Monday, November 30, 2015

Behavioural Economics and Rationality - #BERational


Overview
Behavioural Economics is often characterised as a reforming movement in Economics arguing for relaxation of some of the core tenets of rational choice. There are many historical threads to this narrative. The separation of Economics and Psychology in the first half of the 20th century saw Economics focus on the optimisation behaviour of rational agents under different types of market structure. The work of Herbert Simon and others argued for more constrained forms of optimisation. A range of scholars such as Maurice Allais and Daniel Ellsberg pointed out potential flaws in the model of subjective expected utility maximisation. The work of Daniel Kahneman, Amos Tversky and colleagues in the context of the wider cognitive revolution posted concrete empirical challenges in the form of evidence on loss aversion and heuristics that contrasted with the neo-classical view. A generation of scholars led by Richard Thaler, Robert Shiller, Ernst Fehr, Matthew Rabin, David Laibson and others brought the full implications of this work to bear on Economics and acceptance of a limited set of human cognitive and emotional processes at odds with pure optimisation is now rapidly becoming an accepted part of the corpus of Economics.

The purpose of this post is to collect some wider threads on the discussion of rationality in the social sciences. How has rationality traditionally been discussed across different disciplines? Are there interesting insights from the discussion of rationality in fields such as political science and sociology that we should discuss more in behavioural economics and related areas? As in the case of similar posts I have written of this nature I make the following caveats: this is too broad to be coherent and is intended to be a vehicle to generate discussion of interesting readings; someone else may already have published a review paper on this that I am not aware of and, if so, will happily post it; I do not claim to be an expert on every aspect of this very broad area but will do my best to draw on the most credible sources. I will present the material in rough chronological orders. Suggestions very welcome.

Ancient and Medieval Thought
A volume on Greek concepts of rationality is available here. Hobbes and Machiavelli both put forward models of political behaviour focused on the strategies of self-interested agents.

Scottish Enlightenment and 18th Century
The Scottish Enlightenment, while fundamentally a unifying endeavour, also gave rise to the most coherent expression to date of the role of rationality and self-interest in the form of Adam Smith’s great work “AnInquiry into the Nature and Causes of the Wealth of Nations”. This work still reverberates through the ages of a coherent expression of how the individual rational behaviour of different agents combines to create outcomes in the wider economy. While Smith himself clearly had a far more nuanced view on how people actually behaved it is clear that he saw the power of simplifying assumptions and his ambiguity in this regard in still echoed in modern debates in Economics.

The development of probability theory shed light on how rational gamblers should play lotteries and subsequently had a huge influence on how general rational behaviour might be modelled.

The development of probability theory in the 18th century lead to a wide-ranging examination of the rational method to play lotteries that underpins much of modern utility theory.

19th Century Economic and Sociology Traditions
In the tradition of Adam Smith 18th and 19th century UK economists provided a wide range of accounts of economic rationality and cemented Economics as the study of optimising behaviour under conditions of scarcity. Ricardo, Mill, Jevons, Malthus and many others placed optimising behaviour of consumers and producers at the heart of wider models of production and exchange.

The work of Sigmund Freud shocked Victorian sensibilities in suggesting that much of the motivation for our behaviour is outside our conscious control. Freud is rarely cited in behavioural economics papers and widely shunned in these circles due to his rejection of empirical methods but his ideas are worth reading in their historical context and for the wide range of intriguing ideas he outlined. The psychotherapy tradition of rationality is bound up with the idea of self-analysis. 

Max Weber provided a comprehensive account of various forms of rationality in one of his main treatises. A summary of his ideas on rationality is available here.

20th Century Economics

The development of subjective expected utility theory by VonNeuman provided the default model for much of 20th century Economics. Combined with advanced in game theory these models advanced a structured account of rational human strategic behaviour under a wide range of circumstances.

John Maynard Keynes famously talked about the role of Animal Spirits in influencing consumption and investment behaviour. Recently Robert Shiller has written about the role of emotions in investment decisions and business cycles. A fascinating possibility is that the origin of business cycles lies in emotional responses to economic events. Akerlof and Shiller phrase it beautifully as: “To understand how economies work and how we can manage them and prosper, we must pay attention to the thought patterns that animate people’s ideas and feelings, their animal spirits. We will never really understand important economic events unless we confront the fact that their causes are largely mental in nature”.

