Behavioral Economics Criticism

What is Behavioral Economics?

“There’s no reason to think that markets always drive people to what’s good for them.” —Richard Thaler

Behavioral economics attempts to explain the decision making process of individuals and furthermore challenges the commonly accepted notion that individuals act rationally. One of the fundamental notions of neoclassical economics is that people act in a rational manner when making market decisions. Behavioral economics seeks to counter this by showing the limitations of the accepted rationality of individuals. Nearly all of the findings within the behavioral economics realm have been attributed to various results from experiments and surveys. These experiments and surveys look at the the psychology of individuals and observes how they act in a given sociological context. These results are then analyzed to show a certain type of behavior or effect which leads to individuals not acting rationally with their decisions in the market, thus questioning the foundation of the rationality of individuals in the neoclassical point of view. Some of these behaviors include reciprocity, loss aversion and the notions of fairness, greed and fear.

Irrationality of Behavioral Economic Experiments

Experiments can be extremely valuable in the scientific world when analyzing things such as gravity and magnetism. In the lab, you always know if you drop a ball it will fall to the ground, and this will be true for the world outside the laboratory as well. Economists are trying to use experiments done with humans to explain actions of the outside world. Unfortunately, economic experiments are not the same as scientific experiments. What is shown in an economic experiment in a laboratory will not always coincide with what is really occurring in the real world. There are four major reason as to why it is not feasible to extrapolate laboratory results to the outside world.

1. Subjects know they are being watched
2. Ability for experiments to be controlled
3. Small stakes
4. Ability for subjects to be self-selecting

Subjects know they are being watched

A large aspect of analyzing economic experiments is looking if subjects make moral or wealth-maximizing choices. People are easily influenced if they know they are making decisions in an "artificial environment". It is human nature to act morally if you know you are being watched and judged by an experimenter. In the real world, people are not being watched and therefore will be less inclined to act unselfishly.

Ability for experiments to be controlled

Experimenters have the ability to manipulate and make slight changes to experiments to get the subjects to act in a certain way. A common example given is with regards to the prisoners dilemma game. By using differing words such as "opponent" instead of "partner", the subject will have a tendency to react different ways. Another example given was when a public goods experiment was conducted in many different communities. The results that came were different in many of the communities. Communities that had a culture of sharing returned results of people acting morally and unselfish, while other communities that were not as tight-knit produced results of self-maximizing.

Small stakes

While taking part in an economic experiment, the stakes and cost of making certain decisions are very small for the subject. There is not a very large effect on the subject whether they make one decision or not in an laboratory experiment. Obviously in the real world that are serious consequences and costs when people make decisions. Therefore it is difficult to extrapolate results from laboratory experiments into the real world.

Ability for subjects to be self-selecting

Not all subjects are analyzed in experiments are selected and therefore many subjects are volunteers that are interested in the subject. These people are typically "scientific do-gooders" who have a tendency to want to appease the experimenter and "seek social approval". This obviously does not coincide with the outside world. In the real world, the people making decisions in the market place environment are extremely knowledgeable and have great experience acting in this environment. Subjects performing the laboratory experiments do not have this expertise and will not be a good representation of what is actually going on in the outside world.

Free-Rider Problem

According to the studies of behavioral economics, the results from laboratory experiments show there is no free-rider problem in public goods games. If this were the case, then people would be more inclined to stop using their automobiles in order to reduce carbon emissions. They would be looking out for the greater good of the public, but unfortunately this is not the case. There obviously are situations in the real world which counteract this experiment's results.

The Individual vs. The Group

“It doesn’t matter what you or I do. It’s how the whole group behaves.” —Gary Becker, SM’53, PhD’55

One of the bigger downfalls of behavioral economics is the scope and application of the research. The experiments that explore behavioral economics and their outcomes focus on psychology and sociological norms and customs. While this does provide interesting insight into a given person's decision making process in a given context, some believe that this is not important in terms of the big picture. Economics is a science that strives to explain how agents work within a complex economic system where economies are looked at as a whole. Behavioral economics conducts studies that show why certain people act in a certain fashion; these findings can absolutely not be applied to every person in the market. Although we may find that a group of people exhibit certain qualities that may seem "irrational" it would be foolish to assume that there are enough of these kinds of people who can directly sway the happenings of the market. We can recognize that individuals can make irrational decisions, but this is nullified by how the entire group responds. For example, studies may show that, in a laboratory setting, some individuals act in a behavior that resembles loss aversion, which is sometimes considered to be irrational thinking. From a behavioral point of view, this may seem to cause market inefficiencies. However, we must realize that economics looks at the how the group responds, not the impact of individual psychology.

Gary Becker shares the opinion that most of behavioral economics uses its research to focus on individuals and in actuality should be more concerned with how groups respond. He uses the example that "it doesn't matter if 90 percent of people can't do the complex analysis required to calculate probabilities. The 10 percent of people who can will end up in the jobs where it is required, say in managing mutual funds." He also believes that behavioralists have not gotten to the point yet where they can properly explain what happens in a market. The bottom line and fundamental issue with behavioral economics is that it aims to explain why individuals behave the way they do but these individual decisions are balanced out in the market by other rational thinkers.

Behavioral Economics: Taking Over?

Behavioral economists are aiming to use psychology as a means to explain economics. It is interesting that we can attempt to better model human action and result, but this is just simply confusing psychology with economics. While seeking to explain why we make certain actions and how we sometimes may act "irrationally", what good does this do in explaining how complex systems work? No doubt there is room and a place in the economic field for this research, but its application is limited. Tim Harford sums this up perfectly: "Behavioral economics is already making the running on the subject of consumer decision-making, but in other areas it has little to offer. That is no surprise, because there is so much more to economics than a theory of individual decisions"

Necessary Improvements for Behavioral Economics

Economists are not disregarding behavioral economics totally. They feel that it is progressing but by no means is it in position to remove or take place of orthodox economics. Behavioral economics has made many strides in explaining individual consumer's decision making, but there is so much more to economics than that. Being able to explain individual decisions is not enough to make behavioral economics a wide spread phenomenon. It needs to be more reliable as to explain complex systems such as financial crisis. Economists stated there should be more of a balance between "sophisticated modelling of individual behaviour and more sophisticated modelling of economic systems". Critics of behavioral economics raise the point that behavioral economists are too vague with their studies. There have been studies arising that have evidence contradicting some accepted themes of orthodox economics, but they have been unable to develop those studies into a complete theory that is better than the current one.