Philosophy and Literature

The other side of Behavioral Economics: old and new, a theoretical dispute

If the history of economic thought is a succession of new mainstreams, the current predominant school of thought is undoubtedly Behavioral Economics. Models introducing cognitive limitations of agents are now increasingly spreading and, even in those economic domains where there is more reluctance towards this approach, behavioral considerations are still part of the debate. If the existence of Behavioral Economics is common knowledge, along with the main names associated to it, what could be less known is that theoretical disputes exist not only between Behavioral and Neoclassical economists, but within the field of Behavioral Economics as well. In order to have a clear understanding of the reasons behind such dispute, it is necessary to go back to the beginnings of Behavioral Economics, and in particular to year 1955, when Herbert Simon presented the concept of bounded rationality for the first time in his work “A behavioral model of rational choice”.  

“Broadly stated, the task is to replace the global rationality of economic man with a kind of rational behavior that is compatible with the access to information and the computational capacities that are actually possessed by organisms, including man, in the kinds of environments in which such organisms exist”  

According to Simon, humans are not irrational; they are rational, but boundedly so: they try to make the best decisions, given their cognitive and computational limitations. Since in most real-life situations, genuine or global optima are not computable within feasible limits of effort, individuals may look for a satisfactory, rather than optimal, alternative. This is where heuristics come into play: simplified decision rules, or, differently stated, cognitive effort-saving shortcuts, that help individuals find satisfactory solutions in the contexts of interest. Simon proposed to substitute the optimization theory embraced by traditional economics, relying on the assumption of the rational and materialist homo economicus, with a more human theory of satisficing, constructing on the different view of bounded-rational agents.  

The concept of satisficing is central to Simon’s theory and to what is usually referred to as the Old Behavioral Economics. At that time, however, as usually happens with revolutionary ideas, these concepts did not have great success and, surely, did not alter the fundamental direction of economics. What we now call Behavioral Economics and regard as the most up-to-date economic theory has little to do with Simon’s work but is rather the result of a new stream of Behavioral economists that decided to take a very different approach.  In fact, the most precise name for it would be New Behavioral Economics. This group of economists agreed with the fact that the rationality assumption did not mirror the empirical evidence connected to human decision-making. However, whereas Simon proposed a brand-new model that completely upset the supporters of optimization theory, these other economists tried to integrate empirically discovered anomalies of human behavior into the well-known formal models, with axiomatic foundations and utility-maximizing functions. In general, this was done by relaxing some strict assumptions of Neoclassical models and introducing new parameters capturing specific behavioral phenomena in order to obtain a more general framework with higher descriptive capacity. For instance, think about Prospect Theory by Kahneman and Tversky (1979), and the introduction of the parameter for loss aversion, capturing the fact that people seem to derive twice more pain from losing than pleasure from gaining the exact same quantity of a good, e.g., money, in absolute terms. Or think about the modeling of social preferences and inequity aversion by Fehr and Schmidt (1999), including two new parameters, capturing the degree of envy and guilt that individuals feel when they obtain a payoff that is smaller or larger in comparison to others’ payoffs. This type of models accounts for more realistic characteristics of individuals without modifying the formal structure of traditional economic models. Indeed, they are broader generalizations: when the parameters take specific values, the models’ results are often back to the ones predicted by Neoclassical theories (e.g., when the degree of envy and guilt are both equal to zero, the outcomes are equal to classic game theoretical predictions).  

It should not be surprising, then, that the New Behavioral Economics is the one becoming today’s mainstream. These new models, despite some persisting oppositions coming from Neoclassical economics’ enthusiasts that continue to sustain the superior normative, outcome-based power of classical theories, are starting to be studied and adopted not only in academic environments but also in professional applications and policy design.  

Nevertheless, there are some opponents to New Behavioral Economics, whose discontent has nothing to do with the usual criticism moved to Behavioral theories. On the contrary, these critics argue that aversion theories and simple adaptive (learning or evolutionary) dynamics are not truly, or sufficiently, behavioral. Models representing human decision-making as the result of an optimization process, rather than of the application of simplified decision rules such as heuristics, fail to grasp the real meaning of Behavioral Economics. In this regard, these critics perceive themselves as the true heirs of Simon’s theory. Among the most notable scholars in favor of this view, there is Werner Güth, a German economist, director of the Max Planck institute of Economics in Jena. According to Güth (2007) “(Non) Behavioral Economics – A programmatic assessment”, models including psychological and cognitive factors but sticking to the optimization approach are only “neoclassical repairs”.  

