New Thinking in Economics from Neoclassical Theory to Behavioral Economics and Happiness Research
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Prof. Dr. Karlheinz Ruckriegel Professorship of Economics Faculty of Business Administration/ Management Institute TH Nürnberg Georg Simon Ohm www.ruckriegel.org
London, September 2015, updated version Nürnberg, January 2016 Introduction to "Foundations of Economics", MBA-Course, Management Institute, TH Nürnberg "Wirtschaftspolitik" (Economic Policy), MA-Course, Faculty of Business Administration, TH Nürnberg
„Economics may borrow some methodology from the hard sciences but as a science of human behavior some of these methods are built on ever shifting sand”. 2 N. Gregory Mankiw, Mark P. Taylor, 2010 1. Standard Economic Model as the Foundation of Neoclassical Theory 2. New Thinking in Economics are reflected in (last years) Nobel Prizes in Economics 3. Behavioral Economics - How People really decide (based on the "Dual Action System" / "The Two Systems" - in our brain) 4. From the Standard Economic Model to Reality: What can/should Companies learn? 5. Happiness Research - What People really want 6. Happiness Research - Consequences for Companies: a Win-Win Situation 7. Happiness Research - Consequences for Politics: the OECD Better Life Index 8. Turing away from Materialism - the Economist`s Recommendation to (more) Happiness (Subjective Well-Being)3 „But what ultimately matters is the well-being of citizens.“ OECD, HOW`S LIFE - Measuring Well-Being, Paris 2011, p. 16 „Get ready to change the way you think about economics” 4 Richard H. Thaler, 2015 President of the American Economic Association 2015 „The theories economists typically put forth about how the whole economy works are too simplistic.”5 George A. Akerlof, 2009 (Nobel Prize for Economics 2001) Robert J. Shiller, 2009 (Nobel Prize for Economics 2013) So what`s this course about? I would say this course simply has to do with what people want (goals) and how they decide (about the allocation of their scare resources) in order to get what they want. This follows the commonly accepted definition of the subject economics deals with which was coined by Lionel Robbins in 1932: "Economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses." 6 So this course is about the core of economics: It is about the allocation of scare resources (input) in order to reach some given goals (output). But there is a radical change of thinking about it at the moment in economics. We are going to be talking about in some organized way I hope. So first we are interested in the basic ideas of old thinking in economics the so called Neoclassical Theory. Then we are going to be studying the new thinking in economics - Behavioral Economics on the one hand and Happiness Research on the other hand. Once we understand the nature of neoclassical theory we can then go on to the subject of the new way of thinking in economics: behavioral economics and happiness research. So let`s go through in more detail: 1. Standard Economic Model - the Foundation of Neoclassical Theory7 “The core theory used in economics builds on a simple but powerful model of behavior. Individuals make choices so as to maximize a utility function, using the information available, and processing this information appropriately. Individuals`preferences are assumed to be time-consistent, affected only by own payoffs, and independent of the framing of the decision. Laboratory experiments in both the psychology and the economics literature raise serious questions about this assumptions.” Stefano DellaVigna, Psychology and Economics: Evidence from the Field, in: Journal of Economic Literature, Vol. 47/2, June 2009, S. 315 „Economics may borrow some methodology from the hard sciences but as a science of human behavior some of these methods are built on ever shifting sand”. 8 N. Gregory Mankiw, Mark P. Taylor, 2010 Neoclassical theory is simply based on the assumption that human behavior could be modeled on the basis of the homo oeconomicus assumption and the additional assumption that more material goods/ money is always better then less. The goal is to maximize utility.9 Following the homo oeconomicus assumption people act rationally, selfishly and time consistent, which means they don`t change their preferences. The homo oeconomicus assumption was introduced by Leon Walras in economics in the second half of the 19th century to create/get an artificial "hard science" like physics is in reality to be able to make use of mathematics in economics.10 „Optimization mathematics forced economists to make very ambitious assumptions about the intellectual capacity of its agents – the controversial assumption of perfect rationality.“11 Taking all assumptions together N. Gregory Mankiw (Harvard University) and Mark P. Taylor (Warwick Business School, UK) speak about the so-called "Standard Economic Model" (SEM) in the 3th Edition of their textbook "Economics" from 2014 (p. 102 and 274). Using the term "Standard Economic Model" for the assumptions which are the basis of the neoclassical theory is "brand" new in the 3th Edition. In the 2th Edition from 2011 it isn`t mentioned. But it is very interesting that Mankiw/Taylor explicitly say some pages later: "Research has suggested that this (the Standard Economic Model / SEM, KR) is far from the case" (p. 126, 3th Edition). Mankiw`s textbooks in economics are widespread worldwide. Another worldwide very widespread used textbook is Hal R. Varian`s "Intermediate Microeconomics: A Modern Approach". "The field of behavioral economics is devoted to studying how consumers actually make choices. It uses some of the insights from psychology to develop predictions about choices people will make and many of these predictions are at odds with conventional economic model of "rational" consumers."12
