Rational choice models, despite their mathematical elegance, couldn’t explain all real-world economic behavior. To some economists that meant that a different approach was needed, one that drew inferences based on careful observation of real-world behavior.

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Challenging basic assumptions

Of course psychologists, political scientists and anthropologists have been observing real-world behavior all along, so what was different about this new approach? Let’s pick up her history in the early 1960s and we will find out. At that time the economist named Vernon Smith was questioning some of the core assumptions of rational choice models, particularly as they applied to buying and selling within markets.

To Smith some of the assumptions just didn’t make sense. For example a common assumption was that people have complete information about the qualities of goods to be traded, about the rules of exchange and, well, about everything else. Complete information was thought to be necessary so that markets reach an equilibrium, the steady state in which buyers and sellers are matched in exchange freely with no shortages and no surpluses.

But people don’t have complete information, they don’t know everything about that is the decision situation and even if they did know everything there’s no guarantee that they would use that information efficiently. So Smith created markets in a laboratory, he could control what information people had and the rules of their interactions and then he could observe what happened, and he found something remarkable.

Experimental economics

Even though people didn’t have full information and they weren’t necessarily rational in their behavior his markets reach equilibria anyway, so one didn’t need rational individuals to explain rational markets. This sort of research simulation of markets within a laboratory came to be called experimental economics.

The key object of study for experimental economics is market performance: how markets behave given what individuals know and what they value, and in that domain experimental economics has been very successful as seen in the Nobel Prize awarded to Vernon Smith in 2002.

Behavioral economics

But, there was a second new direction for research that began in the 1960s. Around the same time as Smith early experiments some economists and some psychologists began to study individual choices in other contexts beside competitive markets. They wanted to better understand the biases and anomalies that shape decision-making and this new enterprise became known as behavioral economics.

Behavioral economics applies experimental methods from psychology and other social sciences the problems in economics. Importantly, it begins with observations about real-world behavior and then constructs models that can explain the behavior. That’s the opposite approach from traditional economics which begins with rational choice models and applies those models real-world behavior.

Most of the time the traditional approaches work

Remember the term rational and its opposite irrational often misinterpreted, rational doesn’t necessarily imply thoughtful, well reasoned or even good decisions, it just means consistent with some model,  and that some decisions seem irrational doesn’t mean that all of economics is called into question, it means that some specific aspect of economic theory, some assumption made about what people value can sometimes be incorrect.

I emphasize this point because it is very easy to become enamored with behavioral economics. Learning about the biases that shape our decisions can change the way you think causing you to seek irrationality everywhere, but most of the time we make pretty good decisions. Most of the time the traditional approaches in economics work just fine, but most of the time isn’t all of the time. That’s the key point!