How Psychology Provoked a Revolution in Economics

In March, the Nobel Prize-winning psychologist Daniel Kahneman died. Nobel Prizes are not given in psychology. Kahneman’s prize was in economics.

In an interview in 2016, Kahneman stated that Richard Thaler, the Nobel Prize-winning economist at the University of Chicago, should be accorded the title “the father of behavioral economics.” Kahneman suggested that he might be remembered, instead, as “the grandfather” of that field.

Along with Amos Tversky (who died in 1996 and, thus, could not share the 2002 Nobel Prize with Kahneman), Kahneman conducted a group of experimental studies in the 1970s that showed that humans quite routinely fall short of our normative models of probabilistic inference and economic rationality. Kahneman and Tversky’s research showed, in addition, that the failures were not random. They argued that humans’ thinking about these matters is guided by various shortcuts (“heuristics”) that incorporate biases that often steer us to inappropriate conclusions.

Two Theoretical Strategies in the Human Sciences

Kahneman and Tversky’s studies deal with problems about which people have limited information and, thus, which are clouded by uncertainty and involve risky decision-making. Their accounts of the many heuristics they identified (availability, representativeness, anchoring, etc.) were built from the bottom up on the basis of statistical analyses of their findings from numerous experiments with human subjects.

The behavioral economics that Kahneman and Tversky’s findings inspired and that Thaler invented similarly examines human beings’ actual behavior as they deal with economic problems—from whether to contribute to a retirement savings program that involves an employer match or, by not contributing, to have more money here and now; to whether to go five miles to save 50 percent on a purchase of a needed item that costs $20 or to go five miles to save 1 percent on the purchase of a needed item that costs $1,000. Behavioral economists pursue their research in both the lab and the field.

Traditional economics, by contrast, utilizes a very different sort of theoretical strategy. It employs a normative judgment strategy that operates from the top down (as does, for example, Chomskyan linguistics). It begins with an idealized account of humans as rational actors (or, in the case of linguistics, as ideal speaker-listeners) who recognize and make optimal decisions about economic matters (or, again in the case of linguistics, grammatical form).

Their judgments about those matters carry normative force. They are judgments about how a rational actor should proceed.

For example, all else being equal, consumers almost always opt for purchasing a product at a lower price rather than a higher one. Such idealizations readily lend themselves to mathematical modeling—whether of rational consumers, of types of exchanges, or of markets—from which economists can derive predictions about the world. The presumption is that people mostly do what they ought to do, according to these normative models of economic behavior—and, often, they do.

But Sometimes They Do Not

What studies in behavioral economics have repeatedly demonstrated is that sometimes people’s behaviors not only stray but stray systematically from classical economists’ idealized models. For example, consider findings about the Ultimatum Game.

In the Ultimatum Game, the arrangements are completely transparent to both players. One player, the proposer, is given a sum of money, which is to be split with the second player, the responder. The proposer offers some percentage of the total amount to the responder—say, an amount between 1 percent and 100 percent. If the responder accepts the offer, each player receives the amounts the proposer’s offer prescribes. Crucially, though, if the responder rejects the proposer’s offer, then neither player gets anything.

On the classical economic account, the proposer should make the lowest possible positive offer, since the responder should accept any positive offer, as the responder will be better off thereby. It probably comes as no surprise that behavioral economists have found something quite different.

Playing the Ultimatum Game with American undergraduates shows roughly that proposers usually make offers between 40 percent and 50 percent and that more than half of responders will reject offers below 20 percent. It is no doubt even more surprising to both traditional and behavioral economists that in some cultures many proposers offer more than 50 percent and sometimes a good deal more!