Goodbye to Economic Man:
Having established that we systematically make choices that are quite different from those predicted by current economic theory, behavioral economics is now attempting to develop new mathematical models, often using game theory, that yield accurate choice predictions. For example, there is an article in the latest American Economic Review entitled "A Dual-Self Model of Impulse Control." It turns out that models of dual or multiple selves a long-term self and a short-term self (or selves) best explain choice behavior. Perhaps economics is beginning to move toward the religious concept of man.
Behavioral economics does not challenge our basic values of liberty and freedom and our belief that we should have the right to make our own important choices about our lives what career to choose, whom to marry, where to live, what to study, etc. As one would expect, it concerns mostly choices about money, what to buy and when, what investments to buy and sell and when, how much to save and consume, etc., but it also includes other choices involving probabilities and numerical outcomes. Some of the principal findings of behavioral economics are discussed below, but first let me say something about rationality.
Rationality may have a clear meaning in a world with no uncertainty to maximize utility, or (as in behavioral economics experiments) to maximize the monetary payoff. But when uncertainty enters in, then what do we do? Do we assign subjective probabilities and maximize expected value, or minimize the maximum loss if we are pessimists, or minimize regret if we want a tranquil life? Who is to say that use of any one of these decision rules is more rational than another? Yet they can lead to radically different choices.
One of the principal results of behavioral economics is what is known as "framing": when the same facts are presented in different ways, the choice made may be different. The classic experiment concerns an epidemic affecting 600 people. By following one course of action, 200 of these 600 can be saved with certainty. On the other hand, by following a different course of action there is a one-third chance of saving all 600 and a two-thirds chance that all 600 will die.
Presented in this way in this frame a large majority chooses the certain choice of saving 200. But when presented as a situation in which 400 will die with certainty, or alternatively, there is a one-third chance that 600 will live, a large majority chooses the second option. Yet the two frames are equivalent!
Economics used to say that advertising provided the information needed to make choices. Behavioral economics says that advertising frames choices so that the choice made will be the one the advertiser wants. Framing of choices forces us to work harder to understand fully the choice we face and to make sure that we have all the information needed to make the choice. I suppose we all know this, and we go on the internet, read Consumer Reports, or seek out a friend who is an expert to get the information we need to make choices. We are annoyed about offers we receive for internet, cable, or telephone services at a bargain rate for a few months without a word on what we must pay afterwards.
Another finding of behavioral economics is that we suffer much more from a financial loss than we benefit from a gain of the same size. Known as "loss aversion," this unwillingness to accept the probability of even a small loss, despite the probability of a much larger gain, is a major factor in making investments. We tend to accept greater risk to recoup a loss than we would to make the very same gain.
With the change from employer-provided pensions to personal responsibility to choose investments for retirement, this loss-aversion factor is becoming more important for us. To overcome this, we must make a commitment to consider gains and losses with equal weight in making investments. The word "commitment" arises frequently in behavioral economics, as a way of avoiding bad choices by predetermining how a choice will be made or avoided.
Another key finding is that we value what we have more than what we might acquire. We put a higher price on selling what we already own than the price we put on what we would pay to buy it if we did not own it. Known as the "endowment effect," this factor is important in the real estate market, where owners want to overprice their homes. This, combined with loss aversion in a down market where a home will sell for less than was paid for it, results in unrealistic prices and homes that do not sell.
Loss aversion is also important for the environment, where it affects the pricing of conservation easements and the purchase of conservation properties. When "contingent valuation" is used to determine the value of a conservation property by asking how much one would pay for it, or how much one would sell it for, then the selling price given is consistently higher than the price one would pay for it.
A famous experiment explores the concepts of fairness and trust. The first person has a fixed amount, say $10, which she can keep, or she can give part or all of it to the second person, who will have the amount she receives, if any, tripled. The second person then decides how much, if any, of the tripled amount she returns to the first person. The game is repeated many times. A "fair" solution might be to give away the $10, have it tripled to $30, and for the second person to keep $15 and return $15 to the first person, or perhaps even $20, so that both will gain equally from the initial situation. But this requires trust on the part of both persons, and the actual results may vary greatly.
One outcome that occurs is that the first person, even if she would end up with slightly more than $10, but less than the second person, will refuse to give the second person any funds at all, sacrificing profit maximization to punish what she considers unfair behavior. Use of functional MRI brain scans during this game has disclosed that men and women activate different parts of their brains while playing this game!
Finally, perhaps the most important practical finding of behavioral economics concerns time preferences. When offered a choice of a fixed amount of money versus a larger amount at a later date, if the choice to be made is between receiving both amounts in the future, then we choose the larger, later amount. On the other hand, if the choice to be made is between the smaller amount today or the larger amount later, then we choose the smaller amount today. This means that we discount two events in the future at a lower percentage rate than we use for discounting the immediate future starting today. In behavioral economics, this is called "hyperbolic" discounting.
That we have a strong preference for immediate gratification is hardly a secret. This tendency must be combatted with a strategy of commitment that does not allow the immediate consumption of what had previously been chosen for investment. In finance, saving for retirement will be too small unless some form of commitment is exercised, either by the government, by employers, or by the individual. The problem is compounded by the empirical fact that we are reluctant to consider complicated questions about pensions and retirement, and tend to postpone their consideration.
Economists are interested in whether there are different parts of the brain controlling the short-run impulsive selves and the long-run patient self. A 2004 article in Science used functional MRI scans of the brain to claim that "Separate neural systems value immediate and delayed monetary rewards," with separate parts of the brain considering immediate and delayed choices [summary]. This means that separate selves may be more than a metaphor. This new field is called "neuroeconomics."