But the interesting question is: Why does Varian explain neoclassical theory/ thinking on more than 720 pages from around 740 pages in his textbook if this is - following his one words - "are at odds" with "how consumers actually make choices"? What is the deeper sense of teaching students a content which is not able to explain reality? What should be modern on this approach? And neoclassical theory is not only "at odds" with consumers decision making but also very often with decision making in companies.13 Robert S Pindyck and Daniel L. Rubinfeld are even less critical: As some basic assumptions about preferences they assume simply "completeness, transitivity and more is better than less" and they conclude "Building on these assumptions, we will now explore consumer behavior in greater detail."14 But the even still more tricky thing is that most of (nearly all) textbooks in economics in the past normally did not even mention that all of the neoclassical theory which was shown in the textbook was based only on the simply SEM assumptions. Only the discussion following the great recession/ financial crises (starting in 2007) has changed this (partly). So students especially in economics and business administration were - and often are still -indoctrinated by the SEM assumption and step by step (slowly) they believed in this assumptions. So wrong imprints were coined about the human behavior which also influenced the behavior of those students towards others - concretely spoken often they got more selfish and they expected others to be selfish too. And this coined often their behavior as managers in companies in later years. "In truth, however, nothing could be more ad hoc than the standard microfoundations; as economists such as Pareto, Hicks, and Koopmans have made clear. The assumptions we make about individuals in microeconomics are based on introspection, not on any mass of coherent empirical evidence or even on any intuitive plausibility criteria. The only justification of the hyper-rational, self-interested agent typically used in standard macro models was that it was consistent with the characterization used in micro theorizing. And even that justification is now disappearing with the rise of behavioral economics."
Or to quote Vilfredo Pareto directly: "The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social sciences from the principles of psychology." 16 Vilfredo Pareto, 1906 Now let us come to the new thinking in economics: It has two new directions that lie at different levels. 2. New Thinking in Economics are reflected in (last years) Nobel Prizes in Economics The importance and the value of the new thinking in economics is highlighted in the fact that in last years representatives of the new thinking in economics won nobel prizes. 2015 the nobel prize in economics got one of the most well know happiness researcher worldwide: Angus Deaton from Princeton University. In his work he deals with the situation of the poor (in all countries), the question of how people behave (behavioral economics) and question about what makes people happy (happiness research).17 In 2013 Deaton published his fundamental book "The Great Escape: Health, Wealth, and the Origins of Inequality". In 2013 - more or less as a consequence of the great recession/ financial crisis in the second half of the first decade of this century (starting 2007) - Robert Shiller from Yale University got the nobel prize in economics for his work to explain economic/financial market crises with psychological reasons this means with insights of behavioral economics.18 In 2015 Shiller published the 3th Edition of his fundamental book "Irrational Exuberance". Already in 2002 the psychologist Daniel Kahneman from Princeton University got the nobel prize in economics for his groundbreaking work in showing that people by far not (so) rational in their decision making as the neoclassical theory model assumes.19 The neoclassical theory is mainly based on the homo oeconomicus assumption where the agent of economic theory is rational and selfish, and his tastes does not change. „I had been professionally trained as a psychologist not to believe a word of it.“ so Daniel Kahneman about the homo oeconomicus assumption in his article "Psychological Perspective on Economics" in the "American Economic Review" in 2003.20 In 2011 Kahneman published his fundamental book "Thinking, fast and slow". But in the years following the nobel prize for Kahneman this/his insights were simply ignored by the mainstream in economics unfortunately. Most (or better nearly all) economists prefered to believe in/ use still simply the neoclassical theory based on the SEM. The consequence was that deregulation and believe/ trust/ ideology in/of the self-controlling capacity which means in the efficiency of free financial markets ("efficient market hypothesis") led to the great recession/ financial crisis in the second half of the first decade of this century (starting 2007) with a nearly breakdown of the financial sector in the Western world and a following great recession in the (mainly Western) world.21 „The financial crises which began to gather pace in 2007 and the subsequent recession have led to a major rethink about some fundamental assumptions in economic theory." N. Gregory Mankiw/ Mark P. Taylor, Economics, Second