Economics, Behavioral

BIBLIOGRAPHY

Underlying behavioral economics and distinguishing it from contemporary (neoclassical) economics is the presumption that the realism of behavioral and institutional assumptions matter substantively to the modeling of the economic agent (Simon 1959, 1978, 1987). In contemporary economic theory (e.g., Friedman 1953), assumptions are of little analytical consequence as long as the model’s predictions are correct. In behavioral economics, the realism of assumptions affects the accuracy of models’ predictions. It also helps distinguish between spurious correlations and actual cause-and-effect relationships between independent and dependant variables. Even when “as if” neoclassical behavioral assumptions yield correct predictions, if alternative, more realistic assumptions also generate accurate predictions, abiding by the former spawns false and therefore unscientific causal results. However, behavioral economics does not dispute the notion of abstraction and simplicity in model building; it questions models built upon unrealistic simplifying assumptions. When theory and evidence conflict, one includes in one’s search for modeling deficiencies misspecified assumptions, unlike in conventional analysis that focuses largely on missing variables and questioning the validity of the evidence itself (Reder 1982).

Unlike behavioral economics, economic theory typically plays a marginal role in economic psychology. The latter focuses upon applying psychological tools to economic questions and generating evidence that might underlie behavioral assumption of economic agency. It also examines the psychological motivation for economic behavior (Lewis, Webley, and Furnham 1995).

Contemporary behavioral economics is often associated with the contributions of Hebert Simon and, more recently, Daniel Kahneman and Amos Tversky (Kahneman and Tversky 1979; Tversky and Kahneman 1981), all of whom are Nobel Prize Laureates. Thus far, George Katona’s earlier pioneering contributions (1951, 1975) revising the psychological assumptions of consumer behavior in economic theory have gone largely unnoticed. Connected with Simon, Kahneman, Tversky, and their colleagues and associates are the presentation of new theories that either supplement or revise neoclassical micro and macro theories (Altman 2006; Camerer, Lowenstein, and Rabin 2003; Cyert and March 1963; Frank 1988; Shiller 1993; Thaler 1992; Williamson 1975).

Simon introduced the concepts of bounded rationality and satisficing, integrating into economic theory the reality of the cognitive limitations of individuals in terms of computational ability and knowledge acquisition that can only be realized at a cost. Rational individuals adopt behavioral procedures designed to limit such costs that differ descriptively and normatively from the conventional economic standard. Satisficing is the rational alternative to optimizing in a world of bounded rationality. In this case, it is possible for the firm’s output and profit and the individual’s utility to be less than they would be in a world with no limits to human cognitive abilities. Neoclassical norms are no longer optimal or descriptively accurate. Simon also emphasized the importance of recognizing the importance of power relationships, conflicts, fairness, altruism, and institutions for modeling economic agency—variables that are given little space in conventional theory. Individuals might be maximizing their own well-being at the expense of others or society at large; utililty might be enhanced at the expense of material wealth (Kahneman, Knetsch, Thaler 1986). Kahneman and Tversky developed prospect theory based on their experiments as an alternative to expected subjective utility theory, where individuals weigh losses more than gains and evaluate their utility in terms of relative positioning. Wealth maximization is not the end game in their descriptive modeling framework. Perspectives developed here have given rise to the revealing ultimatum and dictator game experiments wherein individuals make material sacrifices in the name of fairness (Güth 1995).

Independent of the work of Simon and more contemporary behavioral economists, Harvey Leibenstein (1957, 1966, 1979) developed the concepts of efficiency wages and x-efficiency theory (see Frantz 1997, for details). Based on the evidence, he assumes that effort inputs into the process of production are variable, not fixed at some maximum, as is assumed in conventional theory. Therefore, costs need not be minimized nor output maximized. Effort maximizing remains the ideal for wealth maximization or x-efficiency to be achieved. However, for this to transpire, appropriate market conditions and in-firm incentive environments (often far removed from neoclassical norms) must be developed. The efficiency wage and x-efficiency literature have been extended, for example in Akerlof (2002), Akerlof and Yellen (1986), Altman (1996), Darity and Goldsmith (1996), Stiglitz (1987), and Tomer (1997).

There are roughly two major perspectives within behavioral economics. The one that follows and extends the work of the psychologists Kahneman and Tversky is especially focused on, demonstrating through experiments the extent to which human behavior deviates from neoclassical norms, where the latter are used as the benchmark for economic rationality. By such standards individuals are found to be largely irrational, but such behavior might possibly be corrected through education or government intervention. Irrationality in behavior as the norm is completely inconsistent with conventional theory, and would be regarded as suboptimal in the realm of production and consumption. Such findings are therefore thought to undermine the legitimacy of much contemporary economic modeling. Conventional theory is assumed to provide an adequate description of how individuals behave, and holds that this behavior is also normatively optimal. Many behavioral economists argue that conventional theory fails as an accurate descriptor of even average human behavior, although it might very well be normatively correct. Vernon Smith (2003, 2005) has challenged many of the empirical findings of such behavioral economists, arguing that the incentive environment of many of their experiments are far removed from what is typically found in the real world of economic life. But Smith and his colleagues have also challenged the modeling assumptions (especially their institutional parameters) of contemporary theory, also using experimental data. Smith finds that human behavior is largely economically rational.

Compatible with Smith’s view on behavioral economics is a perspective that builds on the contributions of Simon. Individuals are assumed to be largely rational and intelligent, developing procedures and institutions that best suit their individual needs given the constraints that they face (March 1978; Smith 2003; Todd and Gigerenzer 2003). This approach to human behavior is sometimes referred to as “ecological rationality.” Deviations from neoclassical norms are therefore not regarded as expressions of irrationality yielding suboptimal socioeconomic outcomes. Neoclassical procedures might very well yield suboptimal outcomes, but errors in decision making can be corrected through evolutionary processes such as learning.

