It’s often difficult to describe exactly why you enjoy something over something else. Over the course of my education, I have been drawn from mathematics and classical economic theory towards psychology and behavioural economics. Whilst one is not better than the other, I like the latter approach much more these days. So, I’ll attempt to explain why I appreciate the behavioural approach more than the standard one.

What is Economics?

Ask my dad, and he’d say economics is all about supply and demand. A slightly more sophisticated answer might be one that I was given in the first ever economics class I had. My teacher claimed that economics was the study of ‘too many wants, not enough resources’. In other words, economics is a study of resource optimisation and allocation. We have a finite amount of ‘stuff’ on the planet, and to some extent, we all want a piece of it. Hence, we need to sort out a way to arrange it so that it minimises wastage, and so that as many people are satisfied as possible.

This is probably as good a way of thinking about economics as any. But I tend to go one step further. I think economics, at the heart of it, is about individuals and decisions. Individuals want to be as happy as possible. During an individual’s lifetime, he/she will face thousands of decisions that must be made. Each decision can make you a bit better off or a bit worse off in terms of your current status, but also in terms of your long term wellbeing and satisfaction (note that what is ‘good’ now is not necessarily ‘good’ overall, and vice versa). Furthermore, each option is likely to have a different profile of costs and benefits compared to each other option.

When you have millions of individuals making decisions in this way, you create a web of interconnectedness. There may be some decisions which are only self-affecting, but a large number also have an effect on other individuals too. We take something inside us, combine it with some external stimulus or choice, and act. And thus, an economy is born.

Thinking about it this way, it’s not just material resources that we’re interested in. We make decisions about relationships, job satisfaction, ethics, revenge, charity, and so on. All of these things have a big impact on our happiness and life satisfaction, and so we want to optimise our decisions here just as much as we do when we are thinking about spending or investing.

Classical Theory

Based on some of the principles set out by early thinkers such as Adam Smith, economists in the early 20th century set out to create a theoretical framework that could explain market interactions and be solved for an optimal outcome of some nature. Most of these guys were mathematicians at the core, and so they approached economics as an applied branch of maths, much in the same way as a lot of physics theory was at the time (and I suspect still is).

They created many equations, theorems, definitions, axioms and conditions. Most of the results that were generated by this broad theoretical framework relied upon some essential simplifying assumptions about the nature of an individual. They exclude certain strange and inconsistent behaviours, which for the most part seems plausible. People don’t want to behave like idiots (I’m hoping).

These results painted an idealised picture of the world. When everyone behaved consistently and market conditions were perfect, equilibrium would be reached. This equilibrium would satisfy certain properties, and we could explicitly calculate what the ‘best’ outcome would be (given that we first define what we mean by ‘best’, of course).

One of the important roles for economic theory is to advise policy. If we are observing some undesirable outcome in reality, what can we do to bring us to a more idealised state of the world? The philosophy that classical theory seems to imply for policy is that either:

  • We are satisfying all the theoretical conditions in practice, and so we just need to direct the world into a more favourable equilibrium.

or (and perhaps more likely):

  • We aren’t meeting our conditions for an idealised world, and so we need to create rules/structures that bring us closer to a theoretical ideal.

This is one way of solving the problems of society. But there is another.

The Behavioural Approach

Even the early classical economists would probably not deny that people rarely follow a strict, axiomatic set of behaviours. However, many still did believe that people were more or less individually rational (I reckon Gerard Debreu might have beaten you up with a pointy stick if you suggested he was irrational!).

But in the mid 20th century, scholars started to question some of the assertions that classical theory had made. Figures like Allais and Kahneman were among the first to suggest that there was something fishy about the predictions standard theory made (basically, most of them were quite bad!). There had to be an alternative way of looking at how individuals make decisions. Rather than making some assumptions based on how we believed people should act, maybe we could look at how people do act, and then figure out the principles that underlie this behaviour.

With this way of looking at things, it was only natural that psychology would enter the mix. Psychologists had observed and discovered many aspects of human behaviour under decision-making contexts. Some of which, like the ‘attraction effect’ or ‘halo effect’, pretty much directly contradicted some of the classical assumptions enforced upon individuals by economic theory.

So the theoretical template for ‘behavioural economics’ became more like: look at what people do; figure out consistent aspects of behaviour; use this to inform a theory or prescribe policy. And therefore, with the behavioural approach, the way we think about policy is flipped on its head. Rather than trying to make conditions closer and closer to a theoretical ideal, we try to understand the ways people make decisions (whether we like them or not!). If we have not reached an optimum, then we want to try to educate or influence people so that they make better decisions for themselves and others.

Policy in this way looks to me to be much more ‘ground up’ than the classical ‘top down’. Of course, there may be times when the classical approach makes more sense than the behavioural approach and vice versa. One is not universally better than the other. But understanding how and why people do things can lead to far more elegant solutions to problems than we would otherwise have thought. Rather than spending buckets of money reducing journey time along one train route by 10 minutes, maybe we can pay a little to provide some entertainment to passengers so that time appears to pass quicker, or improve their comfort in some materially inexpensive yet effective way.

This ‘libertarian paternalistic’ approach to policy (as described by Richard Thaler and Cass Sunstein) is based around shaping and ‘nudging’ people towards making better decisions for themselves, rather than imposing rules or restrictions. The latter approach, I feel, is somewhat less likely to be sustainable. We can force people to go down a certain path all we want, but if that’s not where they want to go, that’s not where they will end up going. This ends badly for all parties. But if we change the structure or some features of a problem that will guide people into making better decisions by themselves, I think we are much less likely to see any form of backlash or negative repercussion.

It is the human element that governs so much of our lives, and yet is often overlooked in a discipline that supposedly deals with the contentment of humans. When the conditions are right, and when individual affect plays little to no part, classical axiomatic theory can prove to be very useful. But for the remaining majority of situations, I believe we need to try to understand psychological traits, biases and foibles if we really want to intervene with the world to make us better off.