Edition 2011, preface p. xix. In October 2008 the former chairman of the US-Central Bank (Fed) Alan Greenspan was asked in a hearing at the US House of Representatives about his view about the reasons for the financial crises (starting 2007). The chairman of the committee was Henry Waxman. „Henry Waxman summed up: „In other words,“ he said, „you found that your view of the world, your ideology, was not right. It was not working.” „Precisely,“ answered Greenspan. „That `s precisely the reason I was shocked, because I had been going for forty years or more with the very considerable evidence that it was working exceptionally well.” … “The whole intellectual edifice collapsed in the summer of the last year” Greenspan admitted at the October 2008 hearing.”22 “Greenspan struggled to explain what had gone wrong because the intellectual edifice around which he had built his thinking simply didn´t allow room for events of the preceding fourteen months. This was the edifies of rational market theory. The best-known element of rational market theory is the efficient market hypothesis, formulated at the University of Chicago in the 1960s with reference to U.S. stock markets. … Financial markets possessed a wisdom that individuals, companies, and governments did not.”23 "… the basic presumption of neoclassical economics … was that we should have faith in the market system.“ 24 Paul Krugman 2009 (Nobel Prize for Economics 2008) In September 2009 the New York Times published a fundamental article written by Paul Krugman who got the Nobel Prize for Economics in 2008 with the headline „How did Economists Get It so Wrong“. Krugman wrote: „They (the neoclassical economists) believe that all worthwhile economic analysis starts from the premise that people are rational and markets work … In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in the inflating that bubble in the first place. … Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless, market system. … “. William White, who served as the Economic Adviser and Head of the Monetary and Economic Department of the Bank for International Settlements (BIS) from May 1995 to June 2008 and who was appointed chairman of the Economic Development and Review Committee at the Organization for Economic Co-operation and Development (OECD) in Paris in October 2009, wrote in December 2009: "What do the above considerations imply for the future of macroeconomics? The simplifying assumptions of the New Classical and New Keynesian models do not make them obvious candidates for near-term guidance on how best to conduct macroeconomic policies. We are left then with the Keynesian framework, with all the likely fuzziness and uncertainties implicit in the principal functional forms being subject to “animal spirits.”"25 William White, 2009 As a consequence of the - inevitable/necessary - failure of neoclassical thinking meanwhile it has lost credibility dramatically especially in politics and institutions like central banks,26 regulatory organizations (f.e. for consumer protection) and so on. Or to illustrate it with the words of the Chancellor Angela Merkel which she used as opening remarks at the conference of the Nobel Prize winners in economics in August 2014 in Lindau (Germany). In her speech she points to the fact that economists who wants to be taken seriously should concentrate on reality and not on a homo oeconomicus based thinking. She said: “It is about distinguishing research in a "vacuum" from the "reality" ”27 That Chancellor Angela Merkel emphasises the fact of doing research in a "vacuum" means that politics and other institutions which are looking for economist`s advise are fully aware that - despite the disillusion about the worth of neoclassical theory for explaining reality following the great recession - a lot of economists still stick to the neoclassical theory. In psychology this behaviour is well known as "confirmation bias" - a bias to believe and confirm. "Contrary to the rules of philosophers of science, who advise testing hypothesis by trying to refute them, people (and scientists, quite often) seek data that are likely to be compatible with the beliefs they currently hold."28 - or still much easier: To ignore all what is not in line with the believe someone has. An argument which is used in defence of neoclassical theory and the SEM in this context is that without this assumptions mathematics could not be used anymore.29 This argumentation is very interesting because Walras made use of the homo oeconomicus assumption in order to be able to use mathematics. Now it is argued that economists cannot give up the home oeconomicus assumption because otherwise mathematics could not be used anymore. So being able to use mathematic in an intensive way seems the decisive argument in order to stick to homo oeconomicus (SEM) assumption. Or to put it in another way: Research in a "vacuum" is necessary because research on explaining "reality" is not possible with mathematics.30 But what is the real use of being able to make use of mathematics if the results we get are not useful to describe what is going one in reality? To repeat: "In truth, however, nothing could be more ad hoc than the standard microfoundations; as economists such as Pareto, Hicks, and Koopmans have made clear. The assumptions we make about individuals in microeconomics are based on introspection, not on any mass of coherent empirical evidence or even on any intuitive plausibility criteria. The only justification of the hyper-rational, self-interested agent typically used in standard macro models was