Economics as a discipline has detached itself from both psychology and political philosophy in an unfortunate turn of events that has led what used to be known as political economy to become an exercise in obfuscation through mathematics. By assuming what was supposed to be proven, and by blurring the lines between descriptive and normative theory, economics as it is currently practiced has become increasingly irrelevant to the description of the interaction of people going about their business. By forgetting that the economy is in the end comprised of people and instead hypothesizing a rational representative agent economics has assumed away that which it is supposed to describe and explain.
The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .
When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.
That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.
The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.
The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.
Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative. It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured. Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.
Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.
Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.
Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: http://www.nytimes.com/2008/10/24/business/economy/24panel.html [accessed May 28, 2010]
Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1677168 [accessed May 28, 2010]
Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed. (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press
Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at:
http://web.ics.purdue.edu/~treimer/Rieskamp_Reimer_2007.pdf [accessed May 28, 2010]
Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan
The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .
When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.
That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.
The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.
The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.
Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative. It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured. Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.
Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.
Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.
References
Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: http://www.nytimes.com/2008/10/24/business/economy/24panel.html [accessed May 28, 2010]
Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1677168 [accessed May 28, 2010]
Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed. (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press
Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at:
http://web.ics.purdue.edu/~treimer/Rieskamp_Reimer_2007.pdf [accessed May 28, 2010]
Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan
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