According to the neoclassical paradigm, people rank alternatives on the basis of their desirability and choose optimally. How do they behave? An analysis of the context of the economics.
Not long ago, in the first decade of this century, the state of the economics profession was marked by intense debate and disagreement. The adherents of two rival schools of thought, the neoclassical school and the behavioural school, did not see eye to eye in modelling and predicting economic behaviour.
But the state of the profession is slowly but surely heading for a change. In keeping with Hegelian dialectic, thesis-antithesis-synthesis, the rivalry between the two schools of thought has now given rise to attempts to harmonize their seemingly different ways of viewing the world.
A milestone in this synthesis is Raj Chetty’s Richard T. Ely Lecture of 2015 in which he emphasized the need for a marriage between neoclassical and behavioural economics, with standard economists incorporating behavioural factors into models built on neoclassical lines. A number of prominent economists such as Matthew Rabin, George Loewenstein and Erik Angner have been at the forefront of this synthesis.
But what exactly is the difference between neoclassical and behavioural economics? Answering this question holds the key to understanding that harmonization is both possible and desirable.
According to the neoclassical paradigm, people rank alternatives on the basis of their desirability and choose optimally. What guides desirability are the intrinsic characteristics of these alternatives. For example, if we are talking about fruits, sweetness and crunchiness can be considered as intrinsic characteristics. Therefore, we can talk about alternatives as bundles of characteristics, with each consumer choosing the bundle she prefers the most. This corresponds to the real world where given our tastes, we choose different fruits to partake of – some prefer apples, others mangoes and so on.
What neoclassical economists have done traditionally is to assume that these tastes are given and unchanging. Thus, if I am given a choice between apples and mangoes today, and I prefer mangoes then if that choice is repeated at any other point of time, I will again choose mangoes.
The invariability of tastes is contested by behaviouralists. In fact, they contend that tastes vary, often systematically, according to the environment and emotional state of the individual. In this case, ‘environment’ is a very broad term and covers factors such as the extent of satiation and verbal or other cues received recently.
Let me elaborate. Behaviouralists contend that individuals use heuristics or cognitive shortcuts to make choices. One heuristic consists of using information vivid in memory to make choices. This is the availability heuristic. Suppose you watch a movie in which the protagonist’s investment plunges in value. The next day the memory of the failed investment is still vivid in your memory; as a result, you respond very negatively to the advice of an agent about investing in your pensions, forgetting that the movie is not representative of the experience of investors. The point being made is that our choices are very unstable and depend very heavily on the recent information that we have consumed.
Consumers may also ‘anchor’ their decisions on not very relevant information. For example, experiments have asked people to value purchases after being reminded about the last two digits of their social security number. The results have been quite amazing: those associated with a larger number formed by these digits bid a higher value for the concerned purchase even though the number obviously does not have anything to do with the actual value of the item.
Next, consider all-you-can-eat offers or buffets: the customer pays up and then can eat as much as he wants to. Neoclassical economists argue that an additional morsel of food will be ingested as long as it provides positive satisfaction; the customer will stop eating as soon as she anticipates that the next morsel would provide negative satisfaction. This should lead to the conclusion that customers should eat the same amount irrespective of the amount paid. But actual observation does not conform to this prediction: if the buffet is free then individuals are seen to eat much less than if a significant amount is paid.
This is probably because payment of a heavy charge for enjoying a buffet induces guilt which the individual tries to get rid of by eating more. The guilt induced by payment also explains why people who have invested in a new pair of shoes continue to wear them even if they turn out to be very painful or uncomfortable; those who have coughed up a lot of money to enrol in a new course continue to attend it even though they find it to be a waste of time.
Another major characteristic of human behaviour is inertia or the tendency to continue what one has been doing in the recent past. Inertia characterizes major human decisions – for example, an individual might stick with the existing medical insurance policy even though incentives dictate that he should be switching. One of the reasons for inertia is pure laziness, the tendency to conserve energy causes us to shy away from the paperwork involved in switching. Inertia affects major decisions – choosing where we live, how much we save etc.
It is now clear that “choosing what one prefers most” is a description of human economic behaviour which needs to be qualified. That is what an individual prefers most is determined by the environment and sensory information to which she has been subjected; it is also a function of what she has been choosing in the past. But really, we need not discard the notion that individuals choose their most preferred option. All that we need to do is to modify the traditional practice of assuming tastes to be unvarying and independent of environments and contexts.
This really sets the stage for the neoclassical-behavioural synthesis. According to the traditional neo-classical methodology, data on human choices can be used to infer tastes and then used to make predictions about future choices implied by these tastes. However, the synthesis dictates that if these predictions turn out to be incorrect, we introduce a correction – account for behavioural factors such as the ones described above which supplement data on human choices in helping to predict human behaviour.
Not too many people should have a quarrel with this synthesis: it is a broader, more flexible and therefore much more sensible apparatus to analyse and predict human behaviour. And therefore, it should result in better policies and herald a new age where economists are more useful for society.
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(Siddhartha Mitra is Professor of Economics at Jadavpur University, Kolkata.)
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