A Crisis in Economics?

by Mario Rizzo

Periodically, people warn about the “crisis in economics.” I have heard about several of these over my professional career. Somehow the mainstream or orthodox economists never seem to notice these crises or take them seriously. They continue doing what they were doing.

Today the crisis, if there is one, is due to behavioral economics. The traditional rationality assumptions of economics are under assault. Why should we care? After all, they were unrealistic in the first place. And yet they did lead us to some definite conclusions about a wide variety of matters regarding economic theory, applied economics, and policy economics. A consensus seemed to be forming that markets, if not efficient in the strong sense, were at least subject to strong corrective pressures. Now the collection of biases we have accumulated makes it seem like a miracle that markets work at all. We must now not only worry about market failure but we must think about “decisionmaking failure.” People cannot be relied upon to pursue their own interests effectively in matters from deciding how many potato chips to eat to whether to join an employer-sponsored retirement savings program. They might also choose the wrong bank account because of fees for add-on services (like overdraft protection) that are not made salient enough. People cannot be simply given information about the dangers of smoking; they must be subject to worse-case scenarios (biased in themselves) to offset other biases that plague decisionmaking. But many biases move in opposite directions. Others cannot be quantified very accurately. More importantly, biases are being sought. Many researchers stop when they have found one or more.

All this is fueled by several factors. Young economists want to make a name for themselves. The most direct way is to overturn some conventional wisdom. Much of that is based on models that assume agent rationality. So now we get results in public economics that if you don’t make sales taxes salient, that is, don’t add the tax on to the price label before checkout, the taxes will not have much of an effect on demand. When you do, demand for the product will fall. (I wonder what happens if tomorrow all price labels for all products include the tax – will the demand to hold money increase and a recession start?) Another factor is the demand for policy measures by politicians who need to keep providing services. If new (behavioral) problems can be found then new solutions can be proposed. This demand and incentive to respond to it must be great because even articles that are primarily theoretical have some discussion of the possible policy relevance of the model. A third factor is the decades-old mindset of fine-tuning. For example, in a world of scores of biases, all sorts of things can go wrong in financial markets. So why not have regulators with a broad mandate to curb systemically problematic behavior? There can be no end to the possible perverse biased behavior that these regulators need to monitor and control. The approach that Milton Friedman and others preferred was to establish clear general rules. Because behavioral biases are so contextual (that is, they come and go depending on the concrete details of the particular case) it is not feasible to rely simply on general rules.

Out of all this comes two problems. First, are they any general lessons we can teach Principles of Economics students or members of the general public? I still think we can teach basic concepts like opportunity cost – unless of course people fall victim to the “sunk costs fallacy” which behavioral economists say they do. Oh well. There must be something… Second, the normative standard of economists has not changed. The ideal is still neoclassically rational behavior. But now that behavior has become so seemingly preposterous that deviations from ideal behavior almost find themselves. Perspective is lost. We wonder how things can ever go right, even though “Paris gets fed.”

I am afraid that the days of the straightforward Economics in One Lesson of Henry Hazlitt or the direct implications of University Economics of Armen Alchian and William Allen are over. You can have almost any set of beliefs about how the economic world operates and have an economic theory to support it.

I do not suggest a solution. None is possible yet because not enough people have faced the problem squarely.

One thought on “A Crisis in Economics?

  1. This is a thoughtful commentary.

    Mario mentions University Economics by Alchian and Allen. Alchian thought deeply about the rationality issue, well before behavioral economic. As I understood him, he argued that it is the theory that is rational. Even if agents are not individually rational, the predictions of rational economic theory would be born out.

    To update, there need only be agents who are less gripped by biases than the general population. They will do better at profit maximization than the population. Now what do we assume happens next?

    Alchian believed that success is imitated. Even if the General population is gripped by neuroses, they can imitate success. What if they don’t? I guess the least irrational will end up with all the wealth.

    So profit maximization wins out in the end. Even if everyone is Individually irrational. There just must differences in irrationality.

    Thomas Sowell is another social scientist who places weight on imitation. He emphasizes it at the cultural level. Immigrants adopt the American way, for example.

    I also think a more Humean or Hayekian view of rationality could reshape the discussion.

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