Behavioral economics enriches conventional theory by introducing modeling variables and parameters that make for more scientific causal and predictive analysis. It does not reject the importance of incentives and opportunity costs in decision making, but it does question wealth maximization as dominating the decision-making process, economic efficiency as the end product of individual decision making, and the extent to which neoclassical behavioral norms should serve as appropriate benchmarks for economic analysis (Altman 2005). This in turn opens the door wide open for reconstructing economic theory, engaging institutional analysis as a partner in model building and inviting public policy analysis to help better understand the constraints and incentive environments under which economic agents make boundedly rational choices.

SEE ALSO Akerlof, George A.; Behaviorism; Economic Psychology; Economics, Experimental; Economics, Institutional; Economics, Neoclassical; Galbraith, John Kenneth; Maximization; Rationality; Satisficing Behavior; Smith, Vernon L.; Social Psychology; Sociology, Economic; Wages

BIBLIOGRAPHY

Akerlof, George A. 2002. Behavioral Macroeconomics and Macroeconomic Behavior. American Economic Review 92: 411–433.

Akerlof, George A., and Janet L. Yellen, eds. 1986. Efficiency Wage Models of the Labor Market. Cambridge, U.K.: Cambridge University Press.

Altman, Morris. 1996. Human Agency and Material Welfare: Revisions in Microeconomics and Their Implications for Public Policy. Boston, Dordrecht, and London: Kluwer Academic.

Altman, Morris. 2005. Reconciling Altruistic, Moralistic, and Ethical Behavior with the Rational Economic Agent and Competitive Markets. Journal of Economic Psychology 26: 732–757.

Altman, Morris, ed. 2006. Handbook of Contemporary Behavioral Economics: Foundations and Developments. Armonk, NY: M. E. Sharpe.

Camerer, Colin F., George Lowenstein, and Matthew Rabin, eds. 2003. Advances in Behavioral Economics. Princeton, NJ: Princeton University Press.

Cyert, Richard M., and James C. March. 1963. A Behavioral Theory of the Firm. Englewood Cliffs, NJ: Prentice-Hall.

Darity, William, Jr., and Arthur H. Goldsmith. 1996. Social Psychology, Unemployment, and Macroeconomics. The Journal of Economic Perspectives 10: 121–140.

Frank, Robert H. 1988. Passions Within Reason: The Strategic Role of the Emotions. New York: W. W. Norton.

Frantz, Roger S. 1997. X-Efficiency Theory, Evidence and Applications (Topics in Regulatory Economics and Policy 23). Boston, Dordrecht, and London: Kluwer Academic.

Friedman, Milton. 1953. The Methodology of Positive Economics. In Essays in Positive Economics, 3–43. Chicago: University of Chicago Press.

Güth, Werner. 1995. On Ultimatum Bargaining Experiments— A Personal Review. Journal of Economic Behavior and Organization 27: 329–344.

Kahneman, Daniel, and Amos Tversky. 1979. Prospect Theory: An Analysis of Decision Under Risk. Econometrica 47: 263–291.

Kahneman, Daniel, Jack L. Knetsch, and Richard H. Thaler. 1986. Fairness and the Assumptions of Economists. In Rational Choice: The Contrast Between Economics and Psychology, eds. Robin M. Hogarth and Marvin W. Reder, 101–116. Chicago and London: University of Chicago Press.

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Leibenstein, Harvey. 1966. Allocative Efficiency vs. “X-Efficiency.” American Economic Review 56: 392–415.

Leibenstein, Harvey. 1979. A Branch of Economics Is Missing: Micro-Micro Theory. Journal of Economic Literature 17: 477–502.

Lewis, Alan, Paul Webley, and Adrian Furnham. 1995. The New Economic Mind. New York: Harvester Wheatsheaf.

March, James G. 1978. Bounded Rationality, Ambiguity, and the Engineering of Choice. Bell Journal of Economics 9: 587–608.

Reder, Melvin W. 1982. Chicago Economics: Permanence and Change. Journal of Economic Literature 20: 1–38.

Shiller, Robert J. 1993. Market Volatility. Cambridge, MA: MIT Press.

Simon, Herbert A. 1959. Theories of Decision Making in Economics and Behavioral Science. American Economic Review 49: 252–283.

Simon, Herbert A. 1978. Rationality as a Process and as a Product of Thought. American Economic Review 70: 1–16.

Simon, Herbert A. 1987. Behavioral Economics. In The New Palgrave: A Dictionary of Economics, eds. John Eatwell, Murray Millgate, and Peter Newman, 221–225. London: Macmillan.

Smith, Vernon L. 2003. Constructivist and Ecological Rationality in Economics. American Economic Review 93: 465–508.

Smith, Vernon L. 2005. Behavioral Economics Research and the Foundations of Economics. Journal of Socio-Economics 34: 135–150.

Stiglitz, Joseph E. 1987. The Causes and Consequences of the Dependence of Quantity on Price. Journal of Economic Literature 25: 1–48.

Thaler, Richard H. 1992. The Winner’s Curse: Paradoxes and Anomalies of Economic Life. New York: Free Press.

Todd, Peter M., and Gerd Gigerenzer. 2003. Bounding Rationality to the World. Journal of Economic Psychology 24: 143–165.

Tomer, J. F. 1997. The Human Firm: A Socio-Economic Analysis of Its Behavior and Potential in a New Economic Age. London and New York: Routledge.

Tversky, Amos, and Daniel Kahneman. 1981. The Framing of Decisions and the Psychology of Choice. Science 211: 453–458.

Williamson, Oliver E. 1975. Markets and Hierarchies: Analysis and Antitrust Implications. New York: Free Press.

Morris Altman