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Lecture 3 Evolution of BE

  • History of BE
    • Over a period of time, psychology lost its relevance in economics
    • Was not so much around in the 1970s
    • Has steeped in the past of economic thinking
    • It exposed some long-standing concerns in the past that the mainstream model couldn't explain

The Classical Tradition

  • Adam Smith (1723 - 1790)
    • He has commented on most things that we study in economics today
    • "...nothing new in economics; Adam Smith had said it all"
    • introduced imaginary machine
    • Smith was enlightened: principles of free markets
    • Greatest happiness in life didn't come from materialism, but also the companionship of fellow men and women
    • The Theory of Moral Sentiments (1759) is overshadowed by The Nature and Causes of the Wealth of Nations** (1776)
      • placed emotions at the center stage of human life
      • got lost in the later work of neoclassicals' work
    • How prudence and justice were important!
      • Prudence: natural tendency to look after yourself
      • Sympathy: far from rational, actions are influenced by the emotions of other people (the social view)
    • Justice system: deter wrong-doing and punish violators of social rules
    • Impartial spectator: an ideal person who would completely empathize with peoples' emotions
    • Need Virtue: Self-control
    • Form of morality that requires active deliberation
    • The smith view to a large extent is psychological
    • Wealth of Nations
      • Invisible Hand: efficient allocation, capitalistic (laissed faire, less regulated, free economy)
      • Self-interest serves to benefit the whole nation > It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, that we expect our dinner, but from their regard to their own interest
        • Classic example: All follow the left side for driving in India. Work for what suits your own welfare, but it contributes to everyone's safety.
      • Efficiency
        • Noted large efficiency by breaking down the production process into smaller chunks, each handled by a specialized/skilled personnel
        • Humble Pin factory: 18 separate production process. 1 to 20 pins a day per operative... division of labor turned it to 4800 pins a day.
  • Other classical Thinkers - David Ricardo (1722 - 1823)
    • Comparative Cost/Advantage
      • Contends that all countries have the potential to offer something of economic value to themselves and the rest of the world
    • Law of diminishing marginal returns idea
  • Other classical Thinkers - Jeremy Bentham (1748 - 1832)
    • Advocated Utilitarianism: greatest number should be the foundation of moral or legislation
    • Notion of Utility
    • Actions should be judged on the basis of consequences (utility)
  • Other classical Thinkers - Thomas Robert Malthus (1766 - 1834)
    • Relationship between population and the production of food
    • Principles of Population (1798)
      • If the supply of food increases (arithmetically) and if population increases faster (geometric)
      • Mankind is to live on the edge of starvation
      • Comfortable life => more reproduction => starvation => Back to normal => forget the past => comfortable life (repeats)
    • Interest in the sensitivity of people to incentives => nudging
  • Other Classical Thinkers - Jean-Baptiste Say (1767 - 1832)
    • Say's Law: "Build it and they will come"
      • If an expensive ship is built (The Titanic ship) then there will be some takers in the end of the day
      • Workers receive wage for labor
      • Use that money to purchase other goods
      • Increase in production => create demands for other goods in the economic => economic growth
      • Smith's economic machine in motion (self-interest)
    • Entrepreneurship
  • Other Classical Thinkers - John Stuart Mill (1806 - 1873)
    • Principles of Political Economy (1848) (classical economics was then known as political economics, they always have been closely related) based on Smith and Ricardo's work.
    • Developed the idea of "Opportunity cost"
    • Argued for the Ricardian principle of comparative advantage
    • Opportunity cost refers to utility of the best foregone opportunity (when you need to decide between action)

  • Other Classical Thinkers - Willian Stanley Jevons (1835 - 1882)

    • Significant contribution to the marginal view of economic behavior
    • Later formalized into Alfred Marshall's seminal Principles of Economics (1890) that contends that marginal utility decreases with further consumption (Diminishing Marginal Utility)

  • How did Psychology lose relevance in NM?

    • 20th century psychology had no tractable stuff (not much could be incorporated easily into formal economic models)
    • Freudian notion: Psychological ideas were many and varied... hard to distill them down to a set of assumptions/principles
    • Rejection of Psychology: Mathematics started dominating
  • Post-War Economic Approaches
    • First half of 20th century, some economists discussed psychological factors in their work: Irving Fisher, Vilfredo Pareto, and John Maynard Keynes
    • Keynes speculated stock market successfully
    • General trend to ignore psychology
    • Computers become more powerful: build math models of both markets and econ system as a whole... econometrics emerged: develop and test theories
    • Obsessed with mensuration - Greater rigor led to more "precise" results (if not accurate, cause they were deviating from actual results)
  • The Resurgence of Behaviorism in Economics
    • Herbert A. Simon viewed that standard approach is somewhat blinkered - He didn't accept the excuses about why the predictions were deviating from reality (temporary blips they said)
    • Simon emphasized in the understanding of behavior
    • Introduced the term bounded rationality
      • recognize cognitive limitations
    • Several seminal papers complemented Simons work (1950s and 1960s)
      • various anomalies in the NM
  • Birth of BE
    • During the 1970s important dev in field of psychology to establish foundations in BE
    • Heuristics & Biases program of Daniel Kahneman and Amos Tversky
    • At the end of 1970s, BE was born
    • Two main papers:
      • Prospect theory: Decision making under risk (1979) Kahneman and Tversky (Econometrica)
        • Heuristics and biases
        • Reference points, loss aversion, utility measurement , subjective probability judgements
      • Toward a theory of consumer choice (1980) Richard Thaler
        • Mental accounting
  • Further Progress in BE
    • Field has become a more respectable one
    • Different BE theories have quite conflicting beliefs regarding fundamental
      • Role and nature of assumptions
      • Kinds of empirical evidence
    • Not a single theory is able to explain all the observations... (individually good, but still incomplete on its own)