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Behavioral, Experimental, and Austrian Economics

Mises Daily: Sunday, October 27, 2002 by

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This year the Nobel prize in economics was awarded to Daniel Kahneman and Vernon Smith. These two economists have been probing the validity of popular economic theories regarding peoples' choices. Kahneman integrated insights from his psychological research into the field of human judgment and decision making under conditions of uncertainty. Smith has established an experimental laboratory as a tool for validating economic theories. 

The two Nobel laureates are regarded as pace setters in the way economics will evolve in the future. That these economists have begun to question the validity of various popular theories is a welcome move. However, will the ideas that Kahneman and Smith introduced take economics to new heights or could they contribute to its retardation? 

Is there a place for experimental economics?

Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences in economics could lead to a major break-through in our understanding. But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. If anything, the introduction of a laboratory in economics only stifles our understanding. 

Why is that so? A laboratory is a must in physics, for there a scientist can isolate various facts relating to the object of inquiry. Although the scientist can isolate various facts he doesn’t, however, know the laws that govern these facts. All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified. He can never be certain however, regarding the “true” laws of nature. On this Murray Rothbard wrote,

The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.[1]

Contrary to the natural sciences, the facts pertaining to human action facts cannot be isolated and broken into their simple elements. The realities of human action are complex historical facts that have emerged on account of many causal factors. However, contrary to the natural sciences we know the meaning of human action. 

One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.

Manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means to establishing business relationships. Driving a car may be a means for reaching a particular place. In other words, people operate within a framework of ends and means; they use various means to secure ends.

In short, we know that actions are conscious and purposeful. Also, note that this knowledge that human action is conscious and purposeful is certain and not tentative. Any one who tries to object to this in fact contradicts himself for he is engaged in a purposeful and conscious action to argue that human actions are not conscious and purposeful. 

Various conclusions that are derived from this knowledge of purposeful action are valid as well, implying that there is no need to subject them to various laboratory tests as is done in the natural sciences. For something that is certain knowledge, there is no requirement for any empirical testing.

Vernon Smith, however, rejects the view that human actions are conscious and purposeful. Thus Smith wrote,

He (Mises) wants to claim that human action is consciously purposeful. But this is not a necessary condition for his system. Markets are out there doing their thing whether or not the mainspring of human action involves self-aware deliberative choice. He vastly understates the operation of unconscious mental processes. Most of what we know we do not remember learning, nor is the learning process accessible to our conscious experience—the mind………

Even important decision problems we face are processed by the brain below conscious accessibility.[2]

Moreover, argues Smith,

The workings of the economy are not the product, nor can they be the product, of conscious reason.[3]

Not only does Smith downplay the importance of the use of reason in decision making but he argues that good decision making is in response to emotions. He writes,

People like to believe that good decisionmaking is a consequence of the use of reason, and that any influence that the emotions might have is antithetical to good decisions. What is not appreciated by Mises and others who similarly rely on the primacy of reason in the theory of choice is the constructive role that the emotions play in human action.[4]

Obviously once the importance of reason, consciousness and purposeful action is dismissed what is then left is the possibility of mimicking the natural sciences and treating human beings like objects. According to this way of thinking human action is not navigated by reason but by outside factors that act upon men. By means of a given stimulus one can then observe various human reactions and draw all sorts of conclusions regarding the world of economics. According to Mises however,

It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.[5]

By rejecting the importance of the human mind Vernon Smith has in fact treated man as another animal. In fact, some of the experimental economists are indeed conducting various experiments on pigeons and rats in order to verify various propositions of mainstream economics.[6] 

An important foundation for the experimental economics is the 1944  publication of von Neumann and Morgenstern, "Theory of Games and Economic Behavior" ( Princeton, 1944, p. 86). Accordingly it is held that human choices can be ascertained from game-like experiments. The problem with all this that game is not the real world. According to Mises,

The immediate aim in playing a game is to defeat the partner according to the rules of the game. This is a peculiar and special case of acting. Most actions do not aim at anybody's defeat or loss. They aim at an improvement in conditions. It can happen that this improvement is attained at some other men's expense. But this is certainly not always the case. It is, to put it mildly, certainly not the case within the regular operation of a social system based on the division of labor.

