The Implications of the New Behavioral Economics

One of the most provocative developments in economics in recent years has been the revolution in “behavioral economics,” the idea that the way people make choices – for decades the fulcrum of economic analysis of all problems, including seemingly non-“economic” ones – is governed by the findings of cognitive scientists and evolutionary biologists.

For most of the postwar period the dominant model of human behavior in economics was the rational maximizer – a calculating machine who assesses his options given the constraints he faces and makes the single best choice. The choice can be “best,” at least in advance, even in the presence of uncertainty. A person trying to decide which job to take, whether to move, whether to have a third child, or which mutual fund to invest in knows that there are no guarantees, but he combines a probabilistic calculation with his own attitudes toward risk and is then able to rank his options from best to worst. The future can turn out badly if a bad event happens, but going in you didn’t know it would happen. My own summary of this model is that if we knew everything, we would never be disappointed.

But behavioral economics has poked a lot of holes in this model. The work that gets the most attention comes from cognitive psychology, which has compiled a lot of evidence showing that the above model of people choosing so as to maximize “expected utility” is bunk. Instead, we suffer from systematic cognitive biases, and thus make mistakes that a truly rational person would not but which are hard-wired into our brain. So people might choose differently, for example, when told they have an 80 percent chance of surviving an operation than when they are told they have a 20 percent chance of dying. This effect is called “framing,” indicating that how choices are phrased makes all the difference in how appealing they are. Wikipedia maintains a full list of such biases at http://en.wikipedia.org/wiki/List_of_cognitive_biases. The Nobel Prize in economics was (justifiably) awarded several years ago to a psychologist, Daniel Kahneman, for a lifetime of such work. (It probably speaks well of economics that its most prestigious prize can be awarded to someone from another discipline. Gains from trade and all that.)

Less well-known but perhaps as important is bioeconomics, the merging of economics and sociobiology. The Harvard biologist Edward O. Wilson is the most well-known evangelist for biology pollinating if not conquering outright the social sciences. Bioeconomics says we should take account of our genetic predisposition to distrust the other, to fervently desire to propagate our genes, to be predisposed to violence, etc., even when those choices appear obviously “irrational.’ Any economics that ignores this is doomed ultimately to wander in the scientific desert.

There are two issues here, one of science (of seeking to more closely approximate the truth) and of morality. As a scientific matter, the market for economic knowledge is probably sufficiently competitive that if behavioral economics can explain the data it will prosper, and if not it won’t. Indeed, there is some irony in economics finding itself under siege from these disciplines, given that the rational-actor model pioneered in economics has taken over political science in recent years. Political scientists trained in previous generations often bemoan the increasingly mathematical and statistical nature of the articles in the best political-science journals. Even as it has successfully colonized other disciplines, economics finds itself under attack from the rear,

But so what? If economics teaches us anything it is that more competition in ideas will yield better ideas. It may well be that we will better understand, say, the dynamics of collective bargaining once our models have incorporated the hidden, non-monetary motivations lurking deep within the minds of the negotiators on each side. And I don’t think anyone realistically contends that orthodox economics has run out of useful things to say about how markets behave, the effects of an oil price shock, what price controls will do, etc. Even if people can make cognitive mistakes in their reasoning, markets on average may, most of the time, still best be characterized by textbook economic models. While the ultimate verdict is still in dispute, many economists such as Vernon Smith (himself a Nobel winner) indicate that whatever the micro-irrationality, markets at the macro level often look the way the textbooks expect them to look. Behavioral economics, in other words, may be best characterized as an appendix or a series of footnotes in freshman textbooks rather than the table of contents. But we shall see.

But the second consideration, involving morality and law, is much more serious. Many critics of markets as ways of reconciling conflicting human goals increasingly draw on behavioral economics (erroneously) to indict the entire case for markets in many areas. Sometimes this is done slyly. Scientists, for example, may report results from employee benefit plans that show when employees are presented with more choices they are overwhelmed and more likely to choose to contribute to no retirement plan at all, despite the long-term costs and even though more plans should present them with more options and thus make it more likely that they will find one that meets their needs. They might then argue that this suggests that significant privatization of Social Security is a mistake.

Adopting the broader form of this argument – that markets fail because of individual irrationality, and therefore should be more controlled by the state –is worrying for at least two reasons. First, cognitive biases also afflict the people in the government making such choices, and there is no reason to think that they will choose better. This is not just a trivial debating point. Political choice is driven by appeals to the baser emotions much more than the market is, and so the chances that cognitive frailty could lead to poor outcomes are much greater when politics is the arena of decision. (World War I comes to mind.) Second, it is not clear at all that, even if some people are very prone to making choices that they will ultimately regard as poor, binding limitations on everyone’s choice’s should be imposed. If some people can’t make sense of three Social Security choices and would hence prefer only the existing system, should people who can make sense of five, or ten, be deprived of that opportunity?

More broadly, the neoclassical model of human behavior is superior to any of its current alternatives in one moral sense. For all the criticism of its reduction of humans to calculating machines, there is one inviolate principal in the construction of homo economicus: we get to choose our own preferences. Preferences or tastes are taken as given, and the fundamental problem to be solved is then how to best resolve preferences that conflict. The notion of markets as a way to achieve not just sterile “efficiency” but as a peaceful way to resolve our differences implicitly owes a lot to the neoclassical notion that we all have preferences, they’re all equal, and have to be reconciled somehow, with markets being (absent market failure) the preferred way. No one is entitled to more rights than anyone else simply because of their particular tastes.

Contrast that with what the behavioral model could imply. If taken to its conclusion, we are all products of forces beyond our control – of millions of years of evolution, or of brain wiring that makes us dangerous to others and ourselves. This in turn leads all too quickly to the idea that it is the function of the state to control and restrain us, to choose for us better than we could choose for ourselves. This is ultimately a frightening vision, one in which we become permanent wards of a therapeutic state presided over not by politicians but by experts who know what’s best for us. Given the historical record of experts (who, for example, spent a lot of time in the 1920s worrying about immigration polluting the genetic purity of the American population), this prospect is far more alarming.

And the very notion of justice becomes problematic when brain wiring determines the choices we make. The American Enterprise Institute recently held a conference on the legal and philosophical implications of biology-made-me-do-it. (A primitive version of this defense was trotted out for a killer in California who, it was said in the so-called “Twinkie defense,” was driven to do what he did by an excess of junk food.) If neurons are morality, I can never be held responsible for anything; what I need is not punishment but treatment. This vision, of a world without consequences or the freedom to succeed or fail, is a disturbing one. Give me, with all my cognitive imperfections, the freedom to stumble may way through this life, and keep the experts and the would-be therapists in the ivory tower where they belong.