The rise of behavioural economics
Source: By Jayachandran: Mint
Richard Thaler once got together a group of students to take part in what is now recognized as a landmark experiment. He asked students to share an endowment of $20 with an anonymous classmate each. The students who had been given the money had to make a choice: either split the endowment equally with the anonymous partner, or keep $18 while giving the other student only $2.
Standard economics would predict that a rational student would choose the second option, especially since the anonymity ensures there is no threat of reputation. However, a majority of the students who took part in the experiment chose to share the money equally. The results of this dictator game—as well as a similar experiment that goes by the name of the ultimatum game—shows that people value fairness in their economic lives. Thaler wrote about these results in a classic paper on fairness that was published in 1986. His results have been replicated in thousands of experiments in subsequent years.
The decision to award the 2017 Nobel Prize in economics to Thaler is welcome. Thaler is at the forefront of a broad movement to build economics on more reasonable assumptions about human behaviour. The dictator game shows that humans value fairness in their economic interactions. Thaler has also thrown fresh light on our limited rationality, our inability to stick to goals because of the lack of self-discipline, and the trouble we have in discounting the future. His doctoral work on how to statistically value human life has survived the initial scepticism of his thesis adviser. His ideas on the endowment effect and mental accounting have now filtered into public discourse.
Behavioural economists are one part of the broader project to reframe human motivation in economics. A short detour into the history of modern economic thought can throw the spotlight on a bigger set of economic theorists, in part to challenge the popular caricature that economists do not understand the nuances of human behaviour. John Maynard Keynes famously wrote about how the economy was driven by animal spirits—or human psychology. But what is human psychology all about? Keynes left the question unanswered. The game theorists John von Neumann and Oscar Morgenstern created a theory of rationality based on axioms—or the expected utility theory that economic graduates are taught.
Maurice Allais (Nobel laureate 1988) showed way back in 1953 that human behaviour in certain circumstances drifts away from the axiomatic idea of rationality. Herbert Simon (Nobel laureate 1978) integrated the insights of psychology in developing his ideas about bounded rationality. Reinhard Selten (Nobel laureate 1994) studied the impact of bounded rationality on firm behaviour. Friedrich Hayek (Nobel laureate 1974) wrote about tacit knowledge dispersed amongst millions of individuals in a market economy. Vernon Smith (Nobel laureate 2002) pioneered the use of experiments in economics. And game theorists such as Thomas Schelling (Nobel laureate 2005) highlighted the complexities of human interaction even while staying committed to the rationality assumption.
The point to be made here is that the rational expectations assumption in modern macroeconomics has led too many people to believe that all economists have a unidimensional view of human nature. That is far from the truth. In fact, some critics of behavioural economics raise two potent questions. First, does the limited rationality of individuals necessarily mean that aggregate markets are irrational? Second, do human beings behave in real life as they do in controlled experiments? For example, will a man who finds a wad of currency notes on the pavement begin to share it with the people around him in the interests of fairness?
The critics may have a point, but there is no doubt that behavioural economics poses a powerful—and welcome—challenge within economics. Thaler is undoubtedly one of the giants in this field, and his theoretical work is as important as the books through which he has popularized his ideas. As we have pointed out earlier in the editorial, behavioural economics should be seen as one part of a broader attempt to base economic thinking on more nuanced assumptions of human behaviour. The brilliant work in economic sociology by Mark Granovetter is worth mentioning here as well. His name crops up as a prospective laureate during every Nobel Prize season.
Economics took an important turn some four decades ago when models of the macroeconomy began to be built on assumptions about individual human behaviour—or micro-foundations. The first such models assumed the representative human being was perfectly rational, but behavioural economics poses a powerful challenge to that assumption at the level of individual decision-making. The challenge is to integrate its insights into mainstream models that look at the broader economy. Some of the recent Nobel Prize awards—including the most recent to Thaler—show the process has already begun. The heretics are now in the throne room.
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