Behavioural economics has had its Nobel moment, but take it with a pinch of salt

Behavioural economics has had its Nobel moment, but take it with a pinch of salt

Behavioural economics has received the ultimate accolade.

Richard Thaler of the University of Chicago Business School has been awarded the Nobel Prize in economics for his work in this area.

Economics over the past 20 to 30 years has become far more empirical. Leading academic journals do still carry purely theoretical articles, but far less than they once did.

This shift towards the empirical takes two forms. Major advances have taken place in the heavy duty statistical theory of analysing large scale databases containing information on individuals and their decisions. This was recognised when James Heckman and Daniel McFadden were awarded the Nobel Prize in 2000.

Behavioural economics is much less technical. In any given situation, the decision which a purely rational person would take is identified. We then look how people actually behave, and see if there are any deviations from the rational way of doing things.

Perhaps the main finding of behavioural economics is so-called prospect theory, first set out nearly 40 years ago by Daniel Kahneman. In essence, prospect theory says that people dislike making losses more than they like making gains of the same amount.

Another important discovery is that, when weighing up how to value future costs and benefits, people often place much more weight on the present and very immediate future than standard economic theory assumes. Last month I wrote about how this helps to explain the reluctance of electorates to deal with climate change.

These two results are backed by large amounts of evidence obtained in a range of different contexts. So now they are being integrated into economic theory.

But many economists are altogether less sure about much of the rest of behavioural economics. One of the issues is that it often gives the impression of being rather ad hoc. No reason is given as to why people in one situation appear to behave rationally, but in another they do not. Very few guidelines have emerged as to when we can expect to see deviations from rationality.

Another issue is that many economists are prepared to accept that non-rational behaviour might be observed at a point in time. But in a reasonably stable situation, people will learn over time to be rational.

Behavioural economics is not just about advancing knowledge on the workings of the economy. Policy-makers have become interested.

Cass Sunstein, Thaler’s colleague, served in the Obama administration as head of the Office of Information and Regulatory Affairs. David Cameron set up the so-called “Nudge Unit” in his government based on Thaler’s ideas. Thaler claimed 10 years ago that a “nudge” could lead to “better investments for everyone, more savings for retirement, less obesity, more charitable giving, a cleaner planet, and an improved educational system”. In his 2016 book Misbehaving, he has backed off the extravagance of these claims.

Still, whatever the doubts and qualifications, behavioural economics has made a big impact. An economist can no longer be said to have a good training if he or she is not familiar with its main themes.

Paul Ormerod 

As published in City AM Wednesday 11th October 2017

Image: Richard Thaler by Chatham House is licensed under CC by 2.0

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