Topic: The main focus of my paper will be to analyze the striking similarities between the “novel” insights from the field of behavioral economics and insights from Austrian economics.
Proposal: My paper will be divided into three parts, the first of which will describe the characteristics of behavioral economics and Austrian economics. The second section will describe three similar insights from both perspectives on the topics of units of analysis, cognitive ability and utility maximization. Finally the third section will analyze the possibility of understanding Austrian economics as an early form of behavioral economics and theorize the possible policy implications understanding both fields as a coherent narrative of how economic activity takes place.
Similarities between Austrian and Behavioral Economics
Lately, behavioral economics has become increasingly popular due to its criticism of the efficient markets hypothesis, especially in relation to the recent housing bubble collapse. This relatively new area of study brings interesting insights from the field of psychology to explain human decisions in the market place. Likewise, the Austrian school of economics has become increasingly popular due to the U.S. Government decision to bailout the banking system during the 2008 financial crisis. The general discontent of the public with economic views that approve of government intervention in the economy as the optimal choice has sparked a desire for alternative theories on how to reignite the economy that do not involve government intervention. However, it is not only their current popularity that these economic perspectives have in common. Many ideas that behavioral economics claims as insightful have been previously analyzed by Austrian economics in a similar fashion. In particular, these topics include units of analysis, cognitive ability and utility maximization. This paper will explain these similarities and then theorize the possible policy implications from understanding both fields as coherent narratives of how economic activity takes place.
Behavioral economics developed as an area of study during the last decades of the 20th century, and studies how human psychology relates to the economic decision process of individuals and institutions. It has risen to prominence as a scientific field very quickly and was brought to the public's attention through several books and the awarding of the 2002 Nobel Prize to the behavioral economist Daniel Kahnmen. In a similar manner, Austrian economics studies the economy “in terms of the ideas and actions of individuals (methodological individualism)” (King p.6). It had its beginnings as a current of thought through the publication in 1871 of “Carl Menger's Principles of Economics” (King p.5). It was later developed more by great minds such as Ludwig von Mises and Friedrich Hayek. Interestingly enough, the New Word Encyclopedia states that “the Austrian School” is also known as the “Psychological School”.
The Individual as the Unit of Analysis
One reason why both schools of thought are so similar is their recognition that the key to understanding how economies work is on understanding how individuals think and behave in the market. Countries and corporations do not make decisions, people within those structures do. If economists wish to someday create an accurate model of how the economy works, they will first need to provide an accurate narrative of why each person makes a particular decision. Both Austrian and Behavioral economists focus on providing this narrative. The difference is that behavioral economists look to provide the explanation for human actions through psychological experiments, and Austrian economists do so through introspection, logic and reason.However, it was the Austrian economists that first introduced the idea of understanding individual cognitive behavior as the unit of analysis for economics. As the economics journal Emerald discusses on the topic of Advances in Austrian Economics, “Among the very interesting contributions offered by the Austrian School, the analysis of the decision-making processes connected with human cognitive mechanisms is certainly one of the most relevant” (Alfons p.89). As this demonstrates, the recognition of the importance of individuals as a primary unit of analysis that is now claimed by the behavioral economists was already explored by Austrian economists before Behavioral Economics even existed. In fact, it was an Austrian economist, with this idea in mind, who brought fourth important ideas such as the subjective theory of value, which explains the valuations of good and services from the point of view of individuals.
Both approaches to the study to peoples behavior in the marker, contrast with the current neoclassical approach in regards to the units of analysis. The neoclassical approach focuses on understanding the mean or average individual and in order to do this, it postulates an “economic man”. The neoclassical “economic man” is based on the assumption that individuals make rational decisions in order to maximize utility based on full and relevant data information. These assumptions can be of course easily undermined by pointing out that individuals often make irrational choices with partial information which leads to suboptimal outcomes. This, however, would be missing the point. Contrary to popular belief, the “economic man” does not describe all individuals, but rather the average individual. The neoclassical approach, at oppose to the Austrian and Behavioral, approach does not seek to understand individuals as they are, but rather in relation to one another. This is in exactly where many of the criticism to the neoclassical approach come from. The general criticism is that the reason why the neoclassical approach often fails to account for variables that cause sharp deviations from their expected mean is because their lack a realistic model of true average human nature.
Cognitive Ability
Another similarity between both fields is the overlap between their research methods relating to understanding people's cognitive ability to make decisions. Behavioral economists’ research methods are those of the scientific method, which empirically test the validity of hypothesis. For example, if behavioral economists were to theorize that people offered the option of choosing between similar products A and B, would pick A over B because they think A is better, unless an option C is added in which case they will choose B, they would conduct a laboratory test. This test would then be carefully created so that it is reliable, valid and replicable by the broader scientific community. Such research would also involve asking the participants the reasons for their choices, and seeking to understand the fundamental reasons from some theoretical position as to why participants made such choices. In contrast, Austrian economists would take the same hypotheses and would reason their way to a conclusion. They would philosophize about then nature of product A and B, and the characteristics of product C that would make someone change their original preference. This is what is sometimes called armchair economics. Interestingly enough, both methods sometimes yield similar results. This is because the Austrian research method is in some sense factored on the behavioral economics research method. The hypothetical individuals that Austrians theorize have parallels to the individual chosen from a random sample that is subject to the behavioral economics test. Also, since Austrian economists are individuals themselves and because they focus more of their time on understanding the underlying reason why people may think one way or the other, they sometimes come up with a better understanding of how people's minds work.
