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Behavioral economics: Past, present, and future

October 22, 2019
The discipline, which draws on psychology, is seeing a renaissance, writes Michelle Baddeley. But it wasn’t always distinct from its “rational” cousin.

Today, it seems as though everyone is talking about behavioral economics. Governments are embedding behavioral insights into policy. Commercial businesses are using it to inform their marketing strategies. Lessons from behavioral economics are informing relationships between employers and employees. Why? Because behavioral economics combines a unique collection of insights from social science. It brings together economists’ powerful analytical tools, traditionally applied in a restricted way to unraveling the economic incentives and motivations driving us all. But it also addresses the fundamental flaw in non-behavioral economics: its highly restrictive conception of rationality, based on assumptions of agents able easily to apply mathematical tools in identifying the best solutions for themselves or their businesses.

Modern behavioral economists have taken this further by bringing together rich insights from psychology to capture how economic incentives and motivations are changed, often fundamentally, by psychological influences. Neither the economics nor the psychology can stand alone. Without economics, the psychology lacks analytical structure and direction—especially in describing everyday decision-making. Without the psychology, economics lacks external consistency and intuitive appeal. Together, the subjects are uniquely insightful. Together, they enable us to understand what and how real people think, choose, and decide in ways that no single academic discipline has managed before —generating not only new theoretical insights but also new practical and policy insights that, at best, have the power to change livelihoods, prosperity, and well-being across a range of dimensions.

“Together, psychology and economics enable us to understand what and how real people think, choose, and decide in ways that no single academic discipline has managed before.”

Most of the excitement about behavioral economics has bubbled-up in the past 10 or so years. The first milestone was the award of the 2002 Nobel Prize jointly to economic psychologist Daniel Kahneman, alongside Vernon L. Smith. The second was the award of the 2017 Nobel Prize to behavioral economist Richard Thaler, who is most famous for his work on behavioral finance and behavioral public policy—commonly known as “nudging.” These thinkers have had enormous influence on modern policy—not least through advising the policy of then US President Barak Obama and then UK Prime Minister David Cameron.

The progress of behavioral economics between the two milestones of the 2002 and 2017 Nobel Prizes mirrors the emergence of behavioral economics from a largely theoretical subject through to a subject that now has enormous real-world policy relevance—for public and commercial policymakers alike. It also has much to offer ordinary people in understanding some of the decision-making challenges they face. But behavioral economics is a much older discipline than these two 21st-century milestones might suggest. Some could argue that all economics should be about behavior if behavior is what drives choices and decision-making. Economics is the study of decisions after all.

But, from the 19th century onward, economics started to move away from behavior as it might be richly understood in terms of the psychology of choice toward observed choices as a measure of revealed preferences. In providing a neat and simple story about these preferences revealed when we make our choices, the story can only be made sufficiently simple if economists assume that economic decision-makers are constrained by strict behavioral rules—specifically in assuming that consumers aim to maximize their satisfaction and businesses aim to maximize profits. In mainstream economics, consumers and firms are assumed to do this in the best way they can by implementing mathematical rules to identify the best solutions. Modern economists, in the process of building these neat mathematical models that captured these behavioral rules, stripped out all the sociopsychological complexities of real-world decision-making. Historically, however, and before modern economics mathematicized the analysis of choice, economists spent plenty of time thinking about how the incentives and motivations that are the stuff of economic analysis are affected by psychological influences, including going all the way back to Adam Smith.

Pedestrians on a crosswalk are reflected in the facade of a mall in Tokyo’s Omotesando shopping district, in March 2013.

This is where behavioral economics comes from, but what do behavioral economists actually do? To understand this more deeply, we can look at a range of themes that behavioral economists explore to illustrate the power and relevance of their insights. These include behavioral analyses of incentives and motivations; social influences; heuristics, bias, and risk; time and planning; and impacts of personality and emotions on decision-making.

Insights from behavioral economics are now changing mainstream economics and are also having a strong impact on policymaking via nudging.

So, are there new horizons for behavioral economics, or do we know all we need to know? For nudging, more evidence is needed to capture how robust and scalable nudging policies really are—and there has been progress in this direction. Another key area that has been largely neglected until recently is behavioral macroeconomics. British economist John Maynard Keynes pioneered the analysis of psychological influences, particularly social conventions, in financial markets and the implications for macroeconomics more generally, and some of his insights are being reimagined today. A significant hurdle for behavioral macroeconomics, however, is that it is difficult coherently to aggregate into a macroeconomic model the complexities of behavior identified by behavioral economists within a microeconomic context. New methodologies are coming on board however—for example, in the form of agent-based modeling and machine learning. If these new methods can be applied successfully in developing coherent behavioral macroeconomic models, behavioral economics will generate an even more exciting and innovative range of insights in the forthcoming decade than it has in the last.

Michelle Baddeley is director and research professor at the Institute for Choice, University of South Australia.