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Is Behavioral Economics Good Economics?

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Tags Austrian Economics OverviewOther Schools of Thought

11/17/2017

Recently, a relatively new economics called Behavioral Economics (BE) has started to gain popularity. Its practitioners such as Daniel Kahneman, Vernon Smith, and Richard Thaler were awarded Nobel prizes for their contribution in the field of BE.

The BE framework emerged on account of dissatisfaction with the neo-classical theory regarding consumer choices. A major problem with the neo-classical theory that people presented as if a scale of preferences is hard-wired in their heads. Regardless of anything else, this scale remains the same all the time.

The practitioners of BE hold that this is a very unrealistic case. Hence, to make the mainstream framework more realistic they suggested introducing psychology into economics.

It is held that people’s emotional state is going to influence their decision-making process. Thus, if consumers are becoming more optimistic regarding the future then this is going to be an important message to businesses regarding their investment decisions.

According to BE researchers whether consumers are generally patient or impatient determines whether or not they are inclined to spend or save today. If they are more patient and save more, then this can generate funds for entrepreneurs’ new investment projects.

Behavioral economists emphasize the importance of personality. An emphatic person is regarded more likely to make altruistic choices. Impulsive people are more likely to be impatient and not so good at saving up for their retirement. Venturesome people are more likely to take risks — they will be more likely to gamble (see Michelle Baddeley's Behavioural Economics. A Very Short Introduction).

While the BE criticism of mainstream economics is valid, the question arises whether BE solves the issue of unchanged consumer preferences and presents consumers as real people and not as human machines.

The key here is the definition of what human beings are all about. According to BE, people are not rational in a sense that they are using reason in various decisions. According to BE practitioners, the key driver for consumer choices are emotions. For instance, the Nobel laureate Vernon Smith holds,

People like to believe that good decision making 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.1

Obviously once the importance of reason is dismissed, what is then left is 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.2

By rejecting the importance of the human reason, behavioral and experimental economists treat man as another animal. In fact, some of the experimental economists are conducting various experiments on pigeons and rats in order to verify various propositions of mainstream economics.3

Why the introduction of psychology in economics will not make economics more realistic

Psychology is an important element in behavioral and experimental 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 does not 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.4

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?5

Therefore, economics deals with any given end and with the formal implications of the fact that men have ends and utilize 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. This is precisely what psychologist Daniel Kahneman, the Nobel laureate 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 Kahneman has discovered, however, 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.

Contrary to mainstream thinking, the Austrian school of thinking always held that valuations do not exist by themselves regardless of the things to be valued. On this Rothbard wrote, “There can be no valuation without things to be valued.”6

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

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 labeled by mainstream economics as a utility function. Curiously, the assumption of constancy is labeled 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 behavior systematically deviates from the one of the human machine as depicted by the mainstream economics.7

Rather than dismissing the assumption of constant preferences, Kahneman has retained this assumption and has only modified the mathematical formulation of consumer’s preferences, i.e., the utility function, in order to bring supposedly more realism into the 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.8

The Misesian framework of consumer choices

Following Mises’s framework of thinking, we can ascertain the distinguishing characteristic and the meaning of human action. For instance, one can observe that people are engaged in a variety of activities. For instance, they may be performing manual work, driving cars, walking on the street or dining in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.

Furthermore, we can establish the meaning of these activities. Thus, 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 for establishing business relationships. Driving a car may be a means for reaching a particular destination.

In other words, people operate within a framework of ends and means; they use various means to secure ends. We can also, establish from the above that actions are conscious and purposeful.

The knowledge that human action is conscious and purposeful is certain and not tentative. Anyone 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 derived from this knowledge of conscious and purposeful action are valid as well, implying that there is no need to subject them to various laboratory tests as is done in the experimental economics. For something that is certain knowledge, there is no requirement for any empirical testing.

Behavioral and experimental economists such as Nobel Laureate Vernon Smith, however, reject 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.9

Means-Ends and Consumer Choices

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

For instance, if my end is to provide a 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 for grading these institutions is my end, which is to provide my child with a good education.

Or, for instance, if my intention is to buy a car, there are all sorts of cars available in the market, and as such I have to specify to myself the specific ends that the car will help me to achieve. For instance, a factor I may need to consider is 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 the 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 — and 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.

Observe that the means-end framework is the essence of any human action whether the action is in accordance with what is regarded as rational 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, or from questionnaires do not advance our understanding of human action as far as economics is concerned, but on the contrary prevents us acquiring any meaningful knowledge.

Conclusions

By casting doubt on the notion that reason is the main faculty that navigates human actions behavioral economics emphasizes the importance of emotions as the key driving factor of human actions.

By means of psychological analysis, the practitioners of behavioral economics have supposedly demonstrated that people’s conduct is irrational.

Consequently, the practitioners of behavioral economics may have unintentionally laid the foundations for the introduction of government controls to "protect" individuals from their own irrational behavior.

For instance, wide fluctuations in financial markets can be attributed to irrational behavior, which can damage the economy. Hence, it will make a lot of sense to restrain this irrationality by a dosage of restraining regulations.

Note that behavioral economics, while criticizing the mainstream economics for not being realistic regarding human choices, treats human beings as automatons.

  • 1. Vernon L. Smith, “ Reflections on Human Action after 50 years,” Cato Journal 19, no.2 (Fall 1999): 200.
  • 2. Ludwig Von Mises, The Ultimate Foundation of Economic Science. See chapter 2.
  • 3. Frances K. McSweeney and Samantha Swindell, “Behavioral Economics and Within-Session Changes in Responding,” Journal of the Experimental Analysis of Behavior 72, no.3 (November,1999): 355–71.
  • 4. Murray N. Rothbard, Man, Economy and State, p. 63.
  • 5. Ibid., p. 63.
  • 6. Murray N. Rothbard, Towards a Reconstruction of Utility and Welfare Economics.
  • 7. Daniel Kahneman and Amos Tversky, “Prospect Theory: An analysis of decision under risk.” Econometrica 47, no. 2 (March, 1979).
  • 8. Ibid.
  • 9. Vernon L. Smith, “ Reflections on Human Action after 50 years,” Cato Journal 19, no. 2 (Fall 1999): 200.

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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