Utility Maximization
In 2008 behavioral economist Dan Arielly published a book titled “Predictably Irrational: The Hidden Forces That Shape Our Decisions”, in which he described human nature as intrinsically prone to systematic error. The book provided various examples in which irrelevant data consistently lead individuals to take suboptimal choices. With this in mind, behavioral economists conclude that while people think they are making the best choice, they at times objectively wrong. Comparatively, the Austrian school also believes that individuals are capable of making systematically suboptimal choices. Their economic theories only make the assumption that the individuals will think they are making the optimal choice while reality may differ. As economist Randal Holocombe states in the journal article titled, The Behavioral Foundations of Austrian Economics, the “Austrian utility theory rests on the weaker assumption that when faced with a choice, individuals will choose the option they most prefer. This makes the Austrian approach immune to the challenges that behavioral and experimental economics pose to the neoclassical framework” (Holcombe p.302). This comes to show that the understanding of human economic behavior as systematically suboptimal in both the aggregate and the individual scale is not a new insight from the field of behavioral economics, but rather that this idea can find its roots in Austrian Economics.
Policy Implications
As mentioned before, behavioral economics main achievements have been in relation to its criticism of the efficient market hypothesis and its role in the housing bubble, since many analysts systematically undervalued the risk of mortgage-backed securities. As economist George Bragues points out in the Quarterly Journal of Austrian Economics:
“Here was a situation, after all, in which a multitude of sophisticated analysts and investors, operating in the world’s leading financial institutions, grossly overvalued the mortgage backed securities at the heart of the crisis and systematically undervalued the risk in their portfolios, all the while relying on models quantitatively constructed on the assumptions of the EMH” (Bragues p.2).
With this in mind and taking a behavioral economist’s lens to understand the workings of national economies, it is easy to see how this could lead one to think that governments could and should enact legislation that would prevent individuals from making suboptimal choices. Especially if it can be proven that individuals are so susceptible to their environment that they are driven by it, or that everyone involved in a transaction would be better off with government intervention. However, if one takes the Austrian economic perspective into account and its skepticism for government intervention, we can broaden our understanding of the possible consequences of such types of polices. As Austrian economist Niclas Berggren points out, such policy recommendations are short sighted and do not take into account that politicians are also subjects to bias and systematic errors. Berggrens's research on the paternalistic tendencies of behavioral economics’ journal articles has revealed that “20.7% of leading articles in behavioral economics contain some kind of paternalist policy recommendation and that 95.5% of these do not contain any analysis at all of the potential problems with cognitive limitations and biases of policymakers” (Berggren p.2).His research comes to show how behavioral economists are, ironically, systematical blind sighted to the deficiencies of the political process. This is of significant importance since it fuels the idea that politicians can solve market inefficiencies. Such a perspective does not take into account the fact that governmental solutions have the potential to cause greater market inefficiencies.
Conclusion
While their methodology and reliability differ, in light of the similarities that both perspectives have in regards to their units of analysis, approach to cognitive analysis, and utility maximization, it is no surprise both the behavioral and Austrian approaches yield similar explanations for economic behavior. However, behavioral economics does seem to have an advantage over the Austrian approach, as it incorporates the use of empirical studies to a theoretical approach. This does not mean that the Austrian economic perspective is not valuable, but it does mean that as a field, it is better understood as a foundation to build upon than as the ultimate representation for what economics strives towards. The ideal economic perspective is one that adapts with new understanding of human nature and takes different approaches to interpreting data. For example, the neoclassical approach, which is often criticized for not proving a true account of human nature on its theoretical “economic man” assumption, has since adapted and created better models to understand human nature under for example bounded rationality. Bounded rationality been state where the “economic man” acts within a certain limited amount of information. It is through learning and adapting to new information that the neoclassical approach continues to better their models.
Finally, in regards to policy recommendations, a very real danger rests with the possibility of politicians misinterpreting the findings of behavioral economists as a type of license to enact legislation and unintentionally exacerbate market problems. A possible way to avoid such a scenario is to educate politicians and the public at large about the compatibility of the Austrian perceptive with Behavioral Economics, which could temper expectations regarding what politicians can accomplish. Such a view could cause fewer but better laws to be enacted, as it takes into account the inefficiency of governmental alternatives to market inefficiencies.
Scholarly Sources:
1. Holcombe, R. G. (2009). The Behavioral Foundations of Austrian Economics. Review Of Austrian Economics, 22(4), 301-313. doi:http://dx.doi.org/10.1007/s11138-009-0081-9
2. Berggren, N. (2012). Time for Behavioral Political Economy? An Analysis of Articles in Behavioral Economics. Review Of Austrian Economics, 25(3), 199-221. doi:http://dx.doi.org/10.1007/s11138-011-0159-z
3. Alfons Cortés, Salvatore Rizzello (2006), Hayek's Theory of Knowledge and Behavioural Finance, in Elisabeth Krecké, Carine Krecké, Roger G. Koppl (ed.)Cognition and Economics (Advances in Austrian Economics, Volume 9), Emerald Group Publishing Limited, pp.87-108
4. Bragues, G. (2012). Neither Efficient nor Animally Spirited, but Eventually Adjusting: The Stock Market According to L.A. Hahn. Quarterly Journal Of Austrian Economics, 15(1), 89-119.
5. King, J. d. (2012). The Elgar Companion to Post Keynesian Economics, Second Edition. Cheltenham, U.K. and Northampton, Mass.
6. "Austrian school of economics" New World Encyclopedia. 2012.<http://www.newworldencyclopedia.org/entry/Austrian_school_of_economics>.
