Practice Exam Questions
Behavioural and Neo-Classical Economics (Revision Essay Plan)
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Last updated 2 Jun 2018
Here is an essay plan on the following question: "To what extent is behavioural economics a solution to all of neo-classical economics’ problems?”
Neo-classical economics has been the dominant force in economic thinking and policy-making for many years. It formulates precise economic laws regarding production and consumption through the calculation of cost and benefit at the margin. Consumers and businesses are both assumed to act rationally, consumers optimise their purchasing power by equating the marginal utility per pound spent, whilst producers seek to maximise profits in both product and labour markets. Neo-classical economics believes in the concept of equilibrium and the power of market forces to achieve an efficient allocation of resources. Yes, there are instances of partial and complete market failure, but neo-classical economics favours the usefulness of conventional interventions such as taxation and subsidy to change incentives by altering relative prices and thus alter behaviour to help align social cost and benefits.
The neo-classical model of behaviour is built on these assumptions:
- Agents choose independently
- An agent has fixed tastes and preferences
- Agents gather complete information on alternatives choices
- Agents always make optimal choice given his/her preferences
This is not just a micro-model (associated for example with the standard theory of the firm), it is also the foundation of much of macroeconomics e.g. rational expectations theory. In other words, neo-classical economics has been for decades wedded to "Homo Economicus” (a selfish and utility-maximizing, unboundedly-rational agent).
The emerging critique of neo-classical economics came first from economists who questioned whether there was complete information. Akerlof and Stiglitz (jointly awarded the Nobel prize) showed that agents may suffer from information failure – for example, there are many information asymmetries and this can lead to sub-optimal decisions (aka market failure). But in their work agents were still assumed to make the ‘best’ choice given the information they have. The work of Stiglitz and Akerlof extended the realism of conventional theory and has been widely absorbed into mainstream economics, especially policies designed to change the information available to consumers when the government is trying to change consumption of merit and de-merit goods.
Simon in an important paper published in 1955 added further to the questioning of neo-classical economics with his concept of bounded rationality. Most consumers and businesses are unable to make fully-informed judgements when making their decisions and the increasing complexity of products makes life difficult. People have limited attention spans and computational capacity. Bounded rationality suggests that consumers and businesses opt to satisfice rather than maximise. They will use rules of thumb (known as heuristics) and approximations when active across different markets. Behavioural economists point out that bounded rationality is not the same as irrationality, because decision-makers are still attempting to make as rational a decision as possible.
Behavioural economics started to emerge with the ground-breaking work of Kahneman and Tversky (again both awarded the Nobel for Economics although Tversky died before it was given). ‘Agents reason poorly and act intuitively’ according to Kahneman. This view was based upon numerous experiments in which there is a ‘rational’ answer but people frequently don’t choose it. Systematic deviations from rationality were observed challenging many of the assumptions of conventional thinking. Indeed, Thaler - who has popularised the concept of nudges - has argued that "the real point of behavioural economics is to highlight behaviours that are in conflict with the standard rational model."
In behavioural models:
- People have limited computational capacity - they aim to satisfice rather than maximise
- They are strongly influenced by social networks (where copying behaviour is common) and by prevailing social norms
- They often act reciprocally by making kind and generous gestures
- They lack self-control and they tend to be present-biased (for example by heavily discounting future benefits in favour of now)
- They are loss averse - hating losses far more than commensurate gains
- Their behaviour is strongly attached to existing default choices
- They are influenced to some extent by persistent cognitive biases. A bias is a systematic deviation from what is believed to be rational choice
Neo-classical economics assumes that all agents act rationally in their own self-interest. In contrast, behavioural economics emphasises altruism. This is when humans behave with more kindness and fairness than would be the case if they behaved rationally. Altruism is often linked to the concept of inequity aversion i.e. humans do not like unequal outcomes.
There are many cognitive biases that can affect behaviour. One is the anchoring effect when people rely heavily on an irrelevant piece of information to help us make a decision. Another is the availability heuristic where we tend to over-estimate the likelihood of something happening because a similar event has either happened recently or because we feel emotional about a previous similar event. The optimism bias finds that people tend to be overly confident about the outcome of planned actions and decisions and the scarcity bias is the tendency to value something more if it is thought of as rare.
An important aspect of behavioural theory is loss aversion. The basic idea behind loss aversion is that people feel losses much more than gains. We see this often in financial markets for example when stock market investors hold their investment positions with paper losses too long (hoping to that share prices will recover) and sell their investment positions with paper gains too early.
A modern economy dominated by knowledge and information services and where networks are vitally important is better suited to ideas drawn from behavioural economics. Incentives still matter but behavioural economics suggests that the motivations we have when making choices are not those that are taught in orthodox economics. When it comes to addressing persistent economic and social problems such as gambling addiction, rising obesity, anti-social behaviour and the causes of instability in financial markets, behavioural ideas seem to have plenty of validity.
That said whilst Behavioural economics can make a major contribution to overcoming the limitations of Neo-classical economics it is not necessarily a solution. The Behavioural Economics approach itself has been criticised. For example, the use of laboratory experiments has come under sustained attack in recent years. Many experiments have involved using a skewed WEIRD cohort - i.e. many people involved in the tests were drawn from Western, Educated, Industrialised, Rich and Democratic Countries and therefore not a representative sample. Secondly, our observed behaviour in the laboratory is unrealistic - tests normally use small stakes involved in the dilemmas with few real and lasting financial consequences for participants. Thirdly, discoveries about the past from behavioural experiments do not easily generalise to the future - the social context for one generation is often different from another. Mainstream economists from the Neo-classical school challenge behavioural theorists by saying that consumers, given sufficient incentives, will eventually learn that their behaviour deviates from that of the rational model and adjust accordingly.
In my opinion, the academic discipline of Economics should also draw on new ideas from other subjects. For example, we are becoming more expert in understanding neuro-economics - how our brain processes decisions and the limitations that our neuro-system imposes on our choices. Cognitive overload is common when we are faced with a huge array of choices and people frequently fall back on simple heuristics in these situations.
Economics can also learn much about behaviour from studying the Physics of networks and from Linguistics about how the language of communication can change behaviour. If more students were to take courses in History alongside conventional Economics modules, they might be able to understand deeper historical patterns for example in financial markets. The subject can also benefit from lessons from Anthropology which studies cultural influences on behaviour. From Anthropology we learn that humans are complex psychological beings living in different social contexts in which self-interest and altruism are often inter-twined. Most people have an innate sense of fairness in how scarce resources are allocated within a community.
Final reasoned comment
Neo-classical economics has built equilibrium models that have increasingly become divorced from the lives of real people and businesses. In our complex world where uncertainty is the new normal we cannot use a ‘one size fits all’ model for understanding the economy. Behavioural economics is not a solution but, as Paul Ormerod has argued, “An economist can no longer be said to have a good training in economics if he or she is not familiar with the main themes of behavioural economics.”