How does psychology contribute to economics?

Jeff Cockrell | Oct 23, 2017

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Economic models often give people credit for being what may seem at a glance an unexceptional thing: fully rational beings pursuing our own self-interest. But as psychologists, such as 2002 Nobel laureate Daniel Kahneman, and behavioral economists, such as 2017 laureate Richard H. Thaler, have pointed out, an assortment of biases, heuristics, and other factors often move us to behave in ways that seem distinctly irrational. Can social science’s understanding of how humans think and act be used to predict how markets will behave?

Chicago Booth’s Initiative on Global Markets polled its panels of economic experts on that question, and the answer was a resounding ‘yes.’ North American respondents were unanimous in agreement that “Insights from psychology about individual behavior . . . predict several important types of observed market outcomes that fully rational economic models do not.” Among the IGM’s European panel of experts, no respondents disagreed with the statement, though some expressed uncertainty or had no opinion about its accuracy.

Although the responses tended to affirm the predictive power of behavioral economics, members of both panels reiterated that fully rational models still have an important place in economics. Pol Antras of Harvard, who agreed with the statement, added, “Still, models with fully rational agents provide a perfectly good approximation for explaining many market outcomes!”

North American panel

Robert Hall, Stanford
“This type of behavior is common for isolated decisions, such as taking out a mortgage. People do better with frequently made decisions.”
Response: Agree

Larry Samuelson, Yale
“Insights from psychology are important, but fully rational models still exhibit an unparalleled mix of parsimony and predictive power.”
Response: Agree

Richard H. Thaler, Chicago Booth
“Almost chose ‘uncertain’ just to mess with the organizers.”
Response: Strongly Agree

 

European panel

Franklin Allen, Imperial College London
“I think this is true in many markets. In financial markets it may be less true because of the money at stake but they matter there too.”
Response: Strongly Agree

Lubos Pastor, Chicago Booth
“Psychology can be useful, but most puzzling phenomena can also be explained by rational models. What you mean by rationality matters.”
Response: Uncertain

Rafael Repullo, Centro de Estudios Monetarios y Financieros
“Still, as forcefully argued by Steve Ross, fully rational economic models can go a long way to explain many of these market outcomes.”
Response: Agree