Is Behavioral Economics the Past or the Future?

There are fads in every field.  As Heidi Klum would say “one day you’re in, and the next day you’re out.”  Economics is not an exception.  Trendy topics come and go.  At any moment, it’s difficult to tell whether the current hot topic is here to stay or whether it is simply enjoying the academic equivalent of Andy Warhol’s 15 minutes of fame.

When I was getting my Ph.D, behavioral economics was absolutely the hot topic.  To hear some people talk, behavioral economics promised to revolutionize macroeconomics, finance … basically every corner of the field.  Today however, it’s not clear at all what the future has in store for behavioral.

I think the reason behavioral economics was originally so intriguing was that it undercut the basic principles that govern standard economic analysis.  The basic organizing philosophy in economics is that allocations are guided by self-interest.  Or, the way economists would say it, allocations are based on rational decisions.  What economists mean by rational is that (1) people know their own preferences and, (2) their choices are based on these preferences.  Rationality is an extremely powerful card that economists play often.  If a social planner actually cares about the well-being of her subjects, she can accomplish a lot by simply allowing them to make choices based on their own likes and dislikes.  Not surprisingly, rationality often leads to neo-liberal policy conclusions.  At a very basic level, behavioral economics considers the possibility that allocations violate one or both of the conditions above.  Either people don’t know what they really like, or they have difficulty making choices that conform to their preferences. 

In the early 2000’s, my colleagues and I were anticipating a flood of newly minted behavioral Ph.D’s from the top economics programs in the country.  Later, when the financial crisis exploded in 2007-2008 we were again told that behavioral economics would finally come into full bloom.  It didn’t happen though.  The wave of behavioralists never came.  After the financial crisis, young Ph.D’s turned their attention to studying financial macroeconomics – and when they did, they used mostly standard techniques based on rational decision making.  They incorporate more institutional detail rather than behavioral elements.

In my graduate macroeconomics class, I usually devote one or two lectures to results from behavioral economics.  The papers I discuss are the best that behavioral has to offer and many of the students find the topics intriguing.  I cover David Laibson’s (1998) paper on hyperbolic discounting and self-control problems.  I cover a famous empirical paper by Stefano Della Vigna and Ulrike Malmendier (2006).  I briefly mention the paper by Brunnermeier and Parker on “optimal expectations,” a theoretical setting in which individuals can indulge in unrealistic (irrational) beliefs at the cost of making bad decisions (e.g., you can enjoy an irrational belief that you are likely to win the lottery but only if you buy a lottery ticket).  There are also excellent papers by Malmendier and Stefan Nagel (2011, 2013) who show that expectations depend importantly on whether people have personally experienced events during their lifetime. (In one of their papers, people who lived through the great depression, had beliefs and made asset choices which place greater weight on the possibility of a financial crisis.)  There are several interesting papers by Caplin and Leahy who consider, among other things, the possibility that people may get utility just from anticipating future events.  If you know you have to get a painful shot, you might experience feelings of dread or panic above and beyond the physical pain from the shot itself.  My colleagues Miles Kimball, Justin Wolfers and Betsy Stevenson analyze the determinants of people’s subjective happiness (as distinct from “utility”).  In finance, there are classic papers on “agreeing to disagree” by Harrison and Kreps (1978) and the more recent variations considered by John Genakopolos (see e.g., “The Leverage Cycle,” 2009: if pessimists face short-selling constraints, the market price of financial assets will exceed the “fundamental value” of the assets).

Perhaps the most compelling behavioral paper I know of deals with the effect of labelling a choice the “default” option.  The paper I know best on this effect is by Beshears, Choi, Laibson, and Madrian (2006).  They show that simply calling a retirement savings option the default option sharply increases the likelihood that people choose that option.  Clearly, this doesn’t sound like rational decision making.  If option A is an ideal choice for you then you should continue to pick A even if I label option B the default option.  I find this study particularly compelling because the empirical evidence is clear and convincing and also because the potential consequences of this behavioral pattern seem important.

Today, it seems like behavioral economics has slowed down somewhat.  For whatever reason, the flood of behavioral economists we were anticipating 10 years ago never really materialized and the financial crisis hasn’t led to a huge increase in activity or prestige of behavioral work. Certainly the evidence that people don’t typically behave rationally is quite compelling.  It’s easy to find examples of behavior which conflicts with economic theory.  The problem is that it’s not clear that these examples help us much.  Behavioral economics won’t get very far if it ends up being just a pile of “quirks.”  Are these anomalies merely imperfections in a system which is largely characterized by rational self-interest or is there something deeper at play?  If the body of behavioral studies really just provides the exceptions to the rule then, going forward, economists will likely return to standard rational analysis (perhaps keeping in mind “common sense” violations of rationality like default options, salience effects, etc.).  I would think that if behavioral is to somehow fulfill its earlier promise then there has to be some transcendent principle or insight which comes from behavioral economics that we can use to understand the world.  In any case, if behavioral is to continue to develop, it will need some very smart, energetic young researchers to pick up where Laibson and the others left off.  If not, behavioral economics gets a goodbye kiss from Heidi Klum and it’s “Auf Wiedersehen.”

UPDATE: One of the readers has asked for some citations for the work mentioned in the post.  Here is a list of relevant citations. You should be able to find .pdf versions by “googling” the titles. 

Caplin and Leahy. “Psychological Expected Utility Theory and Anticipatory Feelings.” Quarterly Journal of Economics, 2001.

Caplin and Leahy. “The Social Discount Rate.” Journal of Political Economy 2004.

Caplin and Leahy. “The Supply of Information by a Concerned Expert.” Economic Journal 2004.

Choi , Laibson, Madrian, and Metrick. “Saving for Retirement on the Path of Least Resistance.” In Behavioral Public Finance: Toward a New Agenda. 2006.

Choi , Laibson, Madrian, and Metrick. “Employee Investment Decisions about Company Stock. in Pension Design and Structure: New Lessons from Behavioral Finance. 2004.

Choi , Laibson, Madrian, and Metrick. “For Better or For Worse: Default Effects and 401(k) Savings Behavior.” In Perspectives in the Economics of Aging. 2004.

Della Vigna and Malmendier “Paying Not to Go to the Gym” American Economic Review, 2006.

Kimball and Willis. “Utility and Happiness.”  Working paper, 2006.

Laibson, “Golden Eggs and Hyperbolic Discounting.” Quarterly Journal of Economics. 1997.

Malmendier and Tate “CEO Overconfidence and Corporate Investment” Journal of Finance, 2005.

Malmendier and Nagel “Depression Babies: Do Macroeconomic Experiences Affect Risk-Taking?” Quarterly Journal of Economics, 2011.

Malmendier and Nagel “Learning from Inflation Experiences” working paper,  2011.

Stevenson and Wolfers. “Economic Growth and Subjective Well-Being: Reassessing the Easterlin Paradox.” Brookings Papers on Economic Activity, 2008.

Stevenson and Wolfers. “Subjective Well-Being and Income: Is There Any Evidence of Satiation?”  American Economic Review P&P, 2013.