that it was consistent with the characterization used in micro theorizing. And even that justification is now disappearing with the rise of behavioral economics." David Colander, Peter Howitt, Alan Kirman, Axel Leijonhufvud, Perry Mehrling, Beyond DSGE Models: Toward an Empirically Based Macrooeconomics, American Economic Review: Papers and Proceedings, Vol. 98, p. 236.31 Despite the fact that a lot of economists are still stick to simple neoclassical theory the influence of behavioral economics increases step by step at universities too. For example the President of the American Economic Association in 2015 is Richard H. Thaler. Daniel Kahneman called him as the real founder of behavioral economics because he made use of the insights of Daniel Kahneman and Amos Tversky (who died in 1996) in psychology for applying it in economics. In 2015 Thaler published his fundamental book "Misbehaving – The making of Behavioral Economics". It is very interesting that even Adam Smith who is seen as the founder of (modern) economics in the second half of the 18th century is seen as an natural behavioral economist: “In short, Adam Smith`s world is not inhabited by dispassionate rational purely self-interested agents, but rather by multidimensional and realistic human beings.”32 3. Behavioral Economics - How People really decide (based on the "Dual Action System" / "The Two Systems" - in our brain)33 "The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social sciences from the principles of psychology." 34 Vilfredo Pareto, 1906 Behavioral economics deals with the question of how people really decide - so it deals precisely about what Vilfredo Pareto had in mind in 1906. It moves away from the a priori assumption of the Standard Economic Model. Behavioral economics is based on neurobiological and psychological insights of the "dual action system", which consists roughly of our neocortex and our limbic system in our brain (Kahneman calls both in a more precise way System 2 and System 1).35 "Understand How Decisions Are Made: For decades, behavioral decision researchers and psychologists have suggested that human beings have two modes of processing information and making decisions. The first, System 1 thinking, is automatic, instinctive, and emotional. It relies on mental shortcuts that generate intuitive answers to problems as they arise. The second, System 2, is slow, logical, and deliberate. (Daniel Kahneman, winner of the Nobel prize in economics, popularized this terminology in his book Thinking, Fast and Slow.)"
Extensive research has shown that our ability and our willingness to act rationally (logically) according to our neocortex - which means to act often against our emotions, against non-logic thinking which are merely based on associations and against our views of the world by which our limbic system system is mainly driven - is very limited. Or to put it differently: In our dual action system the limbic system most wins. This means also that our decisions are often influenced by biases (a predisposition towards error), heuristics (a rule of thumb used to make a decision), framing effects (decisions are influenced by the manner in which the setting for the decision is described), loss aversion and so on. In addition the ability of our neocortex to think rationally (which means logically - without any logical contradictions) - our cognitive capability - is more or less (very) limited too. Research has also shown that most of the people - 80 % or more - are not selfish. Rather than they are driven by an innate feeling of fairness, more than 10 % are even altruistic. This has something to do with history and evolution of mankind. Crucial for the survival of the tribe of humans (homo sapiens) was our capability to cooperate. But the prerequisite for cooperation was and is fairness. Without fairness there is no cooperation simply at the end of the day.36 Our plans and decisions are also often not time consistent. One reason for it is that we have cold and hot states. In a cold state we think about something in the future theoretically in a calm atmosphere (f.e. we should save more for our retirement) – here the neocortex is active. In the hot state we are in a concrete situation f. e. in a shop. In such a situation our limbic system which only knows the needs and wants of the moment urges us to buy what we want in this moment without thinking about our situation in future (too less money when we get retired). Mostly the limbic system wins. This has something to do with the fact that our limbic system is much stronger than our neocortex and to the fact - so Kahneman calls it - that our neocortex is lazy (it doesn`t want to think too much) too. The limbic system is millions of years old. Its task was simply to do all for surviving in the moment. Our neocortex is relatively young, only some hundred thousand years. Our limbic system only thinks about immediate reward - it doesn`t know about the future, it knows only about the present, the here and now. So rewards which are expected in future are not influencing the limbic system. „It is, after all, in our nature to do things that will provide the most immediate reward. This is wired into our DNA for basic survival. … the reality is, our short-term self (limbic system, KR) still wins and gets dessert, despite objections from our long-term self (neocortex, KR) that wants a healthy and long life.