Some Economists Call Behavior a Key http://kent.kellogg.northwestern.edu/460/news/Some%20Economists%20Call%20Behavior%20a%20Key.htm
February 11, 2001 Some Economists Call Behavior a Key
By LOUIS UCHITELLE
n the histories of economics still to be written, the spring of 1994 will almost certainly be flagged as momentous. That is when an ophthalmologist's son from Main Line Philadelphia — David Laibson — received his Ph.D. in economics, qualifying with a thesis about willpower and money that drew as much on psychology and quirky behavior as on standard economics. Harvard quickly hired him, becoming the first university to deliberately recruit an economics professor trained as a behavioral economist.
Behavioral economics had finally arrived: a discipline that for a half-century had built its theories on the rigid assumption that people acted with rational, unemotional self-interest had formally recognized that human beings had another, feisty, side to them.
Three years later, the Massachusetts Institute of Technology followed Harvard's lead, hiring Sendhil Mullainathan just after he earned his Ph.D. He, too, was steeped in both psychology and economics, as well as memories of an impoverished early childhood in rural India.
Mr. Laibson, now 34, and Mr. Mullainathan, 27, are rising stars in a generation of economists that are gradually integrating behavioral economics into mainstream theory. Many are still graduate students. They are bunched at prestigious training centers — Harvard, M.I.T., Stanford, the University of Chicago, Princeton, Yale, the University of California at Berkeley. And their appearance on the scene is timely.
Behavioral economists help to explain how booms persist while busts, like the one that the United States may now be entering, are difficult to reverse. Their research sheds light on why identity — the traits people assign to themselves and to others — plays a huge and often damaging role in the economy. If the behaviorists are correct, shares of companies on the New York Stock Exchange are overvalued and the Dow Jones industrial average has further to fall. And if the behaviorists prevail, the mainstream view of a rational, self-regulating economy may well be amended and policies adopted to control irrational, sometimes destructive behavior. Twenty-five years of deregulation might lose its appeal.
"We are engaged in a conversation in economics where people who are intrigued by the importance of psychological phenomenon are making their case to the profession at large," Mr. Laibson said. "I am optimistic that we will be successful, but I cannot presume to know the outcome. The mainstream is saying the behavior we describe may be real, but is minor."
The behaviorists' numbers are still small — fewer than 20 percent of the graduate students in economics. But that is up from almost none when Mr. Laibson entered M.I.T.'s graduate program in 1990 and Mr. Mullainathan began his graduate studies at Harvard in 1993.
"If you were to graph the number of behavioral economists on the job market, it was zero, and then there was Laibson and me," Mr. Mullainathan said. "The market saw that we did well, and now there is a ton of graduate students on the market. Well, maybe not a ton. But it looked to me like I was taking a big risk, and afterward, it turned out that I was at the front end of a fad."
Their reputations have been on the rise ever since. Mr. Laibson built his mostly on the strength of an "anomaly" that he had described about people and money. When people expect money but have not yet received it, they are capable of planning, quite rationally, how much of it to spend immediately and how much to save. That squares with mainstream theory, which argues that for a modest incentive, people are willing to save and put off spending. But when the money actually arrives, willpower breaks down and — barring locked-in paycheck deductions — the money is often spent right away. The phenomenon is called "hyperbolic discounting," an economist's way of saying that a bird in hand is worth not two in the bush, but more like six or seven.
Overspending and undersaving are indeed American characteristics that economists struggle to explain. The mainstream argues that people save as much as they can, voluntarily, and that if taxes are reduced, as the Bush administration proposes, people will save a substantial portion of the windfall. Corporate America could then tap those savings to finance investment in, say, computers, making the economy grow.
Behavioral economists say this reasoning is flawed. They contend that despite their best intentions, most people spend almost all of any income that comes their way. Instead of rationally balancing spending and saving over a lifetime, people are indebted from youth to old age, the behaviorists find.
The young behavioral economists are not rebels. Neither are their mentors, the two dozen or so older economists who converted to behavioral economics after they had become university professors. The first was Richard H. Thaler, now 55, the University of Chicago economist who teamed up with two psychologists in the 1970's; out of their collaboration came the early findings of behavioral economics.
Rather than reject mainstream theory, behaviorists embrace its emphasis on rational, self-interested behavior. But they insist on amendments. The economy, they argue, also responds to skewed reasoning, self-indulgence, self-destructive behavior and a host of other human frailties and strengths. Lately, a few behavioralists have ventured beyond psychology, wading into sociology and anthropology to help explain the dynamics of the economy.
