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RSS By: Matt Bogard, AgWeb.com

Matt's primary interest is in the biotech industry and ag policy.

Behavioral Economics

Jun 20, 2009

By Matt Bogard

A recent story on National  Public Radio ( link) gives an overview of a subfield of economics called behavioral economics. Behavioral economics incorporates elements of psychology into economic theory. Some people believe that behavioral economics will improve economic models because it makes a correction for what they believe are errors in the assumptions of classical economics. As a result many people have come to think that behavioral economics may even justify the unprecedented amount of government intervention in the economy and improve our lives. 

First, I would say that the term 'behavioral economics' is very misleading from the start. I don't doubt that there may be ways that concepts from psychology could improve certain aspects of economic models. However, a better term would be psychological economics, cognitive economics, or psychonomics. Economics in general is the study of choices, and how they are made compatible in a world of scarce resources. It is already all about behavior. To name a subfield 'behavioral economics' is redundant and confusing.

Secondly, a major criticism of classical economics is the assumption that people are perfectly rational and perfectly informed. As the article states:

"Economists literally assume that the agents in the economy are as smart as the smartest economist," Thaler says. "And not just smart: We're not overweight; we never overdrink; and we save just enough for retirement. But, of course, the people we know aren't like that.......An imperfectly rational human being challenges a really important idea: the notion that markets work well because individuals can be counted on to make the best choice for themselves."

  One problem is that people get too excited about behavioral economics and over exagerrate the fact that people are not perfectly rational. We all know that people don't always appear rational, and don't always make the best decisions. Some people make very bad decisions. When people learn that  economic 'theory' assumes that people are perfectly  rational, a naive reaction is that economics has to be wrong.  That is a huge mistake.

As an example, we might learn in science class that the earth is not perfectly round and smooth, but we still use perfeclty round smooth globes to learn about geography. We all know that most pool players don't do physics and calculus in thier heads for every shot they take, but the shots can be easily modeled using the laws of physics. We don't trash globes or stop teaching physics in schools just because these 'models' aren't exactly like the real world. In fact these models are useful only because they are not exactly like the real world. They approximate the real world just enough to be useful. To make these models match the real world exactly would make them so complex that they wouldn't be easy to use.

In fact, one of the major criticisms of behavioral economics is that it makes models to complex to be useful. From a the Economist's View blog David Andolfatto writes:

"There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner."

A lot of people are holding out hope that 'behavioral economics' will save us from our selves. That it will allow us to break a basic law of nature: that people own themselves and that you as an individual are the best person to decide what is best for you. If behavioral economics allows this, then there is no limit to what government can do. Suddenly there is no limit to how high taxes can be raised. We can raise the wages for the poor and cap the wages of the rich with no consequence. We can print as much money as we want and not worry about inflation. We can ignore large budget deficits. We can tell car companies what kind of cars to build and return them to profitability. We can tell farmers what kind of crops to grow and how to raise their livestock and still feed the world.

Even if behavioral economics were to offer great breakthroughs, another subfield of economics called Public Choice casts doubt on whether our elected leaders would actually put better policies ahead of thier own personal and political party's gain.

With the basic assumptions of economics, we've seen that people do appear to respond to incentives. We see that tax cuts can lead to job creation and economic growth. We see that  minimum/living wages lead to decreased opportunities for the most disadvantaged. We see that printing large amounts of money leads to inflation. People don't have to be perfectly rational for the most basic principles of economics to be relevant, and behavioral economics likely won't change these findings. ( see Gregory Mankiw's 10 Principles of Economics ).

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COMMENTS (3 Comments)

To Dave:
I'm pretty sure you missed the point of the article.

4:05 PM Jun 13th
Matt Bogard
You make some very good points and I agree with you. I did not want to imply that I thought that people were that rational at all. People don't have to be perfectly rational for the basic conclusions that economists make about taxes and regulations to be correct.

No theory will perfectly predict human behavior.You are correct about what you say regarding the commodities markets. In fact, economics offers what is known as the 'efficient markets hypothesis' which basically says that no one person will be able to make those kinds of predictions you and make a profit unless they have 'special' or 'inside' information. So we don't expect economic models to predict accurately a lot of the things we observe in financial and commodities markets with the precision we would like.

10:18 AM Jun 13th

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