Say Goodbye to “Homo economicus”: The New Science of Behavioral Economics

By Dr. Roger Morefield —

 

HOMO ECONOMICUS AND PARADIGM SHIFT

In his 1962 book, The Structure of Scientific Revolutions, Thomas Kuhn described the process of what he called “paradigm shift,” which is a change in the basic assumptions underlying a science. Recent advances in the theory of consumer behavior have allowed the new science of behavioral economics to replace the old paradigm, which was Homo economicus, or “economic man.”

Nineteenth-century economic thinkers such as F. Y. Edgeworth, William Stanley Jevons, Léon Walras, and Vilfredo Pareto wrote about the economic equivalent of Homo sapiens, whom they identified as Homo economicus. “Economic man” was assumed to be a utility maximizer, a cool customer who would expertly and efficiently calculate the course of action that would bring him the greatest benefit and then promptly choose it. This model of human behavior assumes that economic man is “rational,” seeking out the greatest addition to utility at lowest cost to himself. The model was nice and tidy, portraying Mr. Economicus as a pleasure-maximizing/pain-avoiding machine who, when given all available information about the natural and institutional constraints facing him, would quickly and easily select the optimal course of action without any troubling thoughts concerning the morality of his actions or the effects of his actions on others.

 

Unfortunately this model lacks the power to explain human behavior very well. It is especially deficient in explaining how people deal with risk and uncertainty, how they make choices that require commitment or willpower, and how they make decisions that involve trust, fairness, or reciprocity. Another problem facing the model is that it can’t explain why people engage in altruistic behavior, where there is no likelihood of monetary gain from the action. Please don’t get me wrong here – there is no question that people do respond to incentives. But the issue is about how they respond. In my masters-level microeconomic theory class in graduate school, we learned that, well, OK, if people don’t respond the way the model predicts they’re being “irrational.” This always seemed circular to me – we construct a model with a number of assumptions, including rational behavior, and then when what we observe doesn’t follow the model’s predictions, we say the behavior is irrational!

 

PARADIGM SHIFT IN THE THEORY OF CONSUMER BEHAVIOR

Like me, many people found the Homo economicus model unsatisfying. In the waning decades of the twentieth century, scholars were looking either for a way to rescue the old model or for something to replace it. Two Stanford University psychologists, Daniel Kahneman and Amos Tversky, developed prospect theory, which sees human behavior very differently. According to prospect theory, people evaluate options based on gains or losses relative to the status quo. In addition, gains are subject to diminishing marginal utility, and losses are subject to diminishing marginal disutility. Thirdly, according to prospect theory, people are loss averse, experiencing much more pain from a $1000 loss than the satisfaction they would get from a $1000 gain. Tversky died in 1996, but his collaborator Kahneman received the 2002 Nobel Prize in Economics for his work in prospect theory. It was odd for the Nobel Committee to award the economics prize to a psychologist, but they had done a similar thing in 1994 by awarding the prize to John Nash, a mathematician, for his work in game theory.

 

In 1977, Kahneman began a collaboration with Richard Thaler which resulted in the development of behavioral economics. Kahneman and Thaler’s 1980 paper “Toward a Positive Theory of Consumer Choice” became a cornerstone of the new theory. In the 1990’s Kahneman was also heavily involved in research in hedonic psychology, which studies how the experiences of life relate to suffering and enjoyment. More recently there has been an outpouring of books and papers exploring this new sub-field in economics and all its implications. Three recent and very popular books are Richard Thaler and Cass Sunstein’s Nudge: Improving Decisions about Health, Wealth, and Happiness, Dan Ariely’s Predictably Irrational: The Hidden Forces That Shape Our Decisions, and Daniel Kahneman’s Thinking, Fast and Slow. These books explore human behavior at the intersection of psychology and economics. The new behavioral economics takes into account forces such as emotions, relativity, and social norms to explain human behavior much more effectively than the simplistic neoclassical model.

 

GOODBYE

 

To anyone who’d like to better understand consumer and human behavior from the viewpoint of behavioral economics, the books mentioned above are a great place to start. In addition, see chapter 8 of Economics: Principles, Policies, and Problems, 20th Edition by Campbell McConnell, Stanley Brue, and Sean Flynn. To their credit, the authors include an entire chapter on behavioral economics in the latest edition of Economics. This chapter gives a nice summary of the new science in the field. MIT, Stanford, Harvard, Brown, the London School of Economics, and others have added behavioral economics courses to their curricula. Wiley, Palgrave Macmillan, and Princeton University Press are among the publishers that have recently added behavioral economics textbooks to their catalog.

 

So we say “goodbye” to Homo economicus and “hello” to behavioral economics. This is progress. New knowledge has been developed and the old paradigm has been supplanted by the new.

 

Roger Morefield, Ph.D.
Associate Professor of Economics

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