There is not the slightest analogy between playing games and the conduct of business within a market society. The card player wins money by outsmarting his antagonist. The businessman makes money by supplying customers with goods they want to acquire. There may exist an analogy between the strategy of a card player and that of a bluffer. There is no need to investigate this problem. He who interprets the conduct of business as trickery is on the wrong path.[7]

Psychology and economics

Psychology was smuggled into economics on the ground that human action and psychology are inter-related disciplines. However, there is a distinct difference between economics and psychology. Psychology deals with the content of ends and values. Economics, however, starts with the premise that people are pursuing purposeful conduct. It doesn’t deal with the particular content of various ends. According to Rothbard,

A man's ends may be "egoistic" or "altruistic", "refined" or "vulgar". They may emphasize the enjoyment of "material goods" and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.[8]

Whereas, 

Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or what ends should men value?[9]

Therefore, economics deals with any given end and with the formal implications of the fact that men have ends and utilise means to attain these ends. Consequently, economics is a separate discipline from psychology.

By introducing psychology into economics one obliterates the generality of the theory, and renders it useless.  This is precisely what Daniel Kahneman, the recipient of this year's Nobel in economics, and his followers are doing. 

Through various tests that he has conducted, Kahneman has concluded that people are not always behaving rationally, i.e., in accordance with the premises of mainstream economics. What, however, Kahneman has discovered has nothing to do with whether people are rational or not. It has to do with the flawed premise of popular economics i.e. that peoples preferences are constant. In short, the proposition that people are like machines that never change their minds. 

Now, if preferences are constant then it is possible to compress these preferences into a mathematical formulation, i.e., one can capture people's wishes by means of a formula, so it is held. This is labelled by mainstream economics as a utility function.  Curiously, the assumption of constancy is labelled as an important characteristic of rationality by popular economics. Obviously, people do change their minds, so it is not surprising that Kahneman has "discovered" that real people's behaviour systematically deviates from the one of the human machine.

Notwithstanding all this, Kahneman’s findings appear to seriously challenge the dogma of mainstream economics. Careful examination of Kahneman’s work however, reveals that this is not the case. Rather than dismissing the assumption of constant preferences, Kahneman has retained this assumption and has only modified the mathematical formulation of consumers preferences, i.e. the utility function, in order to bring supposedly more realism into the bankrupt model of mainstream economics. In his highly praised work Kahneman wrote,

Hence, the derived value (utility) function of an individual does not always reflect "pure" attitudes to money, since it could be affected by additional consequences associated with specific amounts. Such perturbations can readily produce convex regions in the value function for gains and concave regions in the value function for losses. The latter case may be more common since large losses often necessitate changes in lifestyle.[10] 

While the original utility function was made up by von Neumann and Morgenstern[11], Kahneman has been engaged in fine tuning the original formulation through the introduction of modifications in line with the outcome of psychological tests that he has conducted. In short, he has introduced a different form of mathematical function. In this regard he has continued with the same absurd model of mainstream economics that doesn’t deal with human beings but with machines. 

It would appear that our Laureate wasn't concerned so much with economics but rather with finding a formula that would correspond to the data from his psychological tests. In short, he has been engaged in curve fitting. If in future tests he will discover some other peculiar results then he will modify his formula again. In other words, we will be presented with a more sophisticated human machine.

 Furthermore, the mathematical and statistical methods that our author is extensively employing are not valid in the sphere of human actions. Take for instance the application of numerical probability, which requires events to be repeatable. However, in human action events are not repeatable. An entrepreneur, in making his decisions, is confronted with unique cases about which he has some knowledge and which have only limited parallelism to other cases (see Rothbard, Toward a Reconstruction of Utility and Welfare Economics). 

Means-ends and consumer choices

A major problem with the mainstream framework of thinking is that people are presented as if a scale of preferences were hard-wired in their heads. In short, regardless of anything else this scale remains the same all the time. However, valuations do not exist by themselves regardless of things to be valued. On this Rothbard wrote, “There can be no valuation without things to be valued.”[12]

In other words, valuation is the outcome of the mind valuing things. It is a relation between the mind and things.

