit. Their bold move to offer students an alternative should be applauded for comprehending that students are consumers. That said, if consumers cannot be trusted to know what is best for them, how can students know that they have chosen the right course?

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