The Problem With Old School Economics

Misbehaving“The core premise of economic theory is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one that it can afford. Furthermore, the beliefs upon which Econs make choices are assumed to be unbiased. That is, we choose on the basis of what economists call “rational expectations.””

Economist Richard Thaler endeavors to clear up this notion of rationality in his book Misbehaving: The Making of Behavioral Economics. Using examples and by asking probing questions Thaler helps to show us how many of our decisions are not rational or well-thought-out.

“Humans have limited time and brainpower. As a result, they use simple rules of thumb—heuristics—to help them make judgments.”

Taking shortcuts saves time and energy, but does lead to particular errors. Psychologist and fellow economist Daniel Kahneman helped popularize the notion of two systems interacting in the mind. System 1 accounted for intuition, it’s fast and efficient but, like Thaler points out, relies on heuristics. System 2 is effortful thought, what we think of as us, the thinking, rationalizing, decision-making self.

System 1 likes to run the show, and always has something to say. Don’t remember the drive home? You likely relied on System 1 to do all the driving. If I were to instruct you, “don’t think of a panda,” would you have succeeded? If not, thank your System 1 for being a little pushy.

One such bias System 1 entices us with is loss aversion. We are more afraid to lose than we are excited about a gain of an equivalent value. Consider a coin flip, heads you win $110, tails you lose $100, you in? Not many people say yes, despite the value being in your favor.

“The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.”

The loss aversion discovery marked the beginning of a string of biases and heuristics being discovered and studied (another important one is the confirmation bias—“People have a natural tendency to search for confirming rather than disconfirming evidence.”). Economics failed to keep up with psychology, however, leading to a number of issues:

“This distinction between what we want and what we choose has no meaning in modern economics, in which preferences are literally defined by what we choose. Choices are said to “reveal preferences.””

Anyone who has smoked a cigarette when they’re trying to quit, ordered a pizza when they’re on a diet, or gotten on Facebook after too many drinks knows that not every action we make coincides with what we really want.

“[Kenneth] Arrow also noted an inconsistency inherent in the behavior of an economic theorist who toils for months to derive the optimal solution to some complex economic problem, and then blithely assumes that the agents in his model behave as if they are capable of solving the same problem.”

We are not all economists, and we do not have the same knowledge regarding appropriate economic behavior. We don’t often have the time to stand around doing economic equations in our mind, we need to go with the gut and hope we made the right decision. Sometimes we just give in knowing it’s the wrong decision. An economic model built on the idea that its agents are all rational decision-makers is not based on us.

For more, consider picking up Richard Thaler’s book on Amazon.