Sunday, 23 March 2014

On the identity and methods of behavioural economics

The FT has a very good article from Tim Harford today, surveying behavioural economics and asking some important questions about it. People within a field can be so immersed in their unconscious assumptions and practices that it takes an outsider to point out some of the questions they are not asking.

Tim says:
The past decade has been a triumph for behavioural economics...[which] is one of the hottest ideas in public policy....Yet, as with any success story, the backlash has begun. Critics argue that the field is overhyped, trivial, unreliable, a smokescreen for bad policy, an intellectual dead-end – or possibly all of the above. Is behavioural economics doomed to reflect the limitations of its intellectual parents, psychology and economics? Or can it build on their strengths and offer a powerful set of tools for policy makers and academics alike?

Quite. That, of course, is a journalistic question - not one intended to be answered within the article, but designed to provoke the prospect of a good ding-song. But the substantive points come soon. Note that Tim, writing for a generalist FT-reading audience, chooses to address his article to public policy so it doesn't look like an abstruse argument between academics. But actually it's about the effectiveness of BE, and economics in general, as a tool at all. Public policy, private decisions, how businesses operate - all can be informed by whatever economic theory we believe in.

...there is something unnerving about a discipline in which our discoveries about the past do not easily generalise to the future...This patchwork of sometimes-fragile psychological results hardly invalidates the whole field but complicates the business of making practical policy.

Indeed - and it divides the field, into those who believe a (more) unified theory is available, and those who believe rational choice is still the main theory available and that behavioural results are only meaningful in relation to that.

The line between behavioural economics and psychology can get a little blurred. Behavioural economics is based on the traditional “neoclassical” model of human behaviour used by economists. This essentially mathematical model says human decisions can usefully be modelled as though our choices were the outcome of solving differential equations. Add psychology into the mix – for example, Kahneman’s insight (with the late Amos Tversky) that we treat the possibility of a loss differently from the way we treat the possibility of a gain – and the task of the behavioural economist is to incorporate such ideas without losing the mathematically-solvable nature of the model.
Consider the example of, say, improving energy efficiency. A psychologist might point out that consumers are impatient, poorly-informed and easily swayed by what their neighbours are doing. It’s the job of the behavioural economist to work out how energy markets might work under such conditions, and what effects we might expect if we introduced policies such as a tax on domestic heating or a subsidy for insulation.

And the problem today is that, without a clear theory, behavioural economists can't work that out. All they can do is suggest various effects that might happen, and design an experiment to test them. Nothing wrong with that, but it's a bit ad hoc.

The most well-known critique of behavioural economics comes from a psychologist, Gerd Gigerenzer of the Max Planck Institute for Human Development. Gigerenzer argues that it is pointless to keep adding frills to a mathematical account of human behaviour that, in the end, has nothing to do with real cognitive processes.
David Laibson, a behavioural economist at Harvard...concedes that Gigerenzer has a point but adds: “Gerd’s models of heuristic decision-making are great in the specific domains for which they are designed but they are not general models of behaviour.” In other words, you’re not going to be able to use them to figure out how people should, or do, budget for Christmas or nurse their credit card limit through a spell of joblessness.

We come back again to the need for a general theory, and one of behavioural economics' regular combatants agrees:

For some economists, though, behavioural economics has already conceded too much to the patchwork of psychology. David K Levine, an economist at Washington University in St Louis, and author of Is Behavioral Economics Doomed? (2012), says: “There is a tendency to propose some new theory to explain each new fact. The world doesn’t need a thousand different theories to explain a thousand different facts. At some point there needs to be a discipline of trying to explain many facts with one theory.”
The challenge for behavioural economics is to elaborate on the neoclassical model to deliver psychological realism without collapsing into a mess of special cases...The question is, how many special cases can behavioural economics sustain before it becomes arbitrary and unwieldy? Not more than one or two at a time, says Kahneman. 
Thaler says: "...if you want one unifying theory of economic behaviour, you won’t do better than the neoclassical model, which is not particularly good"

It seems that Kahneman and Thaler actually agree with Levine in a way; all three doubt that behavioural economics can crystallise into a single theory, though only Levine thinks this is a serious problem.

George Loewenstein and Peter Ubel wrote in The New York Times that “behavioural economics is being used as a political expedient, allowing policy makers to avoid painful but more effective solutions rooted in traditional economics.”

This point is different but important: if policymakers expect behavioural economics to be a substitute for regular economics they'll be disappointed. The two are complementary, and the most important policy contribution of BE may be to tell us which economic incentives will have the biggest impact, and which will have unwanted side-effects, rather than to obviate the need for traditional incentives altogether.

Should we be trying for something more ambitious than behavioural economics? “I don’t know if we know enough yet to be more ambitious,” says Kahneman.

That's a provocative point. Yet it acknowledges that whatever field eventually manages to incorporate both traditional and behavioural economics may have to be called something different.

