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.


61 thoughts on “Is Behavioral Economics the Past or the Future?

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    • Ha, yea I was thinking the same thing. This is a weird post. Only a person committed to rational choice theory in a sort of dogmatic way would characterize behavioral as merely exceptions to the homo economicus assumption. This is certainly not the way Kahneman and Tversky saw it. If people aren’t rational in the way RCT assumes, but you think the world ould be better if they were — as Kahneman thinks — then that’s a normative view you need to argue on normative grounds.

    • I’ve left out a ton of people. There’s experimental work that I’ve left out. There’s work in axiomatic decision theory (my coauthors Emre Ozdenoren and Yusufcan Masatlioglu both work in decision theory btw). There’s Shiller, Thaler, Rabin, Akerlof, …

      If I put in everyone who deserves to be mentioned the post would be huge …

  3. I really hope that time for behavioral economics will come soon. It is really amazing that, after so many misses in recent years, the assumptions made by main-stream economics are still regarded as economic “laws” and still get press. Humans are not (only) rational, every psychologist will assure you that. Unfortunately, we have built our (largely economy driven) society in the assumption we are. Just another proof of our lack of self-understanding.

  4. As former editor of JEBO and editor-in-chief of the new Review of Behavioral Economics (ROBE) I am undoubtedly a biased commentator, but I think you are jumping the gun with your conclusion and ignoring a lot more than just Kahneman. Given your background, I am surprised you have not mentioned the whole matter of social preferences, although admittedly this dates back at least to the now 30-year old ultimatum game experiments. I would admit that there are fads and waves within behavioral econ, with the early wave of behavioral managerial econ deriving from the original bounded rationality work of Herbert Simon now rather sleepy, but I think there is much potential in the area.

    Sticking just with your specialty where you see behavioral not taking off, namely macroeconomics and finance, it is not clear that what you observe is not indeed part of the problem rather than part of the solution. You admit that with the crash there seemed to be this potential for more behavioral macro, but now seem to accept that we are back to business as normal with minor tweakings of DSGE models. You have previously in effect supported this outcome, to much pushback from commentators, including me. This looks to be more of the same, but not anymore justified than earlier other than a “OK, folks, the orthodox gang has won, hang it up and say bye bye.”

    As it is, in the policy shops, unhappiness with this outcome seems as great as ever if not more so. I simply note that the new Fed Chair is both coauthor and wife of one of the leading figures advocating more study and use of behavioral macro, namely George Akerlof. Maybe grad students are getting browbeaten into avoiding it (“Don’t be a sucker; you won’t get published in a top journal.”), but I suspect that it will be having even more influence at the policy level in the near future.

    Barkley Rosser

    • “… it is not clear that what you observe is not indeed part of the problem rather than part of the solution.”

      You could be right. Perhaps the macro/finance focus is crowding out good work in behavioral that might not get done now.

      I certainly don’t think that “minor tweakings of DSGE models” are going to help. Major overhauls of DSGE models in which we introduce realistic institutional detail could go a long way though.

    • “Maybe grad students are getting browbeaten into avoiding it (“Don’t be a sucker; you won’t get published in a top journal.”), but I suspect that it will be having even more influence at the policy level in the near future.”

      I’m entering grad school next year, and when I told a dissertation-phase student at the program that I’m considering behavioral, he told me that behavioral is “saturated.”

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  7. Well, you are basically right, though I’d have sharpened the point a little bit. Great truths aren’t great if they are true all the time. RE is roughly true, just not all the time. Equally importantly, its a very useful modeling tool.
    BE isn’t so much a contradiction as a complement to economics – we aren’t always irrational after all.
    The big question in econ though is how to do what we know. The problem in the response to the financial crisis and to the ensuing recovery hasn’t been a lack of understanding of how to produce better economic outcomes, rather it was how to do the politics. Its like teenage boy, it doesn’t matter that he knows, the problem is he isn’t, getting laid.

    • “RE is roughly true, just not all the time.”

      Everybody who had read his Stiglitz knows that relaxing one assumption of the the standard neoclassical model, perfect information, just a little bit leads to large consequences, i.e. the standard model is not robust in this respect. What if relaxing rationality a little bit also leads to large changes? Your post implicitly discounts this possibility.

      What I find so fascinating is the cognitive dissonance visible in Chris’ post. He is one the one hand aware of the behavioural literature but on the other hand thinks that RE is a great thing.

