The Evolution of Economics and Homo Economicus

For four decades, since my time as a graduate student, I have been preoccupied by these kinds of stories about the myriad ways in which people depart from the fictional creatures that populate economic models. It has never been my point to say that there is something wrong with people; we are all just human beings—Homo sapiens. Rather, the problem is with the model being used by economists, a model that replaces Homo sapiens with a fictional creature called Homo economicus, which I like to call an Econ for short. Compared to this fictional world of Econs, humans do a lot of misbehaving, and that means that economic models make a lot of bad predictions, predictions that can have much more serious consequences than upsetting a group of students. Virtually no economists saw the financial crisis of 2007–10 coming, and worse, many thought that both the crash and its aftermath were things that simply could not happen. (One economist who did predict the crash of the housing market was my fellow behavioral economist Robert J. Shiller, of Yale.)

Ironically, the existence of formal models based on this misconception of human behavior is what gives economics its reputation as the most powerful of the social sciences—powerful in two distinct ways. The first way is indisputable: of all the social scientists, economists carry the most sway when it comes to influencing public policy. In fact, they hold a virtual monopoly on giving advice. Until very recently, other social scientists were rarely invited to the table; and, when they were invited, they were relegated to the equivalent of the kids’ table at a family gathering.

The other way is that economics is also considered the most powerful of the social sciences in an intellectual sense. That power derives from the fact that economics has a unified, core theory from which nearly everything else follows. If you say the phrase “economic theory,” people know what you mean. No other social science has a similar foundation. In fact, economists often compare their field to physics; like physics, economics builds from a few core premises.

The core premise of economics is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one that it can afford. Furthermore, the beliefs upon which Econs make choices are assumed to be unbiased. That is, we choose on the basis of what economists call “rational expectations.” If people starting new businesses on average believe that their chance of succeeding is 75 percent, then that should be a good estimate of the actual number that do succeed. Econs are not overconfident.

This premise of constrained optimization, that is, choosing the best from a limited budget, is combined with the other major workhorse of economic theory, that of equilibrium. In competitive markets where prices are free to move up and down, those prices fluctuate in such a way that supply equals demand. To simplify somewhat, we can say that Optimization + Equilibrium = Economics. This is a powerful combination, nothing that other social sciences can match.

There is, however, a problem: the premises on which economic theory rests are flawed. First, the optimization problems that ordinary people confront are often too hard for them to solve, or even come close to solving. Even a trip to a decent-sized grocery store offers a shopper millions of combinations of items that are within the family’s budget. Does the family really choose the best one? And, of course, we face many much harder problems than a trip to the store, such as choosing a career, mortgage, or spouse. Given the failure rates we observe in all of these domains, it would be hard to defend the view that all such choices are optimal.

Second, the beliefs upon which people make their choices are not unbiased. Overconfidence may not be in the economists’ dictionary, but it is a well-established feature of human nature, and there are countless other biases that have been documented by psychologists.

Third, there are many factors that the optimization model leaves out, as my story about the 137-point exam illustrates. In a world of Econs, there is a long list of things that are supposedly irrelevant.

No Econ would buy a particularly large portion of whatever will be served for dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant in choosing the size of your meal for Tuesday. An Econ would not finish that huge meal on Tuesday, even though he is no longer hungry, just because he had paid for it and hates waste. To an Econ, the price paid for some food item in the past is not relevant in making the decision about how much of it to eat now.

An Econ would also not expect a gift on the day of the year in which she happened to get married, or be born. What possible difference can a date make? In fact, Econs would be perplexed by the entire idea of gifts. An Econ would know that cash is the best possible gift; it allows the recipient to buy whatever is optimal. But unless you are married to an economist, I don’t advise giving cash on your next anniversary. Come to think of it, even if your spouse is an economist, this is probably not a great idea.

