The Basic Idea
The underlying distinction between traditional economics and behavioral economics is an assumption made about the nature of human decision-making. A classical economist might argue that people are rational: they act in their best interests, seeking to maximize their desired outcomes by applying reason and logic to a set of preferences. Conversely, while a behavioral economist might not necessarily say that people are irrational, they would argue that people are not always rational.
Homo economicus (Latin for economic man) is a term often used to describe a hypothetical figure who represents this concept of unconditional rationality. Behavioral economists often point to the absurdity of rationality assumptions in economic theory, highlighting the multitude of anecdotes and experimental evidence that supports the notion that beings often deviate from these assumptions. An idealized definition of behavioral economics is that it sets out to explore the decision-making processes of homo sapiens rather than that of homo economicus. The former being real people while the latter representing a personification of a theoretical concept.
Theory, meet practice
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Rational Choice Theory: A framework that assumes individuals will choose the option that is most consistent with their preferences.
Utility: A mathematical and often hypothetical representation of an individual’s preferences in terms of both monetary and non-monetary rewards.
Expected Utility Theory: A rational choice theory that rests on the notion that given a choice under uncertainty, individuals will choose the option with the highest expected utility.
Prospect Theory: A form of decision theory that suggests people perceive value in relation to gains and losses rather than in absolute terms. Derived from experimental results, it assumes that the prospect of a loss looms larger than that of a gain.
Normative Theory: A theory that characterizes rational choice; assuming what is right or wrong (e.g., expected utility theory).
Descriptive Theory: A theory that characterizes actual human choices (e.g., prospect theory).
The origins of self-interest in economic theory can be traced back to Adam Smith, who wrote The Wealth of Nations in 1776. The canonical book is a foundational text in classical economics, as it outlined the supposed societal benefit of individual self-interest. Smith wrote: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”
The term “economic man” is often traced back to the philosopher and political economist, John Stuart Mill. In the mid-19th century, Mill had set out to define the political economy, describing man’s nature as a “being who desires to possess wealth, and who is capable of judging the comparative efficacy of means for obtaining that end.” While Smith had suggested society is ruled by self-interest, Mill went a step further in advocating that individuals have the means to adequately meet this self-interest. Though Mill never actually used the term, “economic man,” it emerged as a reaction to his work.1 For example, in 1888, John Kells Ingram, an Irish economist, criticized Mill as dealing “not with real but imaginary men – ‘economic men’…conceived as simply money-making animals.”
Despite these criticisms, mathematical theories built upon the pioneering assumptions of Smith, Mill, and others that followed them, would help give rise to rational choice theory as the prevailing view in economic thought. In 1944, John von Neumann and Oskar Morgenstern published Theory of Games and Economic Behavior, introducing the field of game theory to economics. In the book’s second edition released in 1947, they unveiled the axioms of expected utility, a formulaic account of how people choose rationally under uncertain conditions. Like Smith’s Wealth of Nations, von Neumann and Morgenstern’s text became a landmark piece in economics and was used not just as a mathematical model of rational behavior, but as a description of how people actually make decisions.
Although challenges to expected utility theory such as the work of Maurice Allais emerged shortly after von Neumann and Morgenstern’s book, such criticisms didn’t immediately gain traction in mainstream economics. In 1973, Israeli psychologists Daniel Kahneman and Amos Tversky published On the Psychology of Prediction,2 writing that when “making predictions and judgments under uncertainty, people do not appear to follow the calculus of chance or the statistical theory of prediction.” Six years later, they published their paper on prospect theory, a descriptive theory and empirically-based view of decision-making that presented an alternative to the normative account of expected utility theory.
Kahneman and Tversky’s work would inspire the career of Richard Thaler, who has been credited with bringing psychology to economics and popularizing the field of behavioral economics. In 2001, Thaler published a paper titled From Homo Economicus to Homo Sapiens.3 The paper’s abstract reads: “In responding to a request for predictions about the future of economics, I predict that Homo Economicus will evolve into Homo Sapiens, or, more simply put, economics will become more related to human behavior. My specific predictions are that Homo Economicus will start to lose IQ, will become a slower learner, will start interacting with other species, and that economists will start to study human cognition, human emotion, and will distinguish more clearly between normative and descriptive theories.”
John Stuart Mill
According to the Stanford Encyclopedia for Philosophy, Mill was the most influential English language philosopher of the 19th century.4 One of Mill’s many intellectual contributions was his beliefs about the role of free markets in the political economy. His book Principles of Political Economy published in 1848 was the most influential text in economics in the 19th century.
John von Neumann & Oskar Morgenstern
Von Neumann, a mathematician, and Morgenstern, an economist, are known for their intellectual collaboration and creation of the field of game theory in economics. Expected utility theory, the predominant normative theory in economics for the second half of the 20th century, is based on von Neumann and Morgenstern’s theorem devised in 1947.
Daniel Kahneman & Amos Tversky
Renowned in the fields of economics and psychology, Kahneman and Tversky are best known for their groundbreaking work, in the field of judgment and decision-making. Together, their paper on prospect theory published in 1979 became a key component in the foundation of behavioral economics, offering a descriptive theory that challenged traditional assumptions around rationality. Kahneman is a Nobel Laureate, having won the prize in economics in 2002, which likely would have been shared with Tversky had he not passed away in 1996.
A University of Chicago economist, Thaler is best known for his pioneering work in the field of behavioral economics. He is responsible for helping bridge the academic domains of economics and psychology, as well as communicating concepts from behavioral economics to a broad audience through the co-authoring of the bestselling book, Nudge. Thaler won the Nobel Prize in Economics in 2017 for his contributions to the field of behavioral economics.
