Mainstream and behavioural economics are two sides of the same coin

The term ‘economics’ tends to incite a lot of passion. For many people, it typifies a cold, emotionless perspective on life that just looks at money. It represents the cynical world view of those who, as Oscar Wilde said, “know the price of everything and the value of nothing”.

There are undoubtedly people – probably even economists – who do fit that description. But the idea that economics is all about bankers and big business, about commerce and making profits, is not just undeserved.

It is also inaccurate. Economics is in the first place a way of looking at human behaviour, to understand it and to explain it.

Behavioural Economics has been playing a big part in stressing the human dimension in the dismal science. Daniel Kahneman, Richard Thaler, Cass Sunstein and Dan Ariely have been doggedly chipping away at the concept of the homo economicus. (It is interesting to note that only one of these fine gentlemen is actually an economist.)

But you would be wrong to think that this is a totally new development. The father of modern economics, Adam Smith himself, was well aware of human quirkiness, say Nava Ashraf, Colin Camerer and George Loewenstein.

In a paper with the striking title, “Adam Smith, Behavioral Economist”, they show how he wrote about much of what behavioural scientists have more recently been studying in detail.

So Wikipedia has got it pretty much spot on when it describes as “[p]erhaps the most commonly accepted definition of the subject” this quote from the economist Lionel Robbins,

“Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”.

What comes immediately to mind when talking about scarce means is, of course, money. You can use each pound, dollar or euro only once.

And if – like most people – you only have a limited supply of them, you have to choose where you spend it, whether you’re an individual, a household or a firm.

Not so simple

Faced with that choice you have to establish which of the possible uses of your money is ‘best’. Companies generally have pretty solid procedures to compare different options with each other: they look at the net present value or the return on investment.

Both are measures of economic utility, and for a company they can usually be reduced to money. (This goes some way towards explaining the reputation of economics.)

But for households and individuals things are not quite so simple. Classical economists have a tendency to treat people as if they were rational actors, or “econs”. (Richard Thaler and Cass Sunstein introduced this term in their book, Nudge). Just like firms, these folks pursue the maximization of their own (economic) utility at all times.

But real humans tend to ignore the quantitative, predictable rules that describe how firms behave. For one thing, our choices often involve non-financial aspects that cannot easily be evaluated in an objective way. Imagine you get a generous bonus at work – what gives you the most utility: a holiday or on a new kitchen?

This does not mean that economic principles don’t apply to humans, though. Gary Becker, one of the most important economists of the last century, was among the first in his field to apply economic principles in a sociological context.

More than 50 years ago he came up with the idea of ‘human capital’: people can choose to invest in their personal development, much like they can choose to invest in stocks and shares.

But his interest went a lot further, and he covered topics as diverse as crime, marriage, parenthood and discrimination.

It is said that his curiosity in crime arose when he was late for an appointment, and there was no time to find a free parking spot. Instead he estimated the chance of getting a fine and how much it might cost him, and worked out that he might as well park illegally.

And according to Becker criminals were just as calculating: their crimes simply followed from a cool, rational cost-benefit analysis.

Even if the idea of the “rational crime” is a bit outdated – Dan Ariely paints a much more nuanced picture of fraud and deceit in The Honest Truth About Dishonesty – Becker’s work made a huge contribution to the use of economic thinking to get a better understanding of human behaviour.

And that can be done very well without involving money and rationality. In our daily life there is a scarce resource we bump into all the time: time.

Everybody, no matter how rich or poor, has the same, restricted budget of 24 hours per day. And we continually trade with our time. Many of us trade some of it for money: we “sell” our time to an employer or a client, in return for a salary or a fee.

Trade-offs everywhere

But we trade with our time much more widely. A mother promising her little boy she will read him a story if he tidies his toys? Both make a trade-off, which leads to a successful transaction if both mum and son consider the trade to be worthwhile. A guy sacrificing his free Saturday afternoon to help a friend move house?

He is building up credit that he can withdraw later on. A royalist waiting for hours behind a barrier, in the hope that, just maybe, she can get a handshake from the new King? She is an investor taking a gamble with an unlikely, but very high, payoff.

A family deciding to take the plane to their holiday destination in Spain, rather than to go by car? They are a bunch of people that prefers spending their scarce time on the beach rather than in a traffic jam.

Why do these people do what they do? They might not realize it, but they are led by economic thinking: they make a trade-off and choose the option that, for them, and at that time, seems the best. Conventional economists may see a lot of irrationality in our choices, but they mostly miss the point.

If I spend half an hour online looking for the cheapest computer mouse, and that saves me just one pound, does that mean I value my time at just £2/hour, as an economist would calculate it? Nope. Maybe I hate paying over the odds so much that I happily sacrifice my scarce time to avoid doing so.

We even trade with ourselves – our future selves. Picture someone who ‘invests’ an hour in making a shopping list template, ordered according to the different aisles in the supermarket. (Yes, that’s me.)

That means he can save ten minutes every week while pushing his trolley all over the shop. The payback period is just six weeks, producing an annualized ROI of 766%. Not many financial investments produce that kind of return.

And such choices are everywhere. The choice between going to university or starting work at age 18, between going to the pub or washing up tonight, or between a cool job 50 miles away and a boring one round the corner – all examples of trading with ourselves.

Humans vs Econs – adversaries or collaborators?

Do we always make the best choice? Unfortunately not. Sometimes the trade-off is hard to make: spending that unexpected bonus now, or saving it for later?

The pleasure of instant gratification in combat with our long-term desire for financial security. Sometimes our perception plays tricks with our mind: a £20 bottle of wine on the menu looks a lot less expensive if it’s listed next to a £35 one.

Behavioural economists have an endless array of examples of such behaviour that is at odds with what a rational homo economicus would do.

Sadly the terminology they use – real people are “irrational”, and subject to “fallacies” and “biases” – carries a lot of emotional baggage.

This is grist to the mill of those who are unconvinced of the value Behavioural Economics brings to the field. Nobody likes being described as irrational, or as a gullible person who falls for fallacies, or as someone who is biased.

And there is a good deal of criticism of Behavioural Economics around. Some of it takes the defence of the heuristics, the mental shortcuts that have served mankind for thousands of years, that are treated as cognitive biases in behavioural science.

Other criticisms seek to recapture BE concepts by redefining rationality such that conventional economics actually explains human behaviour correctly after all. Perhaps the BE notion of loss aversion is just a special case of the conventional economics law of diminishing returns.

Conflicts among economists are not unusual, but the discord between neoclassical and behavioural economics is unfortunate and arguably entirely unnecessary. But there is hope.

At the end of his book Misbehaving, Richard Thaler casts an optimistic look ahead on the economics profession. He sees more and more ordinary economists with an open mind, ready to let go of the old rational models if they fail to explain reality.

Soon all economics will be just as behavioural as it needs to be, and then the field of behavioural economics will disappear.

That still positions behavioural economics as a subset of economics, which will in the end be embraced by the real, orthodox superset. But is economics as a whole not essentially a deeply human affair?

Every choice we make is really a trade-off. It shows what we are prepared to sacrifice in return for something else. Sometimes we use a dose of deliberate, reasoned, conventional economic thinking.

And sometimes our choice is not so deliberate and reasoned, but instead we are led by emotions, heuristics or just whatever happens to be easiest.

Maybe it is not a question of subset and superset, and there is really just one kind of economics, in which quirky humans and rational econs work side by side, rather than as master and servant.

Because, even if we do not always realize it, we are all economists.

(First published at https://koenfucius.wordpress.com/2016/06/03/we-are-all-economists/ )