A long-ranging tradition in political science examines rational voters. The seminal work of Anthony Downs "The Economic Theory of Democracy" has had a huge influence on modelling rational actors in democratic institutions. The public choice literature associated with Buchanan, Tullock and others emphasised the role of rational self-interest in public institutions.

The ideas of Milton Friedman had a strong influence on the use of the rationality assumption in Economics. His 1952 article on methodology argued that the rationality assumption should be based on whether it provides strong predictions more than its fit with basic intuition about human behaviour. The work of the late Nobel Laureate Gary Becker put forward a comprehensive account of rational choice in the context of marriage, fertility, the family and a range of other domains including crime. Becker's ideas on rational choice have had a profound influence on Economics.

Political Science and Sociological Accounts
Amartya Sen provides a critique of rationality based on the concept of self-interest being a limited construction of how humans function and solve problems - his book "Rationality and Freedom" is a strong statement of his views in this regard . Jon Elster has written several fascinating works addressing rationality in the social sciences. His work should be read by anyone in behavioural economics interested in a broad overview and is regularly cited by the most intellectually influential in the field including several citations in the work of people like Laibson and Loewenstein. Anthony Heath's "Rational Choice and Social Exchange" provides an influential critique of the rationality assumptions from the perspective of sociology. A good piece by John Scott on the rational choice theory in sociology is available here.

Behavioural Economics
The cognitive revolution in psychology in the 1950s and 60s developed a wide range of models of humans as limited-capacity information processors and continues to influence our view of human judgement and decision making to the present day. It goes without saying the work of Daniel Kahneman and Amos Tversky posed one of the most important challenges to economic rationality. The 1982 Kahneman, Slovic and Tversky volume is a desert-island book and has the advantage of being an edited volume giving a broader range of the contribution of the literature up to that time.

A large literature on the psychology of self-control examines one powerful challenge to the idea of economic rationality - readings here. The connection between economic theories of discounting and this psychological literature is an interesting avenue for the development of ideas on inter-temporally rational choice. The work of James Heckman has charted the idea of progression of decision making capabilities in childhood as being at the route of capacity for adult rational decision making.

As well as bounded rationality and bounded self-control, there is also obviously a key question as to the extent that humans are motivated by considerations other than their own utility. This is not technically a question of rationality as it may be the case that people can rationally follow a set of preferences that incorporates the utility of others. However, there are certainly cases in which social preferences are at odds with consistent utility maximisation as well illustrated in the classic ultimatum and dictator game paradigms (see the following post for a long set of links on this issue).

The recent behavioural economics literature has sought to examine rationality in the context of preferences expressed subject to a number of complexity and self-control constraints. An excellent readable paper in the Journal of Public Economics (ungated version here) provides a workable definition of the behavioural view of constrained rationality. The authors distinguish between revealed and normative preferences. Normative preferences describe how people would chose if not limited by a wide range of preference constraints including third party marketing, confusion, default biases, inter-temporal choice effects and other features of decision making that render it difficult to make rational choices.

Critiques of Behavioural Accounts of Rationality
The well-known UK scholar Robert Sugden has written a number of articles critical of the idea that failures in self-control and information processing are sufficient rationales for paternalistic policy. Gerd Gigerenzer is associated with a view of human rationality where heuristics have evolved as efficient mechanism to deal with complexity. The work of Klein has emphasised how heuristics can outperform more deliberative ways of problem solving in many cases.

Other Links:
Oxford Handbook of Rationality

Daniel McFadden - Rationality for Economists

PJ Hammond: Rationality in Economics

Rabin (2002), "A perspective on psychology and economics," European Economic Review

1 comment:

CJ FitzGerald said...

Hi Liam, excellent resource again, thanks. As you know, from my own work I think there are interesting insights from the discussion of rationality in fields such as political science that should be discussed more in behavioural economics and related areas. Bounded rationality has been an important consideration in political studies since Janis' work in the 1970's, and the branch of leadership studies that flowed from it. I say regularly that we should look at political decision makers as more than just choice-architects for citizens with bounded rationality, to also being "victims" of bounded rationality themselves when making decisions that impact on millions.