Considering the ramifications of homo economicus requires a level of speculation. As mentioned earlier, homo economicus is a personification of a theoretical assumption in economics rather than a distinct concept. Although one could say that the field of economics was for a long time restrained by erroneous assumptions about human decision-making, a lack of counterfactual at our disposal makes it near impossible to decipher the consequences of the theoretical journey economics has had.
One can speculate, however, on the influence institutional faith in free markets has had on the global economy. In addition to individual-level decision-making, allegiance to rationality also guided macroeconomic thinking around markets. The efficient-market hypothesis, for example, is the notion that asset prices in financial markets reflect perfect rationality among investors who’ve priced in all available information, making it impractical to consistently beat the market. A similar level of faith in the free market can be seen in the thinking of Milton Friedman, a 20th century economist who was highly influential in America’s monetary policy in the 1980s. Friedman believed in minimal government intervention, leaving the free market to solve societal inefficiencies. He would become an advisor to both Ronald Reagan and British Prime Minister Margeret Thatcher, urging free-market policies. ”It’s hard to think of anyone who’s had more of a direct influence on social and economic policy in this generation,” wrote Allan H Meltzer, an economist at Carnegie Mellon University.
Economic beliefs around rationality dating back all the way to Adam Smith, through to von Neumann and Morgenstern, to Milton Friedman, have cultivated a deeply rooted ideology in economics that has permeated economic and public policy around the world. Under Friedman’s intellectual support, Ronald Reagan’s approach to economic policy, which is sometimes referred to as “Reaganomics” or “trickle-down-economics”, became the scaffolding for future generations of economic policy for a number of fiscally right-wing political parties and sounds strikingly familiar to Adam Smith’s ideas in Wealth of Nations: that societal benefit stems from rational self-interest. Despite their application to real world policies, these ideas remained largely theoretical. In 1983, close to 60 percent of articles in top economic journals used theory as their methodology.5 Some have argued that this type of laissez-faire economics is responsible for the levels of income inequality seen today, as well as creating a financial system that gave rise to the global financial crisis in 2008.6
Unsurprisingly, not all economists have accepted the rejection of normative theories. In his book Misbehaving, Richard Thaler discusses the receptive friction in the field upon the notion of behavioral economics. He also highlights an ongoing debate he has with his colleague at the University of Chicago, Eugene Fama, an architect of the efficient-market hypothesis. Both sides of this debate, which extends beyond the two economists, are embraced by the fields of economics and finance. In 2013, the Nobel Prize in Economics was shared by Fama and Robert Shiller, a Yale economist who believes human psychology leads to market inefficiencies. The fact that the Nobel Prize was awarded to two economists (along with a third, Lars Hanson) who champion contradicting theories reflects the nuance of economic thought.
Not all believers in homo economicus rely solely on theory. Fama and Shiller’s Nobel Prize for instance was awarded for their empirical analysis of asset prices. And an empirical argument can in fact be made in regard to rationality. The key point here is asking what exactly is rationality. Expected utility theory can be seen as a rather nebulous concept once we question the substance of utility. Consider a classic incubator for “irrational” behavior: the ultimatum game. The ultimatum game involves two individuals, where one is endowed with a sum of money (e.g., $10) and they choose how to split it with another person. It is then up to this other person to accept the offer, where both are rewarded the devised amount, or reject the offer, where both receive nothing. The common experimental finding is that when an individual makes a low ball offer, such as $9 for herself and $1 for the other person, that offer is rejected. This rejection behavior is typically labeled as irrational since $1 is still better than $0. These types of findings are ubiquitous in the paperbacks of Dan Ariely and Richard Thaler, but the behavior is not exactly inconsistent with expected utility theory. If we broaden our view of utility to include not just monetary rewards, but also social, emotional, and cognitive rewards, rationality begins to look very different. In the case of an individual rejecting the offer of $1, perhaps the utility they would achieve via the emotional reward in the form of spite is greater than the payout of $1. This would render the rejection rational, as it was a decision that led an individual to maximize their utility given their choice. Of course, ambiguous rewards such as those on the cognitive-emotional spectrum are difficult if not impossible to measure empirically, leaving monetary value in the form of dollars and cents or material goods as the most accessible metric of utility.
A proponent of homo economicus could therefore argue that we can never be sure what an individual’s preferences really are. Making the assumption, for example, that forgoing saving for the future in exchange for present consumption is irrational, can be seen as rather ironic as the assumption that saving is rational rests on a similar normative basis that rational choice theories rely on. In other words, simply providing empirical support to discredit the notion of individual rationality does not address the fact that we cannot actually be sure of whether or not a given decision is in line with one’s preferences.
Related TDL articles
This article, the first of a three-part series, discusses the origins of decision theory, highlights the focus on rationality as the foundation for the theoretical concepts that guided much of economic thought in the 20th century.
This piece is the second part of the Evolution of Decision Making, touching on the emergence of publications in the field of economics that challenged the notion of homo economicus.
- Persky, J. (1995). The ethology of homo economicus. Journal of Economic Perspectives, 9(2), 221-231.
- Kahneman, D., & Tversky, A. (1973). On the psychology of prediction. Psychological review, 80(4), 237.
- Thaler, R. H. (2000). From homo economicus to homo sapiens. Journal of economic perspectives, 14(1), 133-141.
- Macleod, C., (2020). John Stuart Mill. The Stanford Encyclopedia of Philosophy. Retrieved from https://plato.stanford.edu/entries/mill/
- Smith, N., (2016, August). Data Geeks are Taking over Economics. Bloomberg Opinion. Retrieved from https://www.bloomberg.com/opinion/articles/2016-08-25/data-geeks-are-taking-over-economics
- Piketty, T., (2014). Capital in the Twenty-First Century. Harvard University Press.