Richard Thaler’s Nobel Prize

by Mario Rizzo

Richard Thaler has won the Nobel Prize for initiating the behavioral moment in economics.

My view of the Nobel Prize in economics is much like Time magazine’s view of its “Person of the Year.” It is awarded to the economist who “for better or for worse… has done the most to influence” the course of economic thinking – at least in certain respects. It also, like Time magazine, operates under the constraint that an award must be given every year.

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.

Protests and Reason

by Chidem Kurdas

In the past week mass protests erupted in different parts of the world. The reasons were diverse. In the Middle East, demonstrations spread across the region following the killing of American diplomats in Libya over an anti-Muslim film. In China, crowds attacked Japanese shops and offices, over the two countries’ competing claims on some small islands in the East China Sea. In Russia, anti-government protestors called for the removal of President Vladimir Putin.

One can sympathize or not with any given protest—I happen to feel for the Russians opposing a corrupt and oppressive regime. But it may be more useful to pose two cool-headed questions. One, why are the organizers doing this? Two, why are the ground-level participants there?

Top Young Economists Consider Their Future

by Roger Koppl

Ali Wyne of the big think  blog “Power Games”  recently posted an interesting set of comments on the theme “Empirics and Psychology: Eight of the World’s Top Young Economists Discuss Where Their Field Is Going.”  George Mason’s own Peter Leeson  was among the eight “top young economists” sharing their views.

Over at New APPS, the philosopher Eric Schliesser  summarizes the eight comments. “Bottom line: due to low cost computing and a data rich environment the future of economics is data-mining (this was clear from at least four of the comments). This is especially so because the young stars have lost faith in homo economicus (due to behavioral work and the crisis).”

Eric’s summary seems about right to me. There were eight fine minds sharing eight different visions, but two related themes dominated the comments. 1) The old rationality assumption is in trouble and we don’t quite know what to do about it. 2) Economics should be more data-driven now that we have what William Brock has labeled “dirt-cheap computing.”

“Rationality” isn’t always Rational

by Mario Rizzo

Over the past two years I have been reading more than I ever dreamed about rationality in economics, especially in the standard neoclassical theory of choice. I have done this because I want to get at the root of the controversies concerning whether people’s behavior is, in particular contexts, rational or not.  Claims about the rationality of individual behavior are very closely linked to important policy questions about state paternalism. The highly abstract is working its way down the line to practical policy issues.

In all of this I am well-aware of the argument that “rationality” is the result of market processes and of decisionmaking institutions. I have nothing per se against this line of reasoning. Nevertheless, I want to approach the issue on the terms espoused by many choice theorists and behavioral economists themselves. This is the idea that the axioms of rational choice have a normative importance in and of themselves. By and large, behavioral economists accept the normativity of standard rational choice even as they reject the descriptive reality of rational choice.

The funny thing about all of this is that, initially, the axioms of rational choice were supposed to shed light on how people actually made choices. Then a sleight of hand occurred. It was claimed that they shed light on how rational individuals would choose – without addressing the issue of whether people were in fact rational in the sense of the axioms. Finally, it was alleged – in the face of empirical evidence that people often did not choose rationally – that the axioms defined the norms of choice. They told us how rational individuals should choose. More than that. Since being rational is taken as “good,” they show us how people should behave – full stop.