Behavioral Economics #1: The Beginning

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To understand why behavioral economics is such a revolutionary social science, we must first answer a few fundamentally important questions. Why was behavioral economics born? What were the factors that collided to bring about this fascinating new field of economics? Why didn’t we just stick to traditional economics?

Before I continue, I need to post a brief disclaimer that will apply to both this post and the entire behavioral economics series that I plan to write. Even though I have an academic background in the field, I’m not an expert in economics. While I try my best to accurately cite data and research to support my writing, this series of posts isn’t meant to be an exhaustive and perfectly detailed account of the profession. It’s merely a fun exploration of a topic that I’ve grown to love over the years. That said, I encourage you to fact-check my posts and please let me know if I’ve said something inaccurate. I’ll gladly correct my mistakes.

Now then, let’s get started.

The Beginning

In my early days of learning economics, I learned that it is essentially the study of how humans with infinite desires make choices in a world with limited resources. In other words, it’s the study of how we make choices under scarcity, even though most people perceive economics as the study of how to earn lots of money making wrong predictions.

However, I always enjoy pointing out a fun, but surprising piece of economics trivia to people. Take a minute to think about this question: what profession do you think economics was a branch of until 1903?

Answer: Philosophy.

Yes, economics was born from the womb of philosophy, a fact that I was extremely surprised to learn of. Even more interesting is that Adam Smith, widely regarded as the Founding Father of economics, never actually “learned” economics. Specifically,

Smith never took a course in economics. Nobody did [at that time]. Until the nineteenth century, academics considered economics a branch of philosophy. Not until 1903 did Cambridge University establish an economics program seperate from the “moral sciences.”
— From Page 13 of "New Ideas From Dead Economists: An Introduction To Modern Economic Thought" by Todd G. Buchholz

Economics, therefore, didn’t start as the study of financial systems or of how to maximize our material desires, but rather as an inquiry into the “moral sciences” and human nature. Before writing his seminal book An Inquiry Into The Nature and Causes of the Wealth of Nations widely considered to be the precursor to the academic discipline of economics — Smith earned the nickname of “Smith the Philosopher” after gaining fame for his first book The Theory of Moral Sentiments.

Smith devoted almost his entire book to the discussion of sympathy and sentiment and wondered why, if people are supposedly selfish, every town in the world hasn’t regressed to a savage and decadent state of existence. His answer?

When people confront moral choices, he said, they imagine an “impartial spectator” who carefully considers and advises them. Instead of simply following their self-interest, they take the imaginary observer’s advice. In this way, people decide on the basis of sympathy, not selfishness.
— From Page 15 of "New Ideas From Dead Economists: An Introduction To Modern Economic Thought" by Todd G. Buccholz

Though perhaps this explains it better:

Freud’s concept of the “super-ego,” the conscience that restrains humans from certain acts and makes them feel guilty when they do not listen, is not so far removed from the adviser that Smith describes.
— From Page 15 of "New Ideas From Dead Economists: An Introduction To Modern Economic Thought" by Todd G. Buccholz

The early days of economics are steeped in influences from philosophy. David Hume, the renowned 18th century Scottish philosopher, made important contributions to economics through his essays on money, international trade, the morality of an unequal distribution of wealth, private property, economic and political freedom, and his scathing criticism of British mercantilism. In addition to Hume, the contributions of philosophy to economics are plentiful including, but certainly not limited to, John Locke, Saint Thomas Aquinas, John Rawls, Jeremy Bentham, and the great Aristotle himself.

Hence, despite its image today of a discipline obsessed with money and maximizing material well-being, economics started as a genuine examination of “the origin of moral approval and disapproval”, the morality of the economic system, and the normative nature of human life. How interesting, then, that a profession that has such deep philosophical and moral roots seems to have strayed so far from its place of birth.

But that’s another conversation for another day.

Evolution

It would take an entire book to share a detailed account of the evolution of economics (and the creation of each branch of economics) since the time of Smith to the present day. If this piques your interest though, I refer you to Todd. G. Buchholz’s book “New Ideas From Dead Economists: An Introduction To Modern Economic Thought."