"Our vision is that all economics will be seen as behavioral economics," write three of the mentors — George Lowenstein at Carnegie Mellon Institute, Colin F. Camerer at the California Institute of Technology, and Matthew Rabin at Berkeley — in the introduction to a collection of essays on behavioral economics to be published this year. In their vision, "the strict rationality assumptions that many economists still embrace may someday be seen as a quaint, unrealistic, special case." First, They Do the Math
The human mind, the behaviorists say, lacks the circuitry at this stage of evolution to produce a well-functioning market system where people interact freely in pursuit of their preferences. Adam Smith knew this. So did David Ricardo, Karl Marx, Alfred Marshall and John Maynard Keynes. In fact, almost all the great economists incorporated complex psychology into their thinking.
But in the mid-20th century, economics veered. Economists increasingly thought of themselves as practicing a science, which, like physics, was one that could be modeled and explained through mathematical equations. Those equations — not words — soon became the language of economics. Rational, self-interested behavior — a world in which people responded to changes in prices and wages but not to emotion or one another's actions — most easily fit into these new equations.
Even now, words have made only a modest comeback. Mostly, the math is becoming more complicated, to accommodate the rebirth of psychology in economics. Mr. Laibson, who was an economics major as a Harvard undergrad, and Mr. Mullainathan, a computer science major at Cornell, are skilled in the techniques of complex equations. They fill their research papers with algebraic calculations. That is partly good strategy, because behavioral economists want to be taken seriously by their mainstream colleagues. And math is the route to acceptance.
"I have encouraged the young guys to play by the rules, because otherwise they will be ignored," Mr. Thaler said.
The strategy is working. Even diehard rationalists like Robert E. Lucas, a Nobel laureate at the University of Chicago, allow that there are enough puzzles in savings behavior to consider Mr. Laibson's hyperbolic- discounting thesis. But, Mr. Lucas is quick to add, mainstream economic theory answers most questions well enough. "For the price of gasoline, the model we have is sufficient," he said. "If the price goes up, people rationally use less. The psychological processes involved when people alter their behavior are not something we have to think about."
Kevin Murphy, another University of Chicago economist, said that in time, behavioral economics might provide better explanations than mainstream theory does for some phenomena. But right now, he said, what the behaviorists see as irrational, the mainstreamers can often interpret as rational choice. Eating greasy, high-fat hamburgers too often can cost people their health. "But if people accustom their taste so that they enjoy hamburgers," Mr. Murphy said, "then trading health for taste is a rational preference."
Behavioral economics may also change the prevailing wisdom about deregulation, a process that began under President Jimmy Carter in the late 1970's, when the airlines were freed and interest rate ceilings were lifted. Deregulation enjoys strong support from mainstream economists, who believe that a free-market system works best when left in the public's rational hands. California's experience with electric power, however, challenges the efficacy of deregulation. So does gambling, which can be addictive, the behavioral economists say — in contrast to mainstream thinking, which holds that people who gamble rationally choose what they prefer to do.
So far, the behavioral economists balk at government rules that try to offset human shortcomings in the marketplace. But the question intrigues them.
"We don't yet understand the phenomena well enough to make policy recommendations," Mr. Laibson said. For now, he would confine solutions to the private sector. For example, he might encourage automatic payroll deductions to build up 401(k) savings — unless an employee went to the trouble to opt out. Most people are not so activist by nature, the behavioral economists have found.
"It is certainly true," Mr. Laibson said, "that by raising these issues, we are opening the door to a debate about government's role in the markets." Rose-Colored Hindsight
Nothing gets more support from the behaviorists than the view that the stock market responds not to corporate reality, but to the moods of investors — their herd behavior, their overestimation of their investing skills, their reluctance to sell a falling stock and acknowledge a loss, and their gambler's view that stock- market gains are like "house money": it can be left on the table for more action.
That is just one reason that behavioral economists — particularly Robert J. Shiller of Yale — are convinced that stock trading is irrational. "People get overconfident," Mr. Shiller said. "Their egos become involved, and they are fooled by hindsight bias." Using hindsight, he explained, "they think it must have been obvious to people in the 1920's that a stock market crash was coming."
If what was happening then were happening now, investors would see the writing on the wall. "Since they don't see a crash coming now, ergo, there is no crash coming," he said.
Above all, behaviorists contend, standard theory fails to recognize that people take shortcuts in thinking, in effect bypassing rational analysis. People are prone, for example, to "representative" thinking and to "categorization," both often leading to false conclusions.