      We all love our little Mickey Mouse Arrow-Debreu world, it is beautiful and it works so neatly. But in science you gotta throw your theory out of the window if it does not match the facts.

      So unlike Chris I wonder when neoclassical macroeconomics will finally die off. The Great Recession hasn’t led to a Keynesian revivial so I am with Krugman, we truly are in a Dark Age of macro. And the mainstream macroeconomists who embrace the New Neoclassical Synthesis and might seem so moderate on the surface are part of the problem.

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  9. I think you may be correct here.

    I find the study of ‘predictable irrationality’ fascinating, but it is possible that there is no necessary correlation to the field of economics, and you may indeed be right that the revelations of behavioral economics do not actually assist that much in economic modeling. It is too soon to judge probably.

    I only comment to say that I think the field of predictable irrationality is important *whether or not* it should be a part of the economics curriculum. It should be a foundational piece to any liberal arts education, as much as literature in my opinion.

  10. Rational expectations suggests the possibility of a standard of evidence across participants. Behavioral economics undercuts that. But it does seem possible in the future that the heuristics which humans use for making decisions might be used as a basis for economics–perhaps then we would have “weakly rational expectations” or “human heuristic based economics”.

  11. Strongly agree. I’ve been to a couple of seminars for behavioral papers, and it seems like there’s an unnecessary mass of cutesy papers with little economic content under the ‘behavioral’ umbrella that are tolerated at a high level. For every interesting behavioral paper, you see ten papers about, say, left digit bias in the used car market, that identify some psychological bias and show it’s present, but don’t really tell you much about the importance of such phenomena (and that paper was in the AER!). And, unfortunately, since this stuff is so digestible, it’s easily picked up by the media, which I think has partially fueled its popularity.

    It’s also unfortunate that commenters think this post is a defense of standard rational methods. The fact is, with notable exceptions, the behavioral ‘revolution’ hasn’t given other economists much in the way of methods to handle the biases they might point out in contexts that aren’t so glaringly obvious. There isn’t nothing (Koszegi-Rabin 2006, for example), but there isn’t much.

    At the very least, it would be nice to see behavioral papers that tell me why I need to care about these effects in my analysis. Most of the papers you’ve posted do this explicitly. Another recent one you didn’t mention is Grubb-Osborne (2013), which shows that, in the environment they look at (cell phone contracts in 2002–kind of funny to look at that market in the pre-smartphone world), ‘behavioral’ consumers end up getting preyed on and losing out, but attempts of policymakers to correct biases would cause cell phone suppliers to change the kinds of contracts they offer, resulting in a net loss across the board. That’s what I’d like to see more of, myself.

  12. I’m not an economist, but if I did choose to become one, I’d probably do behavioral macro. I think peope have done it fundamentally wrong so far.

    I won’t have time to pursue my models, nor would I subject myself to the collective ‘wisdom’ of current academic hierarchies if creating them. i’ve explained how it should be done multiple times on multiple blogs. Someday people will realize they overlooked the future.

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  14. First of all, I wonder whether behavioral economics isn’t showing up places without an explicit behavioral economics label. You haven’t referenced the studies showing, for example, that people don’t understand Medicare Part D contracts and make systematic errors, that firms can then exploit. Much of this work is done by health scholars and focuses on health, but would probably have a harder time getting through if general behavioral economics hadn’t prepared the audience for it.

    Second, one of behavioral economics’ biggest problems has been the accumulation of a lot of idiosyncratic psychological biases. More recent papers have been exploring how to model if you don’t try to specify all the systematic biases but rather allow for some cluster of biases that have a given type of consequence–that is, trying to develop more abstract, tractable frameworks for modeling behavioral econ.

  15. I am not an economist, but I studied it a little. Much of what I believe is based not on research papers (published or not) but on observation, and analysis of that behaviour observed.

    Rather than try to take humans as a species and overlay their behaviours with wonderfully complex formulae to show how learned the student (or professor) is, Economists need to be first and foremost humanists, and to study cultural norms and behaviours.

    The devout muslim who preys five times a day will behave differently from the atheist who is intent on hedonism. The Christian fundamentalists of the U.S, will differ from the slavic farmers of eastern Europe.

