A Nobel for Humility in Economics

As you are by now all probably aware, Richard Thaler won this year’s Nobel Memorial Prize in Economic Sciences. All question of whether this is a “real” Nobel can now be laid to rest, since the announcement was made via the Nobel Prize’s official verified Twitter account.

Thaler won the prize for his research in behavioral economics, although he’s far from the first behaviorist to win it — Herbert Simon, Daniel Kahneman, and Robert Shiller all got the big gold medal from Sweden. But Thaler’s work is arguably more wide-ranging and influential than any of those earlier pioneers. And it’s the sheer breadth of Thaler’s research that offers a peek into where the discipline of economics is headed.

Loosely speaking, the economics of the past was a search for a grand unified theory. At first, supply-and-demand was the idea that tied econ together. Later, that was replaced with explicit modeling of economic decision-making as the optimization of a rational economic “agent.” To predict anything from the price of tomatoes in Wyoming to the savings rate in Bangladesh, you would just assume that people maximize utility and companies maximize profit, then write down a mathematical optimization problem that would spit out an answer. This method — sometimes called the neoclassical approach — grew so popular that economists started applying it to sociology, law and politics.

Lots of people justifiably made fun of the unrealistic hyper-rational agents in these economic models. Early behaviorists like Kahneman gained credence by poking holes in the idealized vision of homo economicus. But there was still the hope that a general theory of economic behavior existed and could be found. Kahneman tried to replace standard rational optimization with prospect theory. Behaviorists like Matt Rabin hoped that human irrationality could be represented as small deviations from a single unified theory.

I see Thaler’s research as qualitatively different. Whereas many behaviorists want to replace or tweak the standard theory, Thaler started smashing it left and right. He pointed out anomaly after anomaly. And instead of trying to design a new theory-of-everything to explain the anomalies, he borrowed or created situation-specific theories, such as mental accounting and the endowment effect and so on. Sometimes the theory was a very simple one. Or sometimes, like Shiller, he merely documented where standard theory went wrong, and left the theorizing to someone else.

Critics of behaviorism see this as a flaw. They bemoan the replacement of one theory with many. If you have a different explanation for every situation, the anti-behaviorists say, what’s to stop you from telling just-so stories? These critics tend to see Thaler’s research as a destructive force.

But Thaler isn’t just a bomb-thrower — his approach is far smarter than that. I believe he’s out to create a new paradigm — one that doesn’t rely on a grand unified theory of human behavior.

There’s no reason that economics has to be like physics. Physicists are always trying to unify their theories — to show how what appear to be different forces and principles are actually the same. But human behavior might just not be like that — the way that a person decides which brand of soy sauce to buy might simply be different from the way she decides when to buy Apple Inc. stock. Thaler’s research is all about forcing economists to acknowledge this possibility.

So how can we know which theory to use in which situation? Data. The behavioral revolution goes hand in hand with the empirical revolution now sweeping the wider economics profession. Over the past couple of decades, economists have steadily been theorizing less and measuring more.

Let’s hope this isn’t just a fad, but a fundamentally new paradigm for the field. The old way of choosing between different explanations was to start with the assumption of a grand unified theory and then find the minimum possible deviation that explains the phenomenon in question. The new way should be — and in some cases, already is — to gather a number of plausible explanations and let the data dictate which one applies. Then as economists find theories that each work for a small, limited domain, they can explore other areas where each theory might also apply. Slowly, each successful theory’s domain will expand, and when two of them happen to bump up against each other — that is, when they give equivalent results — economists can work on unifying the two.

This is basically how natural scientists approach the world. Instead of jumping to a conclusion that looks as clean and pretty as physics, economists should more closely follow the methods that physicists actually use.

So behaviorism isn’t really about psychology — it’s about humility. Sometimes things people do can be explained by psychological biases, sometimes by purely rational optimization and sometimes by other things entirely. Thaler is intent on making econ about what works, instead of what we think ought to work. As such, it has the potential to have reach and power far beyond the specific topics Thaler has spent his storied career investigating.

(Bloomberg)