Alfred Marshall Lecture
A perspective on psychology and economics

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Abstract

This essay provides a perspective on the recent trend towards integrating psychology into economics. Some specific topics are discussed briefly, and arguments are provided for why greater psychological realism will improve mainstream economics.

Introduction

Over the years, some prominent researchers in both economics and psychology have criticized some of the tenets of mainstream economics as psychologically unrealistic and proposed alternative assumptions that they believed would improve economic analysis. This agitation for greater psychological realism is now yielding results. Commonly labeled “behavioral economics”, these efforts to incorporate more realistic notions of human nature into economics have expanded enormously in the last decade. While still controversial, behavioral economics is on the verge of “going mainstream”, especially in top departments in the U.S. The number of recent hirings, tenurings, conferences, etc., based on behavioral-economic research reflects its growing acceptance. The theme chosen by EEA President Jean Tirole for the three keynote addresses for the 2001 Meetings and the fact that the AEA awarded the John Bates Clark Medal this year to a (second-rate, failed) theorist specializing in behavioral economics indicate that the integration of psychology into economics has been accepted as a promising development at the highest levels of the profession.

More importantly, behavioral economics has begun to insinuate itself into work-a-day economics. Researchers such as David Laibson in macroeconomics and Ernst Fehr in labour economics have established themselves within mainstream economic fields. In several of the top U.S. economics departments, graduate students are being offered field courses in behavioral economics, and students in these departments are writing dissertations in the area.

This recent explosion of interest raises the concern that behavioral economics is just a fad. Indeed, prominent skeptics have predicted that interest in the area will peter out as researchers realize that this latest craze offers little value. Unsurprisingly, I am inclined to believe it is not a fad. As with all innovations and improvements, surely many are over-optimistic about the progress these innovations will bring. But the underlying premise of this movement is far too compelling to consider it transitory: Ceteris paribus, the more realistic our assumptions about economic actors, the better our economics. Hence, economists should aspire to make our assumptions about humans as psychologically realistic as possible. The idea that economists should incorporate behavioral evidence from psychology and elsewhere that indicate systematic and important departures from our discipline's habitual assumptions is so fundamentally and manifestly good economics that I am confident it will have long-term influence in economics.1

As an indication of the impact this research program is likely to have, research has recently been evolving to what I would call “second-wave behavioral economics” – which moves beyond pointing out problems with current economic assumptions, and even beyond articulating alternatives, and on to the task of systematically and formally exploring the alternatives with much the same sensibility and mostly the same methods that economists are familiar with. David Laibson addresses mainstream macro issues with mainstream tools, but adds an additional, psychologically motivated parameter. Ernst Fehr addresses important core issues in labour economics but without assuming 100% self interest a priori. Theorists such as myself use mostly the standard tools of microeconomics in exploring the implications of these alternative assumptions. All said, this second wave of research continues to employ mainstream economic methods, construed broadly. But it shows that addressing standard economic questions with standard economic methods need not be based solely on the particular set of assumptions – such as 100% self-interest, 100% rationality, 100% self control, and many ancillary assumptions – typically made in economic models but not supported by behavioral evidence.

This research program is not only built on the premise that mainstream economic methods are great, but also that most mainstream economic assumptions are great. It does not abandon the correct insights of neoclassical economics, but supplements these insights with the insights to be had from realistic new assumptions. For instance, rational analysis predicts that people care about the future, and hence save, and are more likely to save the longer their planned retirement. But psychologically inspired models that allow the possibility of less-than-100% self-control also make the above predictions and allow us to investigate the possibility that people under-save, and over-borrow, and more nuanced and important predictions such as simultaneous high savings on liquid assets and low savings on liquid assets. Rational analysis predicts that employees are more likely to quit the lower their real wages and the higher the wages available elsewhere. But psychologically inspired models that allow the possibility of some money illusion and loss aversion and fairness concerns also make the above predictions and allow us to investigate the possibility that people are more sensitive to recent cuts in nominal wages than can be explained purely in terms of concerns for relative real wages. Rational analysis predicts that the demand for addictive products is decreasing in current and expected future prices and that people are more likely to consume substances they find enjoyable, and less likely to consumer substances with bad effects. But psychologically inspired models that allow the possibility of less-than-100% time consistency and less-than-100% foresight also make the above predictions and allow us to investigate the possibility that people over-consume addictive substances.

This essay provides my own perspective on where such research integrating psychology into economics is and should be going. I will provide a few examples of some behavioral findings that I think are important to economics. But I will focus more heavily on arguing why integrating such findings into formal economics makes sense as a research program.

I choose such a focus with some hesitation. As a rule, it is bad to spend time on “methodological” and broad-stroke issues rather than the nitty gritty of the phenomena being studied. The goal of this research program is that it become “normal science”, and, as such, the nitty gritty is the point. Papers and talks should (as with this year's Presidential and Schumpeter lectures) address the substance of this new research, not its methodological legitimacy. Indeed, a recurrent (tediously repetitive?) theme of this essay is that this research is not an alternative to the economic research program into which we were all socialized in graduate school, but the natural continuation of this research program. What most of us doing psychological economics spend most of our time on – and wish we could spend all of our time on – is not debates over methodology, but doing normal science. Because this approach is clearly gaining acceptance, essays like this should soon become anachronistic.

At this moment in the profession, however, there is still some residual resistance to expanding the scope of this type of research. The amount of time and intellectual energy – by journal editors, graduate advisors, and seminar audiences – devoted to articulating reasons why this research should not be done is still too high. Hence, I will also use this essay to engage some of the common reasons this research is resisted.

In Section 2, I will briefly outline a framework for thinking about psychologically motivated departures from classical economic assumptions, and then discuss a few notable topics where research has been most active. In Section 3, I explore a variety of themes and perspectives on the way economists ought and ought not incorporate greater psychological realism into economics.2

Section snippets

A framework for modifying unrealistic assumptions

There are many assumptions that economists often make about human nature that behavioral and psychological research suggests are often importantly wrong. These include the assumptions that peopleareBayesianinformationprocessors;havewell-definedandstablepreferences;maximizetheirexpectedutility;exponentiallydiscountfuturewell-being;areself-interested,narrowlydefined;havepreferencesoverfinaloutcomes,notchanges;haveonly“instrumental”/functionaltasteforbeliefsandinformation.Some of the above

Themes and perspectives

The examples in Section 2 are manifestly not an exhaustive list of even the most important departures from classical assumptions that have been identified by psychologists or have been investigated by behavioral economists. Rather than providing more examples, I turn now to a consideration of some of the more general issues in why and how economists should start to embrace this research.

Acknowledgements

I thank Davis Beekman, Erik Eyster, Lorenz Goette, Steve Pischke, and audience members at that lecture for helpful comments, and I thank the MacArthur, National Science, and Russell Sage Foundations for financial support.

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This paper is based on the Marshall Lecture of the same title presented at the European Economic Association Meetings, Lausanne, Switzerland, September 1, 2001, but with the underwear joke removed.

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