“ Tom Rath, Jim Harter, Wellbeing – The Five Essential Elements, 2010 (Gallup), S. 8f. Finally the a priori assumption of "more material things are better than less" does not hold in the light of the results of the interdisciplinary happiness research. Because as soon as the material needs are satisfied more money/ income doesn`t lead to more satisfaction with life – we are getting accustomed to the new situation easily and increase our expectations simply. This is a simply (old) insight from psychology.37 „Unlike assumptions normally used in the psychological literature, standard economics textbooks assume a given utility (or happiness) function in which there is generally no habituation or adaptation. In other words, if the death of our loved one hurts like hell in the first year, economists say that it will hurt like hell – in exactly equal measure – for as long as we live, which seem wholly unrealistic.”38 Insights of behavioral economics are more and more used in politics: - On a micro economic level to help to make better decisions i.e. to take the confirmation bias into consideration. „The false assumption is that almost all people, almost of the time, make choices that are in their best interest or at the very least are better than the choices that would be made by someone else.” 39 Richard Thaler, Cass Sunstein, 2008 "In principle, research findings in behavioural finance can provide important ideas for lawmakers on how to improve investor protection through suitable regulation. Findings from research on behavioural finance allow a better assessment of the behaviour patterns of economic agents and show potential reasons why actual behaviour in investment decisions differs from the idealised investor behaviour in classical finance theory."40 Deutsche Bundesbank, 2011 More information about how the insights of behavioral economics supports political decisions could be found at the homepage of the Behavioural Insights Team of the Government of the UK (United Kingdom) (http://www.behaviouralinsights.co.uk/) and in the new books of Cass R. Sunstein: Why Nudge?: The Politics of Libertarian Paternalism, 2015 and David Halpern: Inside the Nudge Unit: How small changes can make a big difference, 2015. David Halpern is the Chief Executive of the Behavioural Insights Team. Cass R Sunstein was from 2009 to 2012 Administrator of the White House Office of Information and Regulatory Affairs in the US government. He is the founder and director of the Program on Behavioral Economics and Public Policy at Harvard Law School. Together with Richard H. Thaler he is the author of the influential book "Nudge – Improving Decisions about Health, Wealth, and Happiness" which was published in 2008. - On a macro economic level to calm markets because we know especially financial markets are less rational but more fluctuating driven by herd behaviour between panic and mania.41 „… left to their own devices, capitalist economies will pursue excess, as current times bear witness. There will be manias. The manias will be followed by panics. ...
George A. Akerlof, Robert J. Shiller, 2009 „Much of the above reasoning (that markets work efficiently, KR), however, is based on the principle of rational behavior as opposed to a herd mentality or mass psychology … The existence of speculative bubbles suggests that markets react to what Alan Greenspan called „irrational exuberance“ and what Keynes referred to as „animal spirits“. … Such views could lead to irrational waves of optimism and pessimism. … Faith in markets is fundamental to economic growth in most of the world and the financial crisis has shaken this faith to the core."43 N. Gregory Mankiw/ Mark P. Taylor, 2010 Meanwhile the policy of the European Central Bank is based mainly on this insights.44 „Some critics have argued that because of our determined policy action, the shoring up of bank capital and the consolidation of fiscal positions have been delayed. My answer is simple. Our measures gave breathing space from markets driven by panic, which were forcing the economy into a position where inappropriately high interest rates would make default a self-fulfilling prophecy. Adjustment would have been impossible. Instead of better capitalised banks and stronger fiscal positions we would have been left with financial and economic meltdown.“ 45 Mario Draghi, 2013 President of the European Central Bank "On the financial markets, investors frequently mimic one another, behaviour which classical finance theory cannot explain. This is described as herding, or herding behaviour. Herding can cause problems since it can make financial markets more volatile and feed speculative bubbles, such as the recently burst real-estate bubble in the United States."46 Deutsche Bundesbank, 2011 But this insight is a very old one. The reason for establishing the US-central bank system ( Federal Reserve System (Fed)) - in 1913 was financial panics which plagued "the nation": "During the nineteenth century and the beginning of the twentieth century, financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy. The failure of the nation's banking system to effectively provide funding to troubled depository institutions contributed significantly to the economy's vulnerability to financial panics. Short-term credit is an important source of liquidity when a bank experiences unexpected and widespread withdrawals during a financial panic. A particularly severe crisis in 1907 prompted Congress to establish the National Monetary Commission, which put forth proposals to create an institution that would help prevent and contain financial disruptions of this kind." Federal Reserve System, Purposes and Functions, Washington 2005, p. 1f.
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