Abstract
Most predictions derived from economic theory are qualitative: if prices rise, the theory says that demand will fall, but not by how much. Some of the few exceptions to this rule occur when economic theory makes the strong prediction of a zero effect. For example, the way a problem is described or “framed” should have no effect on the choices people make. Decisions regarding the future should not depend on prior expenditures because those are considered “sunk costs”. In other cases, economic theory is just silent. For example, agents are assumed to optimize, regardless of the difficulty of the problem. Economic agents place chess and tic tac toe equally well: perfectly.
The inherent problem is that economists use a single model to both characterize optimizing behavior and also to predict actual behavior. This would be fine if all problems were as easy as tic tac toe and/or all economic agents were as clever as Ken Arrow or Paul Samuelson. But when actual human decision makers face difficult problems that are infrequent (saving for retirement, career choice, marriage, home buying) then behavior is not well described as optimizing. Unlike Milton Friedman’s imaginary billiards player, we don’t all play chess like Gary Kasperov or invest like Warren Buffett.
This discrepancy can be important in designing economic policies. Rather than simply assume everyone will choose optimally, policy makers can create environments that make it easy to find at least satisfactory solutions. Designing such policies requires recognizing the importance of seemingly irrelevant factors. Several economic policy problems will be discussed to illustrate these ideas.
Suggested Reading:
Richard H. Thaler. 2016. “Behavioral Economics: Past, Present, and Future.” American Economic Review 106(7): 1577-1600