You know, and I know, that we do not live in a world of Econs. We live in a world of Humans. And since most economists are also human, they also know that they do not live in a world of Econs. Adam Smith, the father of modern economic thinking, explicitly acknowledged this fact. Before writing his magnum opus, The Wealth of Nations, he wrote another book devoted to the topic of human “passions,” a word that does not appear in any economics textbook. Econs do not have passions; they are cold-blooded optimizers. Think of Mr. Spock in Star Trek.

Nevertheless, this model of economic behavior based on a population consisting only of Econs has flourished, raising economics to that pinnacle of influence on which it now rests. Critiques over the years have been brushed aside with a gauntlet of poor excuses and implausible alternative explanations of embarrassing empirical evidence. But one by one these critiques have been answered by a series of studies that have progressively raised the stakes. It is easy to dismiss a story about the grading of an exam. It is harder to dismiss studies that document poor choices in large-stakes domains such as saving for retirement, choosing a mortgage, or investing in the stock market. And it is impossible to dismiss the series of booms, bubbles, and crashes we have observed in financial markets.

We need an enriched approach to doing economic research, one that acknowledges the existence and relevance of Humans. The good news is that we do not need to throw away everything we know about how economies and markets work. Theories based on the assumption that everyone is an Econ should not be discarded. They remain essential as starting points for more realistic models. And in some special circumstances, models of Econs may provide a good approximation of what happens in the real world.

Moreover, much of what economists do is to collect and analyze data about how markets work, work that is largely done with great care and statistical expertise; and importantly, most of this research does not depend on the assumption that people optimize. Two research tools that have emerged over the past twenty-five years have greatly expanded economists’ repertoire for learning about the world. The first is the use of randomized-controlled-trial experiments, long used in other scientific fields such as medicine. The typical study investigates what happens when some people receive some “treatment” of interest. The second approach is to use either naturally occurring experiments (such as when some people are enrolled in a program and others are not) or clever econometrics techniques that manage to detect the impact of treatments even though no one deliberately designed the situation for that purpose. These new tools have spawned studies on a wide variety of important questions for society. The treatments studied have included getting more education, being taught in a smaller class or by a better teacher, being given management consulting services, being given help to find a job, being sentenced to jail, moving to a lower-poverty neighborhood, and receiving health insurance from Medicaid. These studies show that one can learn a lot about the world without imposing optimizing models, and in some cases provide credible evidence against which to test such models and see if they match actual human responses.

For much of economic theory, the assumption that all the agents are optimizing is not a critical one, even if the people under study are not experts. Economists get in trouble, though, when they make a highly specific prediction that depends explicitly on everyone being economically sophisticated. If you believe that everyone will save just the right amount for retirement, as any Econ would do, and you conclude from this analysis that there is no reason to try to help people save (say, by creating pension plans), then you are passing up the chance to make a lot of people better off. And, if you believe that financial bubbles are theoretically impossible, and you are a central banker, then you can make serious mistakes—as Alan Greenspan, to his credit, has admitted happened to him.

We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior, and stop basing policy decisions on such flawed analyses. And we have to start paying attention to those supposedly irrelevant factors, what I call SIFs for short.

For years, many economists strongly resisted the call to base their models on more accurate characterizations of human behavior. But thanks to an influx of creative young economists who have been willing to take some risks and break with the traditional ways of doing economics, the dream of an enriched version of economic theory is being realized. The field has become known as “behavioral economics.” It is still economics, but it is economics done with strong injections of good psychology and other social sciences.

The primary reason for adding Humans to economic theories is to improve the accuracy of the predictions made with those theories. But there is another benefit that comes with including real people in the mix. Behavioral economics is more interesting and more fun than regular economics. It is the un-dismal science.

Richard H. Thaler is Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics.

Reprinted from Misbehaving: The Making of Behavioral Economics, by Richard H. Thaler. Copyright 2015 by Richard H. Thaler. With permission of the publisher, W. W. Norton & Company, Inc. All rights reserved.