Why We Need Behavioral Economics

By Sean Masaki Flynn

Conventional 20th-century neoclassical economics makes many accurate predictions about human choice behavior and how it responds to financial incentives and incrementally changing prices. But when the decisions involve uncertainty and require the chooser to risk or commit or trust, neoclassical predictions often fail.

The key underlying problem is that real people are often irrational. That’s problematic for neoclassical economics because neoclassical economics assumes that people are rational. Because rationality is at the heart of why neoclassical economics sometimes fails, let’s begin our review of behavioral economics by precisely defining rationality.

Rationality is defined by economists as decision-making that avoids systematic errors.

A systematic error is an error that you do over and over, as if you can never learn from your mistakes. A rational decision maker would not be subject to systematic errors. She would learn from her mistakes and figure out how to get what she wants for the least cost and effort. Outside factors might still derail things, but anything that the rational decision maker could have done to maximize her chances of success would have been learned and applied.

If people were always rational, then standard, mid-20th century neoclassical economics would have always generated reliable predictions about human decision-making. But people regularly and repeatedly engage in behaviors that reduce their likelihood of achieving what they want. They engage in systematic errors. Behavioral economics attempts to explain these systematic errors by combining insights from economics, psychology, and biology. The goal is to develop theories that can deliver more accurate predictions about human choice behavior, including all the irrational stuff.

Decades of research have allowed behavioral economists to develop theories that can explain why our brains employ error-prone mental shortcuts, why we don’t save enough for retirement, why we fall for marketing gimmicks, and why higher incomes rarely lead to permanent happiness. Armed with those insights, behavioral economists have in some cases been able to develop beneficial correctives. And, least dismally of all, behavioral economists have found extensive evidence that people are not purely self-interested.