Cold, calculating and callous
We cannot hope for a realistic economic theory until a more realistic theory of human behavior is adopted
The writer is vice-chancellor of the Pakistan Institute of Development Economics. He holds a PhD in Economics from Stanford University
Modern economic theory is founded on the principle that human beings ‘maximise utility’; that is, they choose the best action from among a collection of choices. This axiom is considered self-evident: why would anyone make an inferior choice, when a better option is available? However, the mathematical formulation of this axiom is far from realistic. After all, it is self-evident that human behaviour cannot be described by mathematical laws. Critics have invented the term “homo economicus” to describe behaviour governed by economic laws, which differs drastically from normal human behaviour. We can describe homo economicus as cold, calculating and callous. We explain each of these terms separately. The theory of consumer behaviour which is taught in business school differs drastically from the same theory taught in the economics school. The homo economicus of economists is cold — not subject to any emotional influences in his consumption decisions. In complete contrast, a fundamental axiom of consumer theory in the business school is that effective marketing appeals to emotions instead of reason. The proven effectiveness of business school methods in getting consumers to purchase a wide range of completely useless goods, shows the superiority of their models of human behaviour. The term ‘maximise’ describes the assumption that homo economicus calculates the consequences of his actions to the last penny, and utilises any opportunity for even the slightest gain. Nobel Laureate Herbert Simon observed that real human beings do not act according to this assumption. He invented the term “satisficing” to describe the observed behaviour of real humans. Satisficing means making a choice which is satisfactory, or sufficient for the purpose, instead of maximising, or searching for the best possible choice. For a wide range of situations, satisficing is a much better description of human behaviour than the maximisation done by homo economicus.
Finally, ‘callous’ refers to the assumption that homo economicus is concerned solely with his own personal gains, and does not have any concern for others. Psychologists who learned of this bizarre theory of the economists, decided to test it in a simple lab experiment. They gave some amount of money, like $10, to a subject, X, and asked him to divide the money with another subject, Y. Subject X was completely free to choose how to divide the money, including keeping all $10 for himself and leaving none for subject Y. In fact, almost no one did this. Many subjects split the money into equal shares, while nearly all gave at least $3 to the other subject. Only economists, blinded by their theories, found these results strange. According to economists, all subjects should keep all $10 for themselves and give nothing to others. Interestingly, in experiments among college students, economics students behaved the most selfishly, occasionally even keeping the entire amount for themselves.
The discovery of the great divergence between homo economicus and real people led to the creation of behavioural economics. This discipline studies actual behaviour of people via experiments like the one described above. This goes against modern economic theory, which uses mathematics to calculate human behaviour. For a long time, behavioural economics was an outcaste subject within the economics discipline. Actual human behaviour was complex and varied, and conflicted strongly with the mathematical laws according to which homo economicus behaves. Leading behavioural economists advised their students not to study the subject, since they would have difficulty finding jobs as economists. The situation changed gradually as the radically different predictions of behavioural economists often turned out to be more accurate than conventional economic theory. Robert Shiller used behavioural theories to show that stock markets were overpriced, something which was not possible in the world of the cold, calculating, and callous homo economicus that conventional economic theories study. After the global financial crisis proved him right, Shiller was awarded a Nobel Prize, and behavioural economics acquired a new respectability among economists. Nonetheless, mainstream economists continue to treat behavioural theories as a sideshow, and homo economicus continues to occupy the central place in modern economic theory. We cannot hope for a realistic economic theory until this situation changes, and a more realistic theory of human behaviour is adopted for use by economists.
Published in The Express Tribune, April 4th, 2016.
Finally, ‘callous’ refers to the assumption that homo economicus is concerned solely with his own personal gains, and does not have any concern for others. Psychologists who learned of this bizarre theory of the economists, decided to test it in a simple lab experiment. They gave some amount of money, like $10, to a subject, X, and asked him to divide the money with another subject, Y. Subject X was completely free to choose how to divide the money, including keeping all $10 for himself and leaving none for subject Y. In fact, almost no one did this. Many subjects split the money into equal shares, while nearly all gave at least $3 to the other subject. Only economists, blinded by their theories, found these results strange. According to economists, all subjects should keep all $10 for themselves and give nothing to others. Interestingly, in experiments among college students, economics students behaved the most selfishly, occasionally even keeping the entire amount for themselves.
The discovery of the great divergence between homo economicus and real people led to the creation of behavioural economics. This discipline studies actual behaviour of people via experiments like the one described above. This goes against modern economic theory, which uses mathematics to calculate human behaviour. For a long time, behavioural economics was an outcaste subject within the economics discipline. Actual human behaviour was complex and varied, and conflicted strongly with the mathematical laws according to which homo economicus behaves. Leading behavioural economists advised their students not to study the subject, since they would have difficulty finding jobs as economists. The situation changed gradually as the radically different predictions of behavioural economists often turned out to be more accurate than conventional economic theory. Robert Shiller used behavioural theories to show that stock markets were overpriced, something which was not possible in the world of the cold, calculating, and callous homo economicus that conventional economic theories study. After the global financial crisis proved him right, Shiller was awarded a Nobel Prize, and behavioural economics acquired a new respectability among economists. Nonetheless, mainstream economists continue to treat behavioural theories as a sideshow, and homo economicus continues to occupy the central place in modern economic theory. We cannot hope for a realistic economic theory until this situation changes, and a more realistic theory of human behaviour is adopted for use by economists.
Published in The Express Tribune, April 4th, 2016.