In a previous post I proposed that irrational economic (and politico-economic) behaviour might, in some instances, be best understood in terms of reference to Jungian archetypes. It has been suggested that my proposal is not necessarily original, and that behavioural economics has already explored various ways in which decision-making departs from the strict rationality assumed in theoretical models based on the idea of homo economicus.
The optimising behaviour patterns of homo economicus, both as a consumer and producer, are deeply embedded in economic theory but have been challenged as departing from real-world behaviour in various ways. I take the view that many of these ‘departures’ are not necessarily irrational.
Heuristics, taking rule of thumb short-cuts in decision-making, is a starting point. Herbert Simon drew a distinction between ‘Economic Man’ and ‘Administrative Man’, arguing that the latter, working in firms and other organisations, confronted by overwhelming quantities of information, finds it impossible to assess and evaluate all available options. Instead, individuals and groups fall back on a process of ‘satisficing’ – making uncontroversial decisions that reflect mainstream thinking and feel plausibly safe. The process is neatly instantiated by a piece of managerial folklore from fifty years ago – ‘Nobody ever got fired for choosing IBM’. In effect, satisficing represents a highly rational response in (commonplace) situations where decisions need to be taken quickly and effectively. Nor should we accept Simon’s assumption that satisficing is somehow restricted to decision-making in a corporate context. It is equally rational for the individual consumer, Simon’s ‘Economic Man’, is similarly confronted by a bewildering array of choices. The response is encapsulated in the Hindi term Chalta Hai – a kind of ‘that’ll do’ approach to getting things done when strictly rational decision-making can be tantamount to paralysis. In a nutshell, it is perfectly rational to optimise use of time by taking non-optimal decisions: “In an information-rich world, the wealth of information means a dearth of something else: a scarcity of whatever it is that information consumes. What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention and a need to allocate that attention efficiently among the overabundance of information sources that might consume it. “
Simon’s work represented an empirical challenge to mainstream economic theory’s assumption of profit maximising behaviour. The challenge was amplified and extended by Kahneman and Tversky’s ‘Prospect Theory‘ (characterised as an ‘Analysis of Decision-Making Under Risk’), and then further extended by Richard Thaler and others. Framing, Reference Dependence and Loss Aversion form a basis in behavioural economics for demonstrating how consumer behaviour does not conform to mainstream economic theory’s assumptions about ‘rational’ utility maximisation. These ideas demonstrate that consumers tend to fix on a particular status quo as a starting point for assessment of choices, and then display an aversion to the possibility of losses in making their decisions. The starting points, the status quo, might be arbitrary and not based on a fully rational analysis, and the possibility of losses may may be greatly outweighed by the possibility of gains. Nevertheless, consumers show a pronounced ‘status quo bias’ in Thaler’s terminology. These tendencies are further amplified by consumer tendencies towards non-linear probability weighting (overweighing small and underweighing large losses and gains), and a diminishing sensitivity to gains and losses.
Are these phenomena necessarily irrational? They might be seen to be such where rational behaviour is defined strictly in terms of maximising financial benefit, but is that the same as maximising utility? Rather than challenging the assumption of consumer/producer rationality, behavioural economics gives us a clearer picture of how that rationality works in terms of utility maximisation. I would argue that, in general, individuals and firms tend to attach a higher utility to ‘peace of mind’ and, as a result, they are not behaving irrationally when making decisions that might appear to be non-optimal from a purely financial perspective.
Behavioural economics has also been applied to the working of investment/financial markets. Bubbles and crashes have been part of the picture for as long as investment markets have existed. Keynes attributed these (sometimes wild) swings to ‘animal spirits’ on the part of investors, and his insight has been developed quite rigorously by Robert Shiller, whose analysis of ‘irrational exuberance’ demonstrates systematic over-pricing in housing and stock markets. Shiller’s analysis is mainly targeted at the ‘efficient-market hypothesis‘, but it does call into question the idea that movements in asset prices have a rational basis. Shiller’s work is reinforced by Thaler’s instantiation of asset pricing in ETFs that is demonstrably out of kilter with the underlying value of fund components – sometimes based merely on fund nomenclature. However, once again I would question whether these effects are necessarily irrational: is it rational to be ‘irrational’ when everybody else is being irrational? Price movements in asset markets can be a source of substantial profit, so it may be highly rational to follow an ‘irrational’ trend. Furthermore, if investors derive utility from peace of mind, then running with the herd could be regarded as the most rational of courses.
- Behavioural economics challenges a series of assumptions that became embedded in mainstream economic theory: individual consumers seek to maximise their utility in a purely financial context; managers seek to maximise profit; investors seek to maximise their financial returns; the efficient-market hypothesis assumes that all relevant information is encoded in market prices.
- Behavioural economics is broadly successful in making this challenge, but in doing so it only demonstrates that the model of rationality governing homo economicus’s decision making as assumed in mainstream economic theory does not hold.
- In effect, behavioural economics gives us a more accurate insight into how homo economicus’s concept of utility is constructed, and how that utility is maximised in practice.
- This does not entail irrationality, but rather gives us a more accurate picture of how rationality is constructed and actually operates for economic agents.
- Behavioural economics, as it has been developed to date, does not in any way explain or account for the kind of irrationality that I have attempted to explore through the concept of Jungian economics.
- Conan Doyle’s irrationally rational costermonger
In The Adventure of the Blue Carbuncle Sherlock Holmes needs to extract a vital piece of information from an intransigent costermonger. Holmes extracts the information by betting the costermonger a pound, and then explains to Watson “I daresay that if I had put £100 down in front of him, that man would not have given me such complete information as was drawn from him by the idea that he was doing me on a wager.” Is the costermonger irrational, or does he simply gain greater satisfaction (higher utility) by winning the bet?
2. Robert Shiller’s Narrative Economics
Published in 2019, Shiller’s book is enormously insightful and truly original. He explores the way in which economic narratives drive economic behaviour and decision-making. Shiller’s ‘narratives’ have a similarity to emergent urban myths. Of course, myths often act as the bearer of archetypes, and I am therefore intrigued by possible connections with JUngian economics. My hunch is that Shiller’s thinking and my own may be convergent. I’ll write more on this at greater depth at some future point. However, one aspect of Narrative Economics is remarkably unusual – it is not often that Nobel Laureates produce their most original and insightful work after being awarded the prize. Shiller seems to have succeeded in this.