“Neoclassical repairs, in the sense of more complex motivational preferences in choice tasks, undoubtedly enrich microeconomics. However, this is a new development in neoclassical microeconomics and offers no true contribution to behavioral economics” 

In Güth powerful words, “A truly behavioral approach should rely on aversion aversion rather than on aversion theories”. He thinks that efforts in the field of Behavioral Economics should not be directed at adjusting existing models but should aim at creating a new and adequate toolbox able to actually deal with the novelties introduced by this discipline. New Behavioral theories, depicting individuals as prone to countless biases, errors, effects and aversions, that is, as fundamentally irrational, may convey the misleading picture that such psychological factors are departures from a standard, rather than the actual state of the world. In fact, individuals, given their bounded rationality, usually make decisions that are still satisfactory and efficient in the concerned environments despite far from being the optimal ones in a global sense. This feature of human decision-making is often referred to as ecological rationality, a term trying to capture the fact that the local nature of heuristics makes them work well in their native environment. In contrast with the New Behavioral Economics’ method of action, these scholars propose to abandon Neoclassical models and to look back at Simon’s theories, with a particular focus on the intuition behind the satisficing approach. In order to make the problem with “neoclassical repairs” clearer, Güth offers a practical example. He considers an ultimatum game with a commonly known monetary reward that a proposer and a responder can share. The responder, after being informed of the proposer’s offer on how to share the reward, can choose between “acceptance” (yielding him the offer amount and leaving the rest to the proposer) or “rejection” (yielding both players zero). Neoclassical economics, assuming profit-maximization by agents, predicts that the responder will always accept, as any positive offer is better than a zero-payoff. New Behavioral models, including a degree of envy in the equation, predict that responders will likely refuse offers that are perceived as too low (specifically, offers lower than one third of the total reward are more often rejected than accepted). This latter prediction deals with the empirical evidence about human behavior in case of perceived inequity, but, according to Güth, is still missing the crucial point that a truly behavioral approach should instead focus on. Individuals are not established with well-behaved preferences telling them how to trade off their payoffs with inequality, but rather have to make up their own mind about what they prefer. “Repairing” the responder’s problem in a “game-fitting” fashion provides a new as-if explanation – as-if individuals maximized their utility given their preferences, i.e., the relative weight they attach to profits and to receiving an equal treatment – but not  a description of how human responders actually determine their behavior. This is the reason why Güth and other scholars sustain the need to construct different models. Up to now, however, attempts to formalize the satisficing approach in order to make it more applicable have been offered by Güth himself (his paper presents a formal discussion of one of the possible model’s specifications) and by few others, leaving room for improvement.  

Among other ideas that these scholars regards as truly behavioral and think would need deeper exploration there are  

  • routines, i.e., the application of a standard rule without reflecting (anymore) on how changes in the environment affect the decision 
  • similarity considerations, i.e., the application of paths of behavior that were successful in “similar” situations  
  • insights from cognitive psychology regarding how individuals perceive numerical stimuli, e.g. the Weber-Fechner law, and determine numerical choice, e.g. the process of “mental accounting” 

On the one side, the debate between Neoclassical and Behavioral economists is likely destined to vanish, partly because the relevance of psychological factors in the decision-making process has now become evident, partly because, as pointed out, they do not use conflicting methodological approaches. On the other side, the debate among those who describe themselves as Behavioral economists will probably get bigger, and the course of actions that will be taken is likely to shape the future evolution of current microeconomic theory.  

As John Maynard Keynes wrote, in a very different context, “the difficulty lies not in the new ideas, but in escaping the old ones, which ramify […] into every corner of our minds”. Even though theoretical disputes may sometimes  appear as a mere exercise of erudition and rhetoric, involving only the academic world, they generate the ideas that, in the end, shape the evolution of our societies.  

Fehr, E. and Schmidt, K.M. (1999) “A theory of fairness, competition, and cooperation,” The Quarterly Journal of Economics, 114(3), pp. 817–868 

Guth, W. (2007) “(Non) behavioral economics – a programmatic assessment,” SSRN Electronic Journal  

Kahneman, D. and Tversky, A. (1979) “Prospect theory: an analysis of decision under risk,” Econometrica, 47(2), p. 263 

Simon, H.A. (1955) “A behavioral model of rational choice,” The Quarterly Journal of Economics, 69(1), p. 99 

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