Part 1 of a Discussion of Peter Foster’s Why We Bite the Invisible Hand Chapter 12 “Homer Economicus”
Foster turns his attention to the field of Behavioral Economics that gained a lot of attention in the early 2000’s. However, it is clear Foster is unimpressed.
Two psychologists kicked the field off, Daniel Kahneman and Amos Tversky. Their early work in 1979 covered prospect theory, which observed people being more risk averse about losses than they should be if they were rationally following probabilities.
Essentially, we hate losing something we have more than gaining the same amount of something.
They worked together starting in the 1960s up until Tversky died in 1996. Their work earned the 2002 Nobel Prize, but since the awards are not given posthumously, only Kahneman received it.
However, it seems if Foster was voting that year, he would not have awarded it to their work. He notes the idea that people care more about losses than gains is already built into economic theory.
The law of diminishing marginal utility is why demand curves are downward sloping, that is, quantity demanded increases as prices fall.
In English: you enjoy the first unit of something more than the second. Therefore, you are willing to pay more for the first than the second.
If you are really hungry, you might be willing to pay $2 for your first donut. If you had to pay for the second one, $2 may seem like too much, but maybe you would pay $1. Since you get less enjoyment from the second one (diminishing marginal utility) you will only buy more if you can pay less (downward sloping demand curve.)
Foster does raise an interesting point. If you have an item that you put a value on, that value would be higher than the value you place on the next unit. Thus, you would value losing the one you have more than gaining another unit.
Despite Foster’s misgiving, the field of behavioral economics did catch on. It was popularized when Kahneman wrote a book in 2012, Thinking, Fast and Slow.
The title refers to the idea we operate using two kinds of thinking: System 1, or fast intuition, and System 2, or slow, logical thinking.
He said that System 1 is usually in charge. System 2 is lazy. Economic understanding requires System 2’s logic and analysis, but that requires effort, which System 1 would rather not make. (p. 256)
As such, we are geared toward taking cognitive thinking shortcuts when we make decisions. This leads to all sorts of heuristics, or rules of thumb, we do not even realize we are employing — many of which lead to faulty decision making.
Here is one list of the many heuristics we employ and cognitive biases we suffer from.
Foster highlights a few of them in his chapter.
We tell ourselves — via “hindsight bias “— that we knew what would happen all along. When it comes to guesses and decisions about issues or topics with which we are unfamiliar, we are influenced to an alarming degree by randomly generated numbers — the “anchoring effect.” Similarly, subjects can be unconsciously primed to influence their thoughts and actions. For example, students involved in a study on the aged subsequently walked more slowly: the “Florida effect.” (p. 254)
I have never heard of the Florida effect; that one was kind of funny.
Foster then identifies a few biases he thinks Kahneman is suffering from.
The “Tuesday with Morrie” effect refers back to an earlier chapter about a book with that title because Morrie did not recognize his own bias of seeing his behavior as justifiably self-interested while calling the same behavior in others selfish. (p. 256)
The Occupy Wall Street effect Foster defines as System 1 satisfying itself with a simple narrative about the evil 1% of income earners, “rather than coming to grips with the counterintuitive fact that it is only in the process of the 1% becoming rich that much of the economic good for the 99% is generated.” (p. 256)
Foster’s Main Issue
I do not think Foster disputes the evidence that we use these heuristics as shown by the field of cognitive psychology. These effects have been found in experiments.
But, I think his testiness comes from them being applied to economics without any apparent recognition of Kahneman’s and others’ hidden biases.
In economics, we assume people are rational. People hear the word “rational” and think to themselves of many examples of people being irrational so clearly economics is doomed from the beginning!
Actually, rational is a mathematical assumption about preferences. If you like red better than blue, and blue better than green, I need to be able to conclude that you like red better than green for the math to work.
Rational does not mean you cannot be wrong, nor does it discount the possibility of delusion. You say you want to lose weight yet there you are with the ice cream at night.
What that actually reveals is your preference to enjoy yourself tonight is higher than the joy you would get in the future if you lose weight. Still rational, just self-deluding!
This rational assumption though is often misunderstood. When we apply our utility maximizing model to human behavior, the hypothetical economic man has been called Homo economicus (a play on Homo sapiens).
According to Kahneman, the rational agent model promoted the notion that people are “Econs”…that purely rational and selfish straw man that had long been a favorite for those seeking to rationalize government intervention…Thus, Kahneman flaunted intellectual superiority over non-existent foes when he declared that “life is more complex for behavioral economists than for true believers in human rationality.”
Here, Kahneman is misunderstanding what economists mean when we model our rational agent maximizing utility.
Deirdre McCloskey wrote about how Adam Smith is mischaracterized as assuming a one-dimensional Homo economicus who only cares about costs and benefits.
Likewise, Foster points out many economists knew they were not saying people act as “Econs” when they use the rational agent model:
- Adam Smith was “all too aware that humans were irrational.” (p. 255)
- Ludwig von Mises noted “like every branch of knowledge, economics goes as far as it can be carried by rational methods. Then it stops…” (p. 255)
- Milton Friedman considered economics to be about group behavior, not individual psychology (p. 255)
- Armen Alchian noted that markets “don’t even require individuals to be self-aware beyond pursuing their own interests.” (p. 255)
Essentially, Foster takes issue with behavioral economics being offered as a solution to correct the silly economists who think people are selfish, one-dimensional utility maximizers because you are fixing a problem that does not exist.
In the next blog, Foster explores how this solution to an incorrect diagnosis leads to a distrust of markets and the Invisible Hand and a call for planning and government intervention.
Reference: Foster, Peter, 2014. “The Darwin Wars” Chapter 12 of Why We Bite the Invisible Hand, Pleasaunce Press.
