The Behavioral Economic Revolution

By guest blogger Elaine Hirsch

For most of the twentieth century, economics has been dominated by the ideas from the neoclassical school of thought. Neoclassical economics encompasses an array of ideas about how people make decisions and respond to incentives. Specifically, it makes simplifying assumptions about the underlying processes determining human action, including the idea that people will always rationally study the costs and benefits of their choices in order to maximize their individual gain, known in economics as utility. Although it is widely used in masters degree programs in economics, many of its assumptions have been rigorously tested in recent years by a new branch of economics, behavioral economics, which is rewriting the rules underlying the discipline.

The growth of economics as a branch of science has much to do with the power of rational choice theory, which states that all people in an economy will act in their personal interests to maximize individual utility. Although this is an assumption used to simplify economic models, it has had a profound impact on the insights brought by economic thinking. Indeed, rational choice theory has been so successful that it has branched out to many different social science disciplines, including areas like political science. However, the rise of behavioral economics, which uses insights from psychology to obtain a more complete picture of human behavior, is coming to discover many instances where people fail to act in ways in accordance with rational choice theory.

Some of the problems concerning neoclassical economics rest on the idea of perfect information, which assumes that people have full access to all the information necessary to make a decision. This, however, isn't the case in reality, as there is usually information held by insiders or just a lack of knowledge due to human laziness which hinders perfect decision making. Without such complete information, it would be impossible to assume utility maximization in all instances. As it turns out, behavioral economics is shedding light on times when this assumption fails. Instead of operating as a homo economicus (utility-maximizing beings), people have a variety of biases that cloud their judgements.

In just one example demonstrated by Daniel Kahneman, a pioneer in behavioral economics, people who were given coffee mugs valued them far more highly than those who were not given them but were asked to bid on them. This bias, known as the endowment effect, suggests that people value an object more simply by possessing it. This emotional attachment to an object can hinder exchange that would otherwise have taken place by "rational" actors. Increasingly, behavioral economics is demonstrating how emotions are as much a part of economic decision making as rational thought.

This idea can have plenty of practical applications, especially as it pertains to the recent financial crises in the United States and Europe. The sub-prime mortgage crisis was fueled by easy access to easy credit, which allowed people to continually bid up the prices of homes across much of the developed world. Ultimately, the price of housing was driven by the dictates of the greater fool theory, which suggests that people purchased assets not based on their intrinsic value but rather because they expect others to pay more than they did for the asset in the future. This kind of behavior can lead to asset bubbles that drive economies into recession when they pop.

Of course, as is often the case in academic disciplines, there is a lot of debate concerning the influence behavioral economics really should have in general economic analysis. Although behavioral economists have performed many enlightening experiments that reveal interesting patterns of human choice, other economists believe that seemingly irrational decision making can be incorporated into the neoclassical framework. However, it cannot be denied that behavioral economics has changed the way economists think about traditional problems in economic science and will likely continue to do so in the future as the science matures.

Elaine Hirsch is kind of a jack-of-all-interests, from education and history to medicine and videogames. This makes it difficult to choose just one life path, so she is currently working as a writer for various education-related sites and writing about all these things instead.