Consider categorization. Many people see a black woman walking with young children and think she is a single mother who is or has been on welfare. That shortcut in thinking helps to explain why black people constantly confront irrational barriers to jobs or good pay.
The effects of such lazy thinking can multiply, at times harmfully. "When people do differentiate between middle-class blacks and poor blacks, then the poor blacks get pushed further down in the eyes of people who might employ them," Mr. Mullainathan said. "Mainstream economics says that a strong economy makes all boats rise. But categorization gives a different slant."
In representation, the present becomes representative of the future. The economy booms for several years, and people conclude that the good times will continue indefinitely. When a recession arrives unexpectedly, their reckless spending and borrowing can haunt them. The recession then becomes the yardstick for viewing the future, and excessive caution can prolong the hard times.
"The big question is: How sophisticated are people as they go through the world, and what do they choose to see and not to see?" Mr. Laibson said.
Not all the behavior in the new economics is ornery. Alongside self- interest, there are places in the human psyche for altruism, loyalty, fairness and a willingness to reciprocate. Various experiments have demonstrated how common these qualities are. They help to explain the environmental movement and volunteer work, as well as the dedication of job holders to their daily tasks in return for a wage above what the market requires.
"We did some work on firms that were insulated from takeovers, and what effect that had on real behavior," Mr. Mullainathan said. Studying such companies, he found that their managers, freed from the fear of takeover, were less concerned about cost-cutting and, as a result, paid higher wages to their workers.
The rationalists argue that workers can make life difficult, so managers with a little flexibility pay them off to reduce their own stress. "But when I describe the research in my class," Mr. Mullainathan said, "several people say, `Oh, could it be that the managers like their workers and want to be fair.' "
Such findings have drawn a few radical economists into behavioral economics, including Samuel Bowles and Herbert Gintis, at the University of Massachusetts at Amherst. As graduate students at Harvard in the late 1960's, they turned to Marxism and the protest movement against the Vietnam War, not so much because of political ideology, they now argue, but because the dominant economics took too narrow a view of human motivation.
"We were trained in models of the economy that we did not believe," said Mr. Bowles, who has been an outspoken critic of mainstream theory. "Behavioral economics is not challenging the mainstream concept that selfishness is an important motive; what we are challenging is that it is the only motive."
Mr. Gintis and Mr. Bowles say they are now comfortable with several findings of the behaviorists. Their own work on fairness depends on the idea that sharing and reciprocity are important impulses in the human psyche. On taxes, for example, people willingly pay their fair share, Mr. Gintis says, until they perceive that some businesses or individuals do not and that the Internal Revenue Service fails to prosecute them. "Then they reciprocate by cheating, too," he said.
The setting of wages also reflects the complexities of human psychology, the behavioral economists argue. Wages should fall when unemployment is high and idle workers are eager to land jobs. But employers do not cut wages. They might not raise them by enough to keep up with inflation, but they almost never reduce them. They refrain out of a sense of fairness or loyalty or friendship, particularly in small offices, or because of a realization that if wages were cut, workers would reciprocate by dragging their feet on the job. In fact, wages are often kept above what the market requires, to raise morale and to motivate workers. The unemployed may offer to work for less, but they are not hired.
This managerial reasoning is known as the "efficiency wage," a concept described more than 25 years ago by George A. Akerlof when behavioral economics was hardly a speck. In 1966, while Mr. Gintis and Mr. Bowles were beginning their graduate studies in economics at Harvard, Mr. Akerlof was finishing his Ph.D. across town at M.I.T. While they were marching toward Marxism, he was moving toward behavioral economics, before it had a name or critical mass.
"Sometimes I think that if I had known what Akerlof was doing, I would have gone in that direction too," Mr. Gintis said. Resurrected in the 70's
From Mr. Akerlof's pen, occasionally in collaboration with the economist Joseph Stiglitz, came early descriptions of market imperfections. The most famous was described by Mr. Akerlof in a 1970 paper, "The Market for `Lemons.' " The lemons were used cars, and the point was that car salesmen knew more about the quality of the cars they were selling than did the buyers, and could thus overcharge. In the mainstream vision of the marketplace, buyers and sellers are both fully informed and the agreed-upon price is the right one.
That early work was a first step toward, as Mr. Akerlof puts it, a resurrection of the behavioral phenomena that still survived in Mr. Keynes's day, in the 30's and 40's.