Economists are giving a great deal of attention to behavioral and neuroeconomics now. Only time will tell if the attempt to build theories that predict actual behavior and derive their logical structure will pay off in better policy in the future, as well as better understanding of how we make choices. I hope they will.
Personally, I see signs of overconsumption and underinvestment everywhere, from the low level of savings in our economy, to the borrowing from abroad to finance the current account deficit in the balance of payments (largely caused by the high level of consumption), to the lack of savings for retirement by the baby boomers, to the failure to prepare for the upcoming crisis in financing Social Security, Medicare, and Medicaid, and to the deficits run by our government. It is hard to believe that our current government will take effective action given current attitudes. Perhaps a new paradigm in economics will help a paradigm that abandons the old "economic man" in favor of a recognition that we make choices as though we have dual or even multiple economic selves.
Yours in friendship,
Please send comments on this or any TQE, at any time. Selected comments will be appended to the appropriate letter as they are received. Please indicate in the subject line the number of the Letter to which you refer!
Our email address for commentary is "tqe-comment" followed by "@quaker.org". All published letters will be edited for spelling, grammar, clarity, and brevity.
Excellent article. As an investor, I get to observe behavioral psychology and economics at work all the time. For example, in assessing mutual funds, investors just seem wired to extrapolate investment results over the past one to three years and to throw money at the best performing funds, despite there being no evidence that past investment results predict future investment results. My orientation sometime makes me wonder about the psychology of group decision making in Quaker meetings: fertile ground for "groupthink"?
John Spears, Princeton (NJ) Friends Meeting.
Great provocative piece! I have often been intrigued by your examples of "framing a choice" and "fairness and trust" having seen this at work in my own family. Why is it we make decisions which seem contrary to our best interests? And, by extension, does this same process extend to areas beyond economics, e.g. Barbara Tuchman's The March of Folly: From Troy to Vietnam, in which she examines the tendency of governments to act against their own interests?
In TQE our primary interest is economics, but a companion piece here might be "Goodbye to Rational Man: Meditations on Behavioral Man."
Norval Reece, Newtown (PA) Friends Meeting.
Brilliant piece. Information and incentives, the cornerstones of the New Institutional Economics, are taken a step further.
J. D. Von Pischke.
I can't speak to the details of "economic man" and "traditional economic theory." However, I do know something about religion and theology, and based on that, it needs to be said that the description here of "religious man" is rather narrow and simplistic; I hope the economics here is better than the theology.
Whole shelves in seminary libraries groan under the weight of books devoted to varying religious notions of a "doctrine of man" (or humanity), also known as "anthropology." This means a religious understanding of human nature and motivations not to be confused with the social science discipline of the same name.
Among these many notions, the ones that are presently most compelling to me are those which substantially downplay the "individual-facing-temptation" model as the locus of activity and interest, seeing humans more as the instruments or even pawns of much larger, impersonal forces, which some call "principalities and powers."
I'm not sure how this view relates to "economic man" and to the research based around such concepts. I expect it would make for a significantly different, and for me a richer, more provocative analysis.
Chuck Fager, Quaker House, North Carolina.
Thanks to William Rhoads for this helpful summary of what behavioral economists have been up to. I think it well past time to move past the idea of homo economicus and to wake up and smell the real people. The research results are an interesting beginning. However, it seems way too early and, accordingly, not very fruitful to jump immediately to mathematical models that carry forward many other unrealistic assumptions often adopted by economists.
Perusing the sample by Fudenberg and Levine cited by William, one finds not only process assumptions like continuity and maximization that so far as I am aware are rarely present in natural or social systems, but also unexamined assumptions about preferences. As Michael and Becker put it: "For economists to rest a large part of their theory of choice on differences in taste is disturbing, since admittedly they have no useful theory of the formation of tastes, nor can they rely on a well-developed theory of tastes from any other discipline in the social sciences, since none exists."
Finding a model that can replicate a narrow experiment that is isolated from the real world may tell us exactly nothing about how people work in practice. Dennett (in Consciousness) describes consciousness as a process involving competing demons struggling for supremacy of attention. (See also The Feeling of What Happens by Damasio.) The evolutionary psychologists describe our minds as modular (but can't agree on what the modules are compare The Adapted Mind by Barkow, Cosmides, & Tooby with Adapting Minds by Buller.
All of this ignores the strong effects of social context and culture. We are not autonomous deciders, but act in contexts that are social and organizational and imbued with that residue of past interactions called culture. In this context, Douglas speaks of goods the things that economists often view as the beginning and the end of the analysis as markers for cultural categories. That is, they are valuable as much for the meaning they convey as for their function. Yes we are hungry, but we can eat bologna sandwiches on wonder bread or hummus on pita. We want to get somewhere, but we can drive a Hummer or a Volvo. We behave differently in a court of law than on a basketball court (though the competition may be just as intense).
Selves are much more complicated than Fudenberg and Levine begin to contemplate. Sen's new book, Identity and Violence, is a much more fruitful sort of inquiry in our present state of knowledge.
C. Baird Brown.
"I read every issue of Forbes, in order to get an idea of the world-view of the prototypical 'Rich Person' ... For the same reason, but in search of information about a very different world-view, I read The Quaker Economist, and am often astonished at what I find there. Sometimes I agree, sometimes I don't, but I always learn something. Unlike Forbes, it's free." Ozarque, 8 Jan 2006.
Copyright © 2007 by William Rhoads. All rights reserved. Permission is hereby granted for non-commercial reproduction with attribution. Students take note: copying any part of this essay into your written work without attribution is plagiarism.