Behavioral economics scenarios: evolution of the paradigm of rationality or revolution of the economic science?

 The connection with psychology is intrinsic in the economy and is inseparable from it, and has been kept since the time of the classical school. Adam Smith, who has been regarded as the founder of the theory of the invisible hand in relation to the market – and even misunderstood to a certain extent – wrote an essay on the psychological principles of individual behaviour (Theory of moral sentiments, 1759.)

It is with the development of neoclassical economics that economists begin to move away from psychology and consider economics as a natural science. The neoclassical economic paradigm includes the crystallisation of the concept of rational choice, connected with mathematical constraints and the analytical method, deprived of any psychological and sociological content.

It is precisely in this stage that the mathematization process, still existing, starts: as recently pointed out by Paul Romer, who was awarded the Nobel Prize for Economics, economics still suffers from the so-called mathiness, i.e. the attempt to reduce matter to a series of predictive mathematical patterns, which are often unable to represent the real world.

The neoclassical school shaped the concept of homo oeconomicus, which is intended as that agent who, having perfect information and a complete preference system at his disposal, is able to autonomously choose the best tools to achieve his goals.

From Keynes to Prospect Theory

In this regard, the discipline of J. M. Keynes sounds revolutionary, since it highlights the fundamental role played by uncertainty for long-term expectations. Entrepreneurs and investors do not mechanically derive any probability judgments from the analysis of past information, but their expectations are rather subjective and are influenced by other factors.

The English economist thus wrote:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

They are the animal spirits which guide the decision-making operation and urge the entrepreneurs to invest, oriented towards action, rather than inaction. Keynes knew and esteemed S. Freud and, in his works, he made numerous references to the new discoveries of the father of psychoanalysis.

However, it is only in the middle of the 20th century that the paradigm of absolute rationality starts to be questioned. The way in which human behaviour meets limits of assessment in its ability to process information begins to emerge, together with the idea that individuals, upon the concrete decision-making process, do not follow any optimizing logics. The recent onset of behavioural economics fulfils the need to combine the economic theory with the insights of psychological research to overcome the limits of the principle of rationality.

The milestone in the development of the fields of this discipline is Prospect theory: Decision Making Under Risk, written by Kahneman and Tversky in 1979, which leverages cognitive psychology techniques to explain a series of anomalies detected in the rational economic decision-making process.

The experimental research of the two scholars leads to an uproarious conclusion about human mind: individuals make their decisions based on a limited number of heuristics, namely mental shortcuts. The use of rationality in the decision-making process is hindered by cognitive bias, i.e. adulterations of judgments that result in systematic errors when it is necessary to make decisions under uncertainty circumstances. In 2002, Daniel Kahneman was awarded the Nobel prize for economics thanks to the combination of the outcome of psychological research with economic science.

From Prospect Theory to nowadays

Is behavioural economics an actual threat to the neoclassical paradigm, which embodies the rationality of human behaviour with the maximization of personal interest? Can it create a new paradigm by highlighting the non-rational behaviour of human beings?

Thaler, who received the Nobel Prize for Economics in 2017 for his studies on behavioural economics, stresses the presence of errors in human behaviour and empirically verifies their systematic nature. Just like Kanheman, he divides individuals into Humans and Econs, where the former have a low rationality degree, are urged by cognitive bias and likely to make errors, while the latter are endowed with rationality, more oriented towards reasoning and are free from heuristics and intuition. The latter should be decision-makers and orient Humans through nudges to help them make optimal choices for them as well as for the whole community.

This model, called libertarian paternalism, assigns the task of urging individuals to make useful decisions in the long term to the State and other institutions. Evidently, by limiting the freedom of the individual and shifting it to the authorities, albeit for the purposes of collective well-being, it opposes the principles of the liberal model. If, as explained by Kahneman, it is difficult to figure out any limitation on freedom when an individual is automatically included in a pension plan and is asked to tick a box to express his opposition, the issue is different when it comes to public policy choices. In fact, the neoliberal paradigm relies on the prohibition of interference in the individual’s choices as well as on the absolute trust in the ability of the markets to allocate goods, based on the theoretical principle of the agents’ rationality.

D. Kahneman and R. Thaler

On the one hand, the current development of behavioural economics shows an irreconcilable incompatibility with it, while, on the other hand, it regards the Econs as rational guides able to fix any “systematic error” made by Humans and intended as deviations from the rational and maximizing behaviour of the neoclassical balance itself.

Thaler attaches special importance to the analyses of the individual’s decisions under uncertainty conditions carried out by Keynes, however it is worth stressing the methodological differences between the two scholars. The Keynesian approach, in fact, is psychoanalytic and aims at identifying the human reasons attributable to the aspects that influence individual choices, thus making the future scenario unpredictable.

According to Keynes, the Econs are subjected to instinctive components as well, which do not respond to the agents’ rationality.

Although some inconsistencies and aporias have been found on the theoretical and conceptual level, behavioural economics is a rapidly evolving discipline: its discoveries are destined to revolutionize the current economic model, further expanding the economic discipline through the contributions from other sciences and guiding it towards a multidisciplinary approach.

 

 

Bibliography

Brancaccio E., Nobel Economia 2017: Thaler e le contraddizioni della “spinta gentile”, Micromega, ottobre 2017

Diacon P. E., Calance M., The relationshipbetweenbehavioural and neoclassicaleconomics, CES WorkingPapers, march 2014

Kahneman D., Pensieri lenti e veloci, Mondadori, 2017

Keynes J. M., Teoria generale dell’occupazione, dell’interesse e della moneta, UTET, 2013

Thaler R. H. e C. R. Sunstein C. R., Nudge, La spinta gentile, Universale economica Feltrinelli, 2014

 

 

 

 

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