Laibson says behavioural economics has only just begun to extend its influence over public policy. “The glass is only five per cent full but there’s no reason to believe the glass isn’t going to completely fill up.

I and many readers of this blog will probably be with Laibson on this point. But perhaps without a new approach, behavioural policy is going to run more and more often into the wall of adhockery - the lack of general theories making us redo things from the ground up in each new situation.

Tim isn't the only person to write about this recently. For a contrary word, try Chris Dillow's comment, which makes some good challenges from his usual half-libertarian, half-Marxist point of view.

Then, here are some links and thoughts from Diane Coyle, including "Is behavioural economics the past or the future" by Chris House. Diane hones down one of Tim's questions into Kao and Velupillai's distinction between classical and modern behavioural economics: modern assumes people are (biased) optimisers, while classical assumes they are satisficers. This is the same distinction drawn by Gerd Gigerenzer, though his research looks at a broader range of decision-making heuristics, of which satisficing is just one. Diane asks, effectively: is the best mathematical approach to tweak the models of maximisation, or to try to build a new behavioural economics based on heuristics?

Chris House's post says: 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.

While this isn't true in psychology or behavioural policy and marketing - all thriving and fast-growing fields - it is true of economics. My experience is that many new economics undergraduates or entrants to economics PhD programs are intrigued by behavioural ideas, they are often guided by supervisors into more traditional areas where it is easier to define a research question that is going to produce safe, publishable papers. Barkley Rosser, commenting on House's post, mentions the new journal Review Of Behavioural Economics, which along with other emerging initiatives may help to change this.

Otherwise, Chris raises that same point:
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 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.

Then there is the David Levine paper that Tim mentions, "Is Behavioural Economics Doomed?". In this, Levine says (among many other interesting things!):
For most decisions of interest to economists these external helpers [computers, paper and pencil etc] play a critical role – and no doubt lead to a higher level of rationality in decision making than if we had to make all decisions on the fly in our heads.

What a brave claim! Do we really rule out from the realm of economically interesting decisions all consumer purchases, the consumer's intuitive feelings about how safe they feel with a certain amount of savings in the bank, and all the decisions about cars, houses and jobs that - although someone might sit and think about them for a while - still involve a big chunk of emotion?

Actually, there is no need to throw out these kinds of decisions in order to meet Levine's key challenge of "trying to explain many facts with one theory." He asserts that mainstream economics is already successful at explaining many facts. But perhaps, when he discards all those "uninteresting" decisions it isn't so hard to explain what's left. Indeed, it's those "uninteresting" decisions which classical economics does struggle with, and only behavioural economics can illuminate. Contrary to Levine, I am convinced that these decisions actually make up the majority of important economic events. But I do recognise his critique - echoed by Tim and implicitly by Velupillai and Gigerenzer: that behavioural economics does not offer a full theory to replace that of mainstream economics. However, it has given us good empirical evidence which we could build a theory on.

As well as defining away a large portion of the economy as "not interesting", Levine also co-opts some of the parts that he does consider interesting, saying they are already handled by mainstream economics: notably the subject of learning. Non-behavioural economists have considered consumers' imperfect ability to learn the preferences of other consumers, or the rules of the "game" they are playing, as a factor in non-optimal decisions. But psychologists know much more about exactly how people learn than economists do - so a successful model of learning as part of economics can only be built with an openness to psychological research. Where Levine may be right is that behavioural economics will not replace mainstream economics, but instead the two fields will merge - with the behaviour of consumers predicted by a combination of objective economic, and subjective psychological, factors.

Anyway, arguments over the boundaries of disciplines are rarely productive: I don't really mind if Levine considers a model to be behavioural or not, as long as the model advances the cause of making successful predictions.

The real questions are: does standard economics fail to address some important problems? How good is behavioural economics at addressing them instead? And does behavioural economics need a unified approach in order to address them?

Most of the people mentioned above have different answers to those questions:

  • Levine wants a unified theory - but think we have to exclude many types of "uninteresting" decision in order to get one.
  • Kahneman and Thaler want different theories for several different areas - but those incompatible theories will not be able to deal with the many boundaries where different aspects of economics interact with each other.
  • The classical economists already have a unified theory - but there are many things it can't explain.
  • Gigerenzer has a philosophy - but no overall theory. And I'm not sure if he expects or really wants a unifying theory any more than Kahneman does (this may be one of the few things they agree on).
[Update: much of this debate was anticipated in this Werner Guth paper of 2007]

My view, which I think concurs with Laibson's: a single broader theory is possible. I think we've hit a theoretical dead end with the traditional maximising agent, so it will have to be based on more psychologically realistic foundations, such as those of Velupillai, Gigerenzer or Bettman, Payne & Johnson. To achieve this, we need to carefully choose the right elements to build into our model of decision-making in a way, so that it can make useful predictions of how those elements might operate. I have a paper coming out later this year which suggests one direction towards this.

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