Rescuing Economics to Explain the World

David Schatsky | March 28, 2008, 09:51 AM

Faith in the market to deliver optimal outcomes in a broad range of situations has had a good run. And although mayhem in the financial markets these days is tempering the enthusiam of some for unfettered capitalism, its run will pobably continue.

There have been interesting efforts in recent years to apply the tools of economics to explaining everyday phenomena. "Freakonomics," the 2005 best seller, for example, explored the role of classic economic concepts such as information assymetry and incentive systems in a range of phenomena from lazy real estate brokers to cheating school teachers and sumo wrestlers to the microeconomics of an office bagel delivery business.

More recently, a number of economists and others have been looking at the apparent inability of economic theory to explain human behavior. Many of these works are arguing that economics still works--and indeed provides a very powerful analytical toolset--but that some of its concepts have been too narrowly defined.

Bryan Caplan, in "The Myth of the Rational Voter," for example, poses this question: "Why do voters seem to support economic policies, such as protectionism, that are often counter to their own material interests?" It would seem to suggest that voters behave irrationally, and rational behavior is a core assumption of economics. Caplan says that voters may be ignorant but not necessarily irrational. You just need to understand the notion of incentives more broadly to include not just economic incentives but emotional and moral ones. Some people feel good about supporting a policy (high emotional incentive) that they recognize their single vote has a vanishingly small chance of influencing the passage of (tiny economic counterincentive).

(Another recent book--I haven't read it yet--takes a different approach: arguing that people are irrational, but predictably so.)

A new book, called Nudge, cited by John Tierney yesterday in the New York Times, appears to be in the same vein [haven't read it yet; it's on my list]: Why do people make dumb choices?

We can’t even prepare properly for something as straightforward as our own retirement. We’ll put in long hours shopping for a cellphone or a television set, but we’re too busy to agonize over pension plans: in one study, most people spent less than an hour choosing theirs. We’re not good at making immediate sacrifices for an abstract benefit in the future. And this weakness is compounded when, as with climate change, we have a hard time even understanding the problem or the impact of our actions today.

How to encourage and enable people to make smarter decisions? Make it clearer what the true costs and benefits are of the choices they make, and expand the definition of costs and benefits to include social and ethical ones:

“Getting the prices right will not create the right behavior if people do not associate their behavior with the relevant costs,” says Dr. Thaler, a professor of behavioral science and economics. “When I turn the thermostat down on my A-C, I only vaguely know how much that costs me. If the thermostat were programmed to tell you immediately how much you are spending, the effect would be much more powerful.”

It would be still more powerful, he and Mr. Sunstein suggest, if you knew how your energy consumption compared with the social norm. A study in California showed that when the monthly electric bill listed the average consumption in the neighborhood, the people in above-average households significantly decreased their consumption.

How concepts are defined--the clarity and the scope of the definition--has an enormous influence on the usefulness of the concept. I was probably first exposed to this idea when I read "1984" in highschool and considered the power of language to shape thought. And I grappled with is as a software developer, making choices about the granularity and interfaces of software modules and object classes in object-oriented programming systems. The right modularity would make it 10 times easier to build a reliable and maintainable system. The wrong modularity would cripple you.

It is very interesting to see these folks applying economic thinking to areas not usually thought of as economic, and also revisiting and refining economic concepts to keep the tools of economics sharp enough to cope with a world that is getting more complex every day.