By 1985, Mr. Akerlof had met the two psychologists whose research and experiments, in collaboration with various economists, produced many early findings of behavioral economics. One of them, Amos Tversky, died in 1996; the other, Daniel Kahneman, now at Princeton, taught a graduate seminar on psychology and economics with Mr. Akerlof at Berkeley.
"George did not get credit for that course," Dr. Kahneman recalled. "The idea of teaching with a psychologist was considered so flaky that he was told to do it on his own."
Now, at 60, Mr. Akerlof is pushing behavioral economics into sociology and anthropology. From studies of black children in inner-city schools, he and Rachel E. Kranton of the University of Maryland have described a group identity that settles on the children, giving them a sense of self that is linked to what they perceive as their social category. Usually that categorization confines them, so they have to decide how to behave. The rebelliousness that often results has filled the jails with black young people, Mr. Akerlof said.
By altering identity — and therefore expectations — a few "miracle schools" in poor neighborhoods have greatly improved student performance, Mr. Akerlof said, citing Central Park East Secondary School in Harlem as an example. Mainstream economics suggests that training and education should be enough to allow anyone to enter the world of good jobs and should, if available, trump group identity. Mr. Akerlof's model disagrees.
"When we gave this paper at Berkeley, someone said that we had developed a terminology that bridged economics and sociology," Mr. Akerlof said. "The sociologists already knew all this and now we are putting it in a framework that economists can understand."
He was drawn to behavioral economics, he said, because "the disparity between blacks and whites" is the most important issue in America, yet one that mainstream economics fails to address effectively.
During his undergraduate years at Yale, he participated in civil rights protests in the South. A year spent in India, as a young economist, introduced him to the sociology of castes, a version of discrimination. "I used what I saw to think about things in very different ways," he said.
That same need to think about issues that mainstream theory does not explain also helped to draw Mr. Laibson and Mr. Mullainathan into behavioral economics.
After growing up near Haverford, in the suburbs of Philadelphia, where his father was a noted ophthalmologist, Mr. Laibson went to Harvard with only a vague understanding of economics. It bothered him in those early economics courses to have to assume perfect rationality. "I wondered what was missing," he said.
What opened his eyes was that first year in graduate school, when M.I.T. offered a course in behavioral economics taught by Peter Diamond, an economist, and Drazen Prelec, a psychologist. "I had thought that economics was about saving the world," Mr. Laibson said, "but I see now that it is about asking and answering fascinating questions."
Mr. Mullainathan is constantly aware of the very different life he would have lived had his father not become an engineer, found work in Los Angeles and then brought his wife and young son from India in 1980. Even now, visiting relatives in India, the son meets boyhood playmates who are sharecroppers earning $150 a year. And when his father was briefly out of work in California, the son worried that his family would slip back into poverty.
He entered Cornell intending to be a computer engineer, but he took courses taught by two behavioral economists — Robert Frank, a labor expert, and Mr. Thaler, the pioneer in mixing psychology and economics. Through them, he saw economics connecting with his own experience. "I really decided at that point that I wanted to do economics and I wanted to bridge this divide between the real world and the theoretical world," Mr. Mullainathan said. Moving to the Next Level
The research goes on. Mr. Laibson is trying to understand "cueing" as a phenomenon in economics. Cueing helps to explain why advertising works; it refers to the stimuli that arouse latent desires or draw a cured addict back to his addiction.
Hotel room minibars provide considerable stimuli when small liquor bottles are displayed on the refrigerator door, behind a wire mesh. "Think about what it must be like for the recovering alcoholic to sit in that hotel room and stare at that alcohol for three hours before he goes to bed," Mr. Laibson said, suggesting that regulation might be in order. "That alcohol is a very powerful cue," he said, "and it may be inappropriate for a recovering alcoholic to endure that experience."
While Mr. Laibson describes specific phenomena, Mr. Mullainathan searches for patterns in human behavior — for example, how investors make decisions. From his research, he concludes that people put stocks into categories just as they put people into categories, arbitrarily classifying a General Electric as a technology stock and a Cisco Systems as a glamour stock. They trade them accordingly, until something happens, then reclassify them into new categories, he says.
"When I see a common thread, that gets me going," Mr. Mullainathan said. From this sort of broad understanding may someday come more effective monetary policy.
"I would love to see how Alan Greenspan would behave 80 years from now, when economics is much more behavioral," Mr. Mullainathan said. "We cannot know, of course. But one thing we do know: 80 years from now he would behave differently than he is behaving today, and that is kind of cool."
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