By Sunanda Natrajan
For the most part of the century, mainstream economics has always restricted itself to a set of assumptions about the rationality of man and answered questions about taxes and inflation. A layman’s knowledge of Economics is as simple and straightforward as it can possibly be, where the concept of ‘homo economicus’ portraying humans as rational, self-maximising agents still continues to form the groundwork and economists like Adam Smith, John Maynard Keynes and Fisher testified to these assumptions to extend validity to their theories.
However, it was psychologists like Kahneman, Tversky and Schwartz who went one step ahead and told us why having ‘more is less’ (that is, the Paradox of Choice) and why the order of responses in a form affects our judgement. Essentially, before the advent of behavioural economics, economic decision-making was viewed as a carefully calculated process which involved a fixed number of variables and produced anticipated results. Then behavioural economics came and made us question the status quo.
Understanding Behavioural Economics
In mainstream economics, there are four primary theories that guide economic behaviour: Expected utility theory, the theory of exponential discounting, social utilities and the ultimate objective of attaining equilibrium. Up until now, core economics has relied solely on mathematical methods backed by scientific data with much pride. While that was deemed to be useful in creating a uniform basis to crucial economic decision making on a micro as well as macro level analysis, the major obstacle was the gross inconsistencies that came along with those models and methods.
The basic reason behind these inconsistencies is the fact that economic theories are based on a set of assumptions that economists believe to be true about an individual economic agent. Assumptions of rationality, profit and utility maximization, consistent preferences, etc. among many others are the backbone of these theories and while they are true in the case of a lot of people, economists were stubborn to accept that they might not be universally applicable. Since they starkly contrasted with the many realities of daily life, behavioural economics came into the picture to lend us an understanding of the integration of human psychology and economics.
Behavioural economics is primarily an approach aimed towards unifying the disciplines of psychology and economics. Since Economics is the science of how resources are efficiently and optimally allocated between individuals in order to maximise their satisfaction, the psychological factors underpinning the process of human decision making is an integral aspect of how every conclusion is arrived to and this is the underlying idea behind the concept of Behavioural Economics. In fact, behavioural economics seeks to use psychology to inform economics, while retaining the emphasis on mathematics and empirical data. For instance, not many are aware of one of the earliest works of Adam Smith ‘Theory of Moral Sentiments’ which talks about how psychology affects economics. Therefore, instead of a brand new synthesis, behavioural economics is actually a reunification of the two disciplines.
Recognition of the discipline
With years of extensive research and significant contributions made to every field, behavioural economics has now become a burgeoning field that has proven to be relevant time and again. However, an unfortunate reality that continues to prevail is how mainstream economists view behavioural economics and cast a shadow of doubt over its legitimacy as a subject.
In 1950, economist Herbert Simon was the first one to attempt to unify psychology and economics when he tried to study and advocate theories in economics based on algorithms that embodied cognitive mechanisms and subsequently acknowledged the ‘bounded rationality’ of humans. Since then, the area of behavioural economics has progressed by leaps and bounds with many Nobel laureates in the field too; Richard Thaler being the most recent one. Later in the 1970s, many psychologists started using rules of probability and maximisation of utilities to understand judgement and theorized how perceptions could be understood through the lens of optical illusion. Behavioural theorists like Kahneman, Tversky, Fischhoff, Slovic and many others tried to use psychological principles to express the economic behaviour of various agents.
Despite advancement and its widespread prevalence as an area of study, the discipline has faced a lot of backlash from mainstream economists, both classical and neo-classical theorists. Having been credited with building the foundational pillars of Economics, economists belonging to the time of Ricardo and Keynes seem to show great hesitation in the works and contributions of these behavioural scientists. One of the reasons for such resistance is the pessimistic fear that psychological principles and their pieces of evidence are too fragmented to suggest plausible alternatives to rationality. However, this idea of ‘fragmented evidence’ has been disproved several times and now, behavioural economics has come to encompass empirical evidencing in its research too. In light of this, economists have also questioned the manner and method of using such psychology, stating that combining psychological biases and human irrationalities in mathematical models is inappropriate. Other reasons include the cultural dregs of the 70s and 80s when defending free markets and irrationality of human beings seemed to pose a major threat to the already existing ideal. Furthermore, incorporating too many insights and opinions with regard to a particular concept, economists believe, can lead to a problem called ‘overfitting’, a phenomenon where models promulgated by scientists are so flexible that they seem to explain everything but are capable of predicting nothing. Owing to its countless assumptions, overfitting is already largely present in Economics and so they’re apprehensive of making it more malleable.
A unified theory of behavioural economics
In the background of such resistance, French-born Harvard professor Xavier Gabaix took a major step in his 2017 paper. In his recent paper on “Behavioural New Keynesian Model”, he has attempted to create a unifying theory for behavioural economics by introducing behavioural modifications in a standard macroeconomic model and thereby, answered many baffling questions at once. To be precise, Gabaix includes a variable of instability in the new-Keynesian model, thereby countering the Ricardian Equivalence and many other such theories that conjecture that economic agents use information of the present and forecasts about the future before taking a decision. Therefore, Gabaix’s model is ‘bounded away from rationality’ and that is why it is important to highlight it as an important step towards unification of economics and psychology. Standard economic theories have miserably failed, time and again, to explain inflationary fluctuations and price movements and interest rate changes. Additionally, the economic assumption of ‘ceterus paribus’ adds to the uncertainty of their application in real life scenarios. Therefore, this work adds to the so-called ‘fragmented’ theory of behavioural economics and gives uniformity and consistency to the subject. Even in the global perspective, these variables have a significant bearing on International Economics because measurement of macroeconomic variables in international trade could not be carried out and stated with absolute accuracy, owing to the differing psychological conditions that impact our economic participation.
The way ahead for the discipline
We all know that to err is human. Therefore, behavioural economists have proved how psychological realism is important to consider in economic theory. There are a lot of apprehensions and fears regarding the introduction of behavioural modifications in Economics. However, many policymakers and corporate strategists have given their testimonies on how this research has helped in improving their productive efficiency, marketing and advertising and even employee welfare. Even though the assumption of ‘homo economicus’ helped economists create elegant models for the economy, the irrational behaviour revolution got underway and is now making great contributions to economic research.
Featured image source: Flickr
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