This article is from the RIIB blog of June 24, 2009.
This past Saturday I happened to be listening to CBC radio’s science show “Quirks and Quarks”. The show was advertised as having a report on the latest research advances on the space elevator. Being a bit of a science junky, I tuned in. Before I could hear about the space elevator, I was subjected to a report on the exciting new field of “Behavioral Economics”. The report began with the usual description of the “traditional economic approach”; namely, that economists have believed for most of the past 100 years that individuals make decisions fully aware of economic principles. This is the stereotype of the individual as “economic man”, the rational, calculating machine. The listener is then told that recently, thanks to research advances in behavioral economics, we have come to learn that individuals aren’t nearly so adept at making decisions as economists have traditionally believed. Individuals make mistakes, they employ rules-of-thumb and they are affected by framing and emotion. Our eyes have been opened, oh happy day!
I have heard this characterization of the traditional economic approach time and again. The characterization is complete rubbish. No proponent of the traditional economic approach believes that individuals are calculating machines who make decisions fully aware of economic principles. Such economists understand that individuals make mistakes, use rules-of-thumb and can be affected by emotions. The model of economic man as the “rational calculating machine” is an abstraction and not meant as an accurate description of human decision making. It is a simplification.
This admission, of course, raises the question, “If the description of human decision making is wrong, why use it?”
The object of economic study is not human decision making. The point of economics is to understand how large numbers of individual decision makers, interacting in markets of different sorts and faced with market prices, determine the allocation of goods and services in the economy. What economists observe and have systematic data on is not the decisions of each individual. Rather, economists observe market outcomes – prices and quantities. Economists observe the way that oil production and consumption change as oil prices rise; they observe the impact of taxes on investment, work and consumption. These sorts of market outcomes are the stuff of economic study, not individual decision making.
So where does economic man come in and why the emphasis on this sort of decision maker in traditional economics? As I pointed out above, economic man is a simple abstraction adopted by economists to provide a systematic means of getting from individual decision making to the variables of interest – the market outcomes. By forcing decision makers to be “rational, calculating machines”, economists provide discipline to their analysis that may otherwise be lacking. I once attended a lecture where the speaker was trying to understand the behaviour of stock prices after an initial public offering (IPO). The speaker claimed that the standard pattern was for prices to rise significantly above the initial offer price and then, after a week or so, to decline to a value at or slightly below the initial price. The question was how to understand the initial price run-up. Why would people buy at these very high prices when we all know that prices will likely decline later. The answer the speaker gave to this question was “some people are just stupid”. While it may be right that some people don’t understand the market, this “explanation” presents a basic problem. If I am allowed to resort to justifications that rely on the idea that people are crazy or stupid or just like doing certain things, then, while I’ve justified the observed phenomenon, I really haven’t explained or understood it. Give the economist sufficient leeway on the ways that individuals make decisions and anything can be justified but little may be understood. Economic man forces economists to be more disciplined in their search for understanding.
That economic man provides discipline for economic analysis is, of course, not sufficient reason to cling to the assumption. Economists have persisted in their use of this abstraction for one simple reason: It has worked extremely well in helping economists understand and (qualitatively) predict market outcomes. Think of the recent financial meltdown in the US. The original driver of the meltdown was the large mortgage default. If you tell an economist that mortgage salespeople are paid bonuses for writing mortgages but not penalized upon mortgage default, the economist will tell you that you should expect many mortgages to be sold and defaulted upon. Specific salespeople may continue to be careful when providing mortgages but, on average, the incentive in the market (for the “self-interested maximizer of income”) is to sell mortgages and not worry about default.
There are, of course, situations in which the notion of economic man is not helpful. Economic man does not work well at explaining why someone gives $5 to the Canadian Cancer Society, why an individual votes in a national election or why a fast-food restaurant sells more hamburgers if the interior is red than if it is green. An alternative notion of individual decision making is required here because these are inherently not questions about market outcomes.
And if, one day, some alternative model of decision making proves more successful at explaining market outcomes, I guarantee that economists will adopt it. Economists are pragmatic, if nothing else. In the mean time, economists will continue to assume that economic decision makers are “rational”, not because economists believe that this is an accurate description of human decision making but for a very practical reason: Damned if it doesn’t work.