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Psychology and Economics

By Dr. Hassan Shirvani—Among the collateral damages of the recent global economic crisis has been the reputation of the economics profession whose members famously failed to anticipate the financial tsunami that rocked the world.

Enmeshed in their complex mathematical models with their highly unrealistic assumptions, most economists were seemingly as stunned by the suddenness and the severity of the economic downturn as the average person on the street.  Even Queen Elizabeth of England, on hearing about the destructive effects of the crisis, admonished her economic experts as to why “everyone had missed it.”

Bounded Rationality

To better understand the reasons for their analytical failure, many economists have been searching for alternative economic models with greater explanatory and predictive powers.  Out of this chaotic state has emerged a renewed interest in a school of behavioral economics which advocates the use of psychology in economic analysis.

Rejecting the assumption of rationality favored by most conventional economists, the new school argues that most individuals are characterized by bounded or limited rationality.  This simply means that most economic units find it difficult to process the available information correctly due to their cognitive shortcomings.  Most of us, in other words, are bad thinkers, making decisions that are often against our own best interests.  In addition, behavioral economists assert that most individuals are subject to altruistic impulses and suffer from limited will powers, both of which are in violation of the standard economic assumptions that individuals are self-centered and self-controlled.

To support these positions, behavioral economics often presents extensive laboratory-based experiments that tend to show that most humans are indeed subject to a host of cognitive biases and errors.  Examples of such biases include addiction, myopia, overconfidence, procrastination and various framing effects.

There is no question that human behavior is far too complex to be captured by any simple model of rational choice.   It is also true that many of us have our moments of bounded rationality.  For example, whenever we whistle while passing a graveyard at night, knock on wood as a protection against bad eyes, or refuse the advice of our spouses to stop our cars and ask for directions, we are in the throes of our cognitive glitches.  And yet, none of us believe that just because of these psychological issues, we are therefore incapable of making the right decisions for ourselves most of the time.

If this were true, humans would not have survived their seven million years of evolution.  Indeed, many of our psychological traits, such as altruism, risk aversion, fear, and greed have been developed as defense mechanisms to help us better survive in our mostly hostile environments.  In addition, many of these cognitive issues have long been familiar to, and been taken advantage of, by marketers and politicians, among others.  While there are highly simplified models of economic behavior that assume hyper-rational and self-centered individuals, there are also more realistic models that do consider such traits as altruism and herd behavior.  At any rate, it is hard to attribute the recent global economic meltdown to psychological factors alone.


Real Failure of Economics

In the light of the foregoing, the real problem with modern economics is hardly about whether economic agents are fully or only partially rational or whether they are decisive or not.  Rather, it is the heavy emphasis placed by modern economics on individual economic behavior, to the almost total disregard for the economic, political, and social environments in which individuals operate.  For example, many individuals often act differently in isolation as opposed to a social setting.  That is why we have herd behavior for both consumers and investors.

In addition, modern economics has long ignored the institutional characteristics of modern industrial economies, modelling them as though they were no different from small medieval villages.  Under these conditions, there is little room left for giant corporations and powerful labor unions to control prices and wages, or for hedge funds to manipulate the financial system through their access to privileged information.

Likewise, modern economics largely glosses over the issue of economic inequality, relegating it to the domains of politics and sociology.All of the above omissions proved fatal to the existing economic models during the recent economic crisis, precisely at a time when they were needed to both explain the onset of the Great Recession and to devise policies to deal with its aftermath.  In contrast, a more appropriate model would have paid closer attention to the dynamic forces that were essential to the development and periodic crises of the global economic system.  In particular, such a model should have recognized the role of unbridled free markets and their associated deregulation of the economic and financial sectors in creating the recent environment of excessive leverage and risk taking, lax corporate governance, and widening economic inequalities.

In addition, a more appropriate model should have incorporated the role of the recent globalization which, by providing access to cheap foreign labor, served to lower domestic incomes in many industrial economies.  It was partly to address this income shortfall that many low and middle income consumers gorged on debt, thus setting the stage for the 2008 credit crisis and the subsequent crash of the world economy.


As the foregoing discussion makes it clear, the limited rationality of individuals, while causing deviations from their optimal economic behavior, is far from sufficient to account for major economic crises.  In other words, psychological factors are at best the icing on the cake.  It is far better to try to understand the structural characteristics and the operational fragilities of modern economic systems from an institutional perspective.  It is only through such an understanding that we may have a reasonable chance of ever coming up with sound economic policies to forestall any future global economic catastrophe.

Hassan Shirvani, Ph.D.
Professor Cullen Foundation Chair in Economics

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