David Edmonds: Okay you’ve got a choice, buy this plastic alarm clock right next to where you are standing for $28 or walk ten blocks and buy it in another shop for half price; $14. Now try this one, buy a laptop for $1995 in the shop next to you or walk ten blocks and get it for $1981. Well chances are you are more likely to walk to save money on the cheap clock then the expensive laptop, which is odd because in either case you could save exactly the same amount of money. In the past twenty years there has been a revolution in economics with the study not of how people would behave if they were perfectly rational, but of how they actually behave. At the vanguard of this movement is Robert Shiller of Yale University.
Nigel Warburton: Robert Shiller welcome to Social Science Bites.
Robert Shiller: My pleasure.
Nigel Warburton: The topic we are going to focus on is behavioural economics. Now we know roughly what economics is, but what’s behavioural economics?
Robert Shiller: Well the word ‘behavioural’ refers to the introduction of other social sciences into economics: psychology, sociology, and political science. It’s a revolution in economics that has taken place over the past twenty years or so. I think it’s bringing economics into a broader appreciation of reality. Economics was actually more behavioural fifty or a hundred years ago. At Yale University where I work, 1927 was the year where the department of economics, sociology and government was split into three separate departments and they moved us all apart.
Nigel Warburton: Why would it matter if they just split the departments up, I mean there’s an argument that specialisation actually allows people to progress further in their field – rather then knowing a little bit about everything.
Robert Shiller: Absolutely. There are both advantages and disadvantages of this structure. The advantage is that we develop mathematical economics and mathematical finance to a very advanced level – and it’s useful: we have option pricing theory that is very subtle and allows complex calculations that have some relevance to understanding these markets. But it loses perspective on why we have these options anyway. It offers a justification typically that involves rational behaviour. You can get into the swim of that, thinking ‘I want to know why smart people use options’ And it’s instructive to go through the exercise of thinking ‘is it really ever right to buy these investment products?’ But that doesn’t mean that you’re answering the question why people really do buy options and why this market exists and why other markets that sound equally plausible don’t exist.
Nigel Warburton: So what you’re saying is that traditional economics has focused on a kind of ideally rational individual: what would they do if they behaved in their own best interests based on the information available? But behavioural economics brings in the fact that we don’t always behave in our own best interests. (...)
Robert Shiller: There’s a lot going on. It turns out that the human mind is very complicated. Economic theory likes to reduce human behaviour to a canonical form, the structure has been, ever since Samuelson wrote this a half century ago, that people want to maximise their consumption. All they want to do is consume goods; they don’t care about anyone else. There’s neither benevolence nor malevolence. All they care about is eating or getting goods and they want to smooth it, they described it in terms of so-called utility functions through their lifetime and that’s it. That is such an elegant simple model, but it’s too simple and if you look at what psychology shows, the mind is the product of human evolution and it has lots of different patterns of behaviour. The discoveries that psychologists make to economics are manifold.
Nigel Warburton: One that I know you’ve discussed is this notion of fairness that might trump the economic rationality.
Robert Shiller: A sense of fairness is a fundamental human universal. It’s been found in some recent studies that it even goes beyond humans, that higher primates do have some vestigial or limited understanding of fairness and equity. In terms of how the market responds to crises, economists assume that everything is done purely out of self-interest. And yet non-economists when we ask them about how things work, they have a totally different view. In one of my questionnaire surveys we asked something like this: if the economy were to improve what would your employer do?
a) nothing – why should he help me just because the economy goes up?
b) well the economy improves means the market for my services improves so my employer would realise out of self-interest that he would have to raise my wage in order to keep me.
c) my employer is a nice person and he would recognise that he should share the benefits with his employees.
I gave this question to both economists and non-economists. The economists all picked B, or most of them picked B! They think that market forces dominate. Whereas very few of the non-economists did: they thought either their employer was a bad guy which is A, or their employer is a nice guy, that’s C. So there’s a different worldview and I think that if people think that fairness is such an important thing in labour contracts then modelling the world as if it’s of total insignificance is wrong.
Nigel Warburton: So doesn’t this just make everything much, much more complicated because you can’t reduce individuals then to some kind of cipher where they are simply maximising their self-interest in terms of economic benefits?
Robert Shiller: That’s why a lot of economists don’t like this. Maybe with some justification they’ll say that there’s too many details in this theory, you can explain anything with it. But I’m un-persuaded by that criticism because, first of all, we can work on this and study people more and understand what psychological principle is relevant. And secondly, it doesn’t help to have a theory based on wrong assumptions.
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