Emergence of Behavioral Economics

Historical Context of Behavioral Economics

- Adam Smiths book Theory of Moral Sentiments included concepts which lead to current
developments in the field of behavioral economics
- Economists then moonlighted as psychologists due to the actuality that psychology has not yet
existed as a discipline
- Behavioral economics largely emerged in reaction to neoclassical economics (Angner &
Loewenstein, 2006)
- The rejection of academic psychology by economists began with the neoclassical revolution
- During the 20th century, economists hoped their discipline could be like a natural science
- At this time, Psychology was just emerging and was not considered very scientific
- Because of this, economists found it as as unsteady foundation for economics
- The distaste for psychology led to the expunge of psychology in economics although this
happened very slowly it did reach a point where psychology had largely disappeared
- There were several developments led to the emergence of behavioral economics:

One development was the rapid acceptance by economists of the

expected utility and discounted utility models as normative and descriptive models of
decision making under uncertainty and intertemporal choice, respectively.

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Whereas the assumptions and implications of generic utility analysis are rather flexible, and
hence tricky to refute, the expected utility and discounted utility models have numerous
precise and testable implications. As a result, they provided some of the first "hard targets"
for critics of the standard theory. Seminal papers by Allais (1953), Ellsberg (1961) and
Markowitz (1952) pointed out anomalous implications of expected and subjective expected
utility

- Beginning around 1960, cognitive psychology became dominated by the metaphor of the
brain as an information-processing device replacing the behaviorist conception of the brain as a
stimulus-response machine.

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The information-processing metaphor permitted a fresh study of neglected topics like
memory, problem solving and decision making. These new topics were more obviously
relevant to the neoclassical conception of utility maximization than behaviorism had
appeared to be.

- Psychologists such as Ward Edwards, Duncan Luce, Amos Tversky and

Daniel Kahneman, began to use economic models as a benchmark against which to contrast their
psychological models. Perhaps the two most influential contributions were published by Tversky
and Kahneman

- Their 1974 Science article argued that heuristic short-cuts created probability
judgments which deviated from statistical principles.
- Their 1979 paper entitledProspect theory: decision making under risk" documented violations of
expected utility and proposed an axiomatic theory, grounded in psychophysical principles, to
explain the violations.
- The latter was published in the technical journal Econometrica and is one of the most widely cited
papers ever published in that journal
- A later milestone was the 1986 conference at the University of Chicago, at which a large number
of social scientists presented papers of similar nature
- Ten years later In 1997, a special issue of the Quarterly Journal of Economics was devoted to
behavioral economics

Early papers established a recipe that many lines of research in behavioral economics
have followed:

1. First, identify normative assumptions or models that are ubiquitously used by economists, such
as Bayesian updating, expected utility and discounted utility.
2. Second, identify anomaliesi.e., demonstrate clear violations of the assumption or model, and
painstakingly rule out alternative explanations (such as subjects confusion or transactions costs). 3.
And third, use the anomalies as inspiration to create alternative theories that generalize existing
models.
4. A fourth step is to construct economic models of behavior using the behavioral assumptions from
the third step, derive fresh implications, and test them.
This final step has only been taken more recently but is well represented in this volume of
advances.

With economics known as a distinct field of study, psychology on the other hand, did not yet exist as
a field of its own. Therefore economists then, were also the psychologists of their period. The most
notable is Adam Smith with his well known concept of the invisible hand and his book, Wealth of
Nations, was another literary work entitled Theory of Moral Sentiments which insights include that of
human psychology; leading to current developments in the field of behavioral economics. For
instance, (Smith, 1970, p.192) states We suffer more, it has already been observed, when we fall
from a better to a worse situation than we ever enjoy when we rise from a worse to a better situation
Which is the concept of Loss Aversion. Angner & Loewenstein (2006) state that behavioral
economics largely emerged in reaction to neoclassical economics. In more specific conditions,
behavioral economics emerged in response to the concept that social and behavioral sciences
should keep away from referencing factors which cannot be directly observed or measured. In
addition, this notion is known to be commonly held by neoclassical economists. With the desire of
economists for the discipline teo be considered a natural science, psychology was expunged from
economics. It is regarded as an unstable foundation of economics as a discipline, extracted from the
idea that psychology was not regarded as scientific.

However, there have been several noteworthy developments that led to the establishment of
behavioral economics as a field of study. One development, according to (Angner & Loewenstein,
2006) was the rapid acceptance by economists of the expected utility and discounted utility models
as normative and descriptive models of decision making under uncertainty and intertemporal choice
following this occurrence is the acknowledgement of papers and articles by known psychologists
such as Tversky and Kahneman whose works have largely influenced the discipline. Their published
works along with several others led to the use of economic models as points of reference in contrast
to psychological models. Furthermore, they have established a way that many lines of research in
behavioral economics have followed.

Sources:
Angner, E., & Loewenstein, G. (2006). Methods: Theory. Simple models of psychological
phenomena. Handbook of the Philosophy of Science, 5, 2-8. Retrieved from
http://www.cmu.edu/dietrich/sds/docs/loewenstein/BehavioralEconomics.pdf

Camerer, C. F., & Loewenstein, G. (2002). Behavioral Economics: Past, Present, Future. Retrieved
from http://nowandfutures.com/d2/BehavioralEconomics(conventional)ribe239.pdf
Smith, A. (1970). Of The Character of Virtue. In The Theory of Moral Sentiments (6th ed., p. 192).
Retrieved from https://www.ibiblio.org/ml/libri/s/SmithA_MoralSentiments_p.pdf