Behavioral Economics: 2 different streams of thought

Studying Behavior economics/finance is really interesting.  Unlike economics, which looks at rational behavior and builds models, BE/BF looks at irrationality and builds models around it.

I came across this superb paper by Floris Heukelom (University of Amsterdam, and Tinbergen Institute), which summarises the works of the leading economists in the field and also neatly seperates the two mainstream thinking in BE/BF.

The paper tells me that Russell Sage Foundation has been funding most of the research in BE. There are 7 leading thinkers:

  1. Daniel Kahneman (Princeton, Nobel Laureate 2002)

  2. Amos Tversky, (Stanford, died in 1996)

  3. Richard Thaler, (Univ of Chicago)

  4. Colin Camerer, (California Institute of Tech)

  5. David Laibson, (Harvard)

  6. George Loewenstein, (Carnegie Mellon) and

  7. Matthew Rabin (Univ of California, Berkeley, Clark Medal Winner 2001)

(Kindly note: All seven are from different Universities in US  a hallmark of excellence of US higher education system.)

Read their work in the paper. However, what interested me was that at the end, the author explains that there are 2 disitinct streams of thought emerging in BE/BF: 

  • The first theoretical branch is organized around the work of Tversky, Kahneman and Thaler. It argues that the uncertainty the individual is faced with is of a fixed, or exogenous nature. This uncertainty can be found in the flipping of a coin, the weather broadcast for tomorrow and disposable income five years hence. The theory to analyze this decision behavior under uncertainty is decision theory. Behavioral economics of the first branch favors Kahneman and Tversky’s normative-descriptive distinction. Normative here is best understood as the objective, psychophysical benchmark with which the researcher compares human behavior. Following Kahneman and Tversky, the first branch of behavioral economics strives to build a descriptive theory of individual human decision behavior under exogenous uncertainty.

  • The second branch of behavioral economics is organized around Camerer, Loewenstein, and Laibson. It considers the uncertainty of the decision behavior to be of an endogenous or strategic nature. That is, the uncertainty depends upon the fact that, like the individual, also the rest of the world tries to make the best decision. The most important theory to investigate individual decision behavior under endogenous uncertainty is game theory.The second branch of behavioral economics draws less on Kahneman and Tversky. What it takes from them is the idea the traditional Samuelson economics is plainly false. It argues, however, that traditional economics is both positively/descriptively and normatively wrong. Except for a few special cases, it neither tells how the individuals behave, nor how they should behave. The main project of the second branch is hence to build new positive theories of rational individual economic behavior under endogenous uncertainty. And here the race is basically still open.

Hmm, I didn;t know this at all. Just glancing over work by Rabin, Lowenstein tells me there are exciting times ahead for economists. But much will depend on how the leading researchers in the field shape future perspectives. I agree a lot to with what the author ends the paper with:

As far as the rest of the economic community is concerned, it may be guessed that as long as behavioral economics does not have a theory for market behavior and macroeconomic phenomena, it will at most be integrated with existing theories.

Nice read.

4 Responses to “Behavioral Economics: 2 different streams of thought”

  1. Central banks need to apply behavior economics « Mostly Economics Says:

    […] I always believe BE/BF can help us understand many a challenges in a better manner. It just needs better models and applications, which is being worked on by a few economists. […]

  2. Using behavioral economics to improve regulation « Mostly Economics Says:

    […] came across this superb paper from the Behavior economic stalwarts- Colin Camerer, Matthew Rabin, George Loewenstein and others. In this paper, they show how BE can […]

  3. Have economists moved from Homo Economicus to Homosapiens « Mostly Economics Says:

    […] There are many economists working on behavioral economics (see a profile of leading BE economists here) and Boston Fed has even set up a centre on research in the field (see […]

  4. The case of Missing Markets and behavioral economics « Mostly Economics Says:

    […] to address problems in markets, for policies etc. But times are changing. Thanks to persistence of some beautiful minds, it is being seen as a vital reason for missing […]

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