Purposeful action implies that people assess or evaluate various means at their disposal against their ends. In short, individual ends set the standard for human valuations and thus choices. Thus by choosing a particular end an individual also sets a standard of evaluating various means. 

For instance, if my end is to provide good education for my child, then I will explore various educational institutions and will grade them in accordance with my information regarding the quality of education that these institutions are providing. Observe that my standard of grading these institutions is my end, which is to provide my child with good education.

Or, for instance, if my intention is to buy a car then there are all sorts of cars available in the market, so I have to specify to myself the specific ends that the car will help me to achieve. I need to establish whether I plan to drive long distances or just a short distance from my home to the train station and then catch the train. My final end will dictate how I will evaluate various cars. Perhaps, I will conclude that for a short distance a second hand car will do the trick. Since an individual's ends determine his valuations of means and thus his choices, it follows that the same good will be valued differently by an individual as a result of changes in his ends. 

At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated—i.e., people's living standards will increase. Another limitation on attaining various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. Diamonds in my possession will be of no help in this regard. 

The fact that people are operating within a means-end framework doesn't mean that they are like the superhuman as depicted by mainstream economics. On the contrary, the means-end framework is the essence of any human action whether the action is in accordance with what is regarded as good conduct, or not. 

Furthermore, once it is accepted that human actions are conscious and purposeful it will not make much sense to extract preferences in a laboratory, or by means of questionnaires, since only something that is constant can be extracted. Hence, the various results obtained from laboratory tests do not advance our understanding of human action as far as economics is concerned, but on the contrary prevents us acquiring any meaningful knowledge whatsoever.

Conclusions

Both of this year's Nobel prize laureates in economics may have unwittingly laid the foundation for a retardation rather than an advancement of the economics discipline. Rather than elevating the essence of human beings—which is the thinking faculty—both laureates have tried to show in their research that human actions and reason have very little in common. 

In particular Vernon Smith openly casts doubt on the notion that reason is the main faculty that navigates human actions. For him the main driving force are emotions. By casting doubt on peoples' capacity for exercising their brains the Nobel laureates may have unintentionally laid the foundations for the introduction of government controls to "protect" individuals from their own irrational behaviour. 

For instance, wide fluctuations in financial markets can be attributed to irrational behaviour, which can damage the economy. Hence it will make a lot of sense to restrain this irrationality by a dosage of restraining regulations. In fact, in one of his speeches the Fed chairman blamed the booming stock market on exactly this: irrational exuberance.


Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Dr. Shostak expresses gratitude to Michael Ryan for helpful comments during the writing of this article.


[1] Murray N. Rothbard  "Toward a Reconstruction of Utility and Welfare Economics,"On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J. : D. Van Nostrand, 1956) p 3.

[2] Vernon L. Smith  "Reflections on Human Action after 50 years." Cato Journal, 19, No. 2 (Fall 1999) , p 200.

[3] Ibid., p 201.

[4] Ibid., p 203.

[5] Ludwig von Mises The Ultimate Foundation of Economic Science. Chapter 2 Mises Institute website.

[6] Frances K. McSweeney and Samantha Swindell,  "Behavioural Economics and Within-Session Changes In Responding,"  Journal of the Experimental Analysis of Behavior 72, No. 3 (November, 1999): 355–71.

[7] Ludwig von Mises, Human Action, p 116.

[8] Murray N. Rothbard,  Man Economy and State, (Los Angeles: Nash Publishing) p 63.

[9] Ibid., p 63.

[10] Daniel Kahneman and Amos Tversky, "Prospect Theory: An analysis of decision under risk." Econometrica 47, No. 2 March, 1979

[11] John von Neumann and Oscar Morgenstern, Theory of Games and Economic Behavior, 2nd ed. (Princeton, N.J. : Princeton University Press, 1947), pp 8, 15–32, 617–32.

[12] Murray Rothbard, Toward a Reconstruction of Utility and Welfare Economics.