Nevertheless, I do want to make a few general remarks regarding the evolution of economics and the core beliefs that characterized this evolution.

Perhaps due to its roots in philosophy, economics became blinded by questions of what should be rather than what is. Economics became a very normative social science that, quite dangerously, took its normative questions as concrete facts. Specifically, instead of asking whether people actually do what’s in their best interests, economists simply assumed that they did because, well, that’s what we should do, right?

Moreover, instead of studying whether people actually:

Economists assumed that people always did these things and never succumbed to such traps, and then simply built economic models based on these assumptions.

In fact, economists assumed that all humans were homo economicus (which, as Richard Thaler did in his book Misbehaving, I’ll shorten to Econ). Econs are creatures with “an infinite ability to make rational decisions” that never fall victim to cognitive biases, are never overconfident, and never struggle with self-control. Thaler elaborates on the concept in his book Misbehaving:

In a world of Econs, there is a long list of things that are supposedly irrelevant. No Econ would buy a particularly large portion of whatever will be served for dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant in choosing the size of your meal for Tuesday. An Econ would not finish that huge meal on Tuesday, even though he is no longer hungry, just because he had paid for it and hates waste. To an Econ, the price paid for some food item in the past is not relevant in making the decision about how much of it to eat now.

An Econ would also not expect a gift on the day of the year in which she happened to get married, or be born. What possible difference can a date make? In fact, Econs would be perplexed by the entire idea of gifts. An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal.
— From Page 6 of "Misbehaving: The Making of Behavioral Economics" by Richard Thaler

As Thaler mentioned on page 7 of his book, this model of economic behavior based on a population consisting only of Econs” became the gold standard in economics. At the same time, though, he noted that “economists carry the most sway when it comes to influencing public policy” and have “a virtual monopoly on giving policy advice.”

Clearly, this is a recipe for disaster: an academic discipline with so much influence on public policy uses models of economic behavior based on extremely unrealistic and erroneous assumptions. The vast majority of people are not Econs which means that, as Thaler states, economic models make a lot of bad predictions.

Virtually no economists saw the financial crisis of 2007-08 coming, and worse, many thought that both the crash and its aftermath were things that simply could not happen.
— From Page 4-5 of "Misbehaving: The Making of Behavioral Economics" by Richard Thaler

In my eyes, traditional economics was a profession that studied how human beings — living in a world with limited resources but unlimited desires — (should) make decisions, without ever taking the time to understand how humans make decisions in the first place. In other words, economics studied human choice without understanding humans.

And unfortunately, few cared to question this glaring blind spot despite how much influence economics has on governmental policy-making — and, by extension, on the lives of hundreds of millions of people — and despite the fact that the Founding Father of modern economic thinking, Adam Smith, wrote his first book about the (moral) sentiments and passions of human beings.

To economists, the world was full of Econs.

Beautifully Irrational

The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.
— Vilfredo Pareto, 1906

Thank God for psychologists.

Psychologists always knew that we do not live in a world of Econs. They know that we’re embarrassingly irrational creatures that fall victim to a plethora of cognitive biases. Thankfully, brilliant psychologists like Daniel Kahneman and (the late) Amos Tversky, in partnership with Richard Thaler, looked at economists and said “Are you guys crazy!? How can you assume these things about the way people act and make decisions? Have you actually tried finding out if people make decisions like this?

And it’s a good thing that they did because economics couldn’t afford to continue along this misguided path. As Thaler documented in his book Misbehaving and in his now-discontinued column Anomalies, there were far too many cases of economic behavior that violated traditional economic theory to continue to dogmatically pledge allegiance to such theory.

Eventually, they were too many “anomalies” to ignore — too many instances that showed that very few humans were Econs — such that cracks started to show in the armor of traditional economics. These cracks became glaringly big until a new field of economics was finally taken seriously, a new field that was the marriage of psychology and economics:

Behavioral economics.

Books cited in this post

See you, Space Cowboy.