    And when Adam Smith was studying the population back in (1770s?) as a Scot, the population were a little more heterogenous. Today’s British, American or Russian societies are far more multi-cultural in form. Back when homo-economous was being written about in the early 20th century, the vast majority of the economy was devoted to the spending of MEN, and perhaps was rather more rational, today (at least in my household) the vast majority of the economy is controlled by a woman.

    Any study therefore of the economy, MUST include the study of we humans, and the gender differences and their particular spending choices. BUT the sociologists refuse to accept, or even to recognise many of these differences for political reasons.

    Having read “Sex and the Brain” by Jo Durden-Smith, and Diane de-Simone (more than 4 times) some 30 years ago, I learned that men’s brains and women’s brains are wired VERY defferently. The 7 or 8 Venus and Mars books by Dr. John Gray, and several others by other authors in a similar vein, all show this, and the economy is a much more emotionally decided system. And mass media, the TV, Radio, Newspapers, the Internet, and of course people’s daily interactions will all colour their spending habits, and thus the weight they attribute to particular uses for their purchasing power.

    Not everyone wants an Andy Warhol on their wall, yet despite this one sold recently for $106m (at least in that ball-park) and not everyone will settle for cous-cous and salmon fish fingers.

    And emotional intelligence (which I suspect was just another intellectually superior word for ’empathy’) is driving more and more decisions.

    Perhaps economists need to study Abraham Maslow, and in particular his hierarchy of needs.


  16. As a psychologist, and one who is working in the area of behavioral economics, I’d say the field may not have created a paradigm shift in economics yet, but it’s still very much alive, and psychologists are embracing it. Behavioral economics is the first attempt to bridge psychology and economics, and though I can’t speak to most economics journals, the psych journals have a growing amount of work coming out in this area, and even some marketing journals are covering this as well. Perhaps it is not as popular in economics journals because it represents a more significant departure from economists’ key assumptions about human behavior. It will take time for cross-disciplinary research to filter back into the mainstream of either psychology or economics, but at least from the perspective of psychologists it is very much a growing area of study.

  17. You mention a lot of interesting papers that had me going to google and IDEAS to track them down, but I’m not sure if I’ve gotten the right ones. Could you provide links or even fuller citations at the end?

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  19. Hello Chris,

    Nice ‘rant’ on the status of BE. Believe it or not, I went through much the same set of thoughts and emotions as you when I encountered another financial event – back in 1980. I was considering U Chicago at the time.

    Let me ask you this… perhaps the problem is more fundamental? Perhaps BE, and Econ in general, are fighting for academic space because none of them have proven themselves to be the better discipline? By better I mean that they have rigorous definitions, explain the data, have been successfully replicated, and have created theories that are useful tools for prediction.


  20. Isn’t the myopically rational forward looking actor just another kind of kook within the glorious varied pageant of putatively microfoundational beings?

  21. Interesting point of view. Is it possible that Behavioral Economics is yielding to the emergence of Neuroeconomics? Behavior is often explained by availability of brain energy and physical constraints as they relate to an individual’s construction of neural architecture. In fact, the very existence of akrasia either as a default state or as a brain disorder would argue for a more neurocentric view of decision-making behavior.

    In my assessment of the industry, there seems to have been a major shift towards the utility of neuroscience methods in the explanation of behaviors. I wonder if those who might have been inclined to study Behavioral Economics find Neuroeconomics to be more appealing?

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  28. Behavioral economics is both the past and the future. I heard on NPR’s planet money that Adam Smith perhaps knew more about behavioral economics than the average 20th century economist, when they had to quantify everything.

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  30. The principles or insights which come from behavioural economics are that of human (mis)jusgement, decision making theory, and systematic cognitive biases. These are not a fad, and for economics to continue to be at all helpful in understanding the way the world works henceforth, it would be wise to not so easily reject it.

  31. A catalog of “quirks” (in this case, consistent cognitive biases) is how you start doing scientific work.

    Physics was a catalog of “quirks” for *centuries* before they started finding unifying theories. (Before that, unifying theories were nonsense garbage like Aristotle’s ideas.) Chemistry to a great extent still *is* a catalog of quirks, and was entirely so before Mendeleev. Biology is unavoidably a catalog of quirks and can never be anything else (thank you, evolution!) Don’t knock it.

    Thankfully behavioral economic research really is successful now, since it’s the *only real economic research*.

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