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Wednesday 22 December 2010

Economics & Psychology: The Divorce

Self-Interest’s Not Interesting

For a long while economists worked hard to cleanse their subject of any trace of psychology which, on the face of it, was rather odd as the main assumption for the subject is that people act in their own self-interest, a psychological principle if there ever was one. The argument in favour of such an approach is that it doesn’t really matter whether the assumption of self-interest is true or not as long as the reality is matched by the theoretical predictions.

Well, as we know, the reality has a nasty tendency to go off and do its own thing and the idea that economics can exist without taking account of psychology has taken a beating in recent years. What’s odd, though, is that the idea was ever even considered. Understanding why that happened is a critical step in creating a new economics, one that actually has some genuine predictive capacity and which can avoid screwing up the world in its efforts to get economists invited to all the best parties.

Hedonic Utility

As described in On Incentives, Agency and Aqueducts the idea that self-interest drives individuals is the core concept in economics. The goal of this self-interest varies according to whom you talk to but trace the history back long enough and it came down to maximising pleasure and minimising pain, the pleasure-pain principle: otherwise known as hedonism. Economists, as we know well, relate this to maximising utility and early economists linked the psychological concept of hedonism to the economic concept of utility. Hence: “hedonic utility”.

Out of this principle economists like Francis Edgeworth and William Stanley Jevons built a version of economics modelled on physics: in any exchange people aim to maximise their hedonic utility and in doing so free markets and competition give rise to the basic principles of economics: the Law of One Price, equilibrium laws of supply and demand and so on and so forth. This was a version of economics built out of a psychological model of human behaviour that existed around the end of the nineteenth century. So how did economics get from this state to one in which it flatly denied the existence – or at least the importance – of human behaviour?

Well, to put it simply, psychology happened.

Psychology Attacks

Economics predates psychology as an independent subject by a hundred years or more. We can comfortably class Adam Smith of the middle eighteenth century as an “economist” but the first recognisably modern psychologists didn’t appear until the end of the nineteenth century. And when they did they immediately started pointing out flaws in the economists’ behavioural models.

The idea that people were solely interested in themselves and then only in terms of hedonic utility was soundly rubbished by William James in 1890:
“So widespread and searching is this influence of pleasures and pains upon our movements that a premature philosophy has decided that these are our only spurs to action, and that wherever they seem to be absent, it is only because they are so far on among the 'remoter' images that prompt the action that they are overlooked … However the actual [mental] impulsions may have arisen, they must now be described as they exist; and those persons obey a curiously narrow teleological superstition who think themselves bound to interpret them in every instance as effects of the secret solicitancy of pleasure and repugnancy of pain.”
Economics Hides

One telling reaction by economists, in lieu of anything better, was to ignore the evidence from psychology. Eventually, though, their more ongoing and balanced approach was to develop an economics that actually set out to expunge any trace of human motivation or emotion and tell the psychologists to get stuffed. Now granted, this sounds odd, but it has to be put in the context that psychology spent half of the last century pursuing the same goal, through Watson and Skinner’s behaviourist approach.

Behaviourists argued that all that mattered for psychology was peoples' observable behaviour en-masse and that their internal state of mind was invisible, unmeasurable and therefore unimportant. This idea that only quantitative, measurable criteria counted was, of course, taken from the hard sciences: no chemist ever worried about the mental states of a carbon atom. For a long while no psychologist worried about the mental states of a human being.

Pareto’s Ordinal Utility

Economists similarly set out to focus on external behaviours, by looking at what choices people made rather than trying to discern why they made them, and by proceeding on the basis that everyone follows their own desires, whatever they may be. There’s a curious circularity in this approach – if you start by assuming that people are acting in their own self-interest and then measure them as though they are you end up with a subject that’s at grave risk of disappearing up its own orifice.

So just as Skinner focused on measuring what people did without wondering why they did, and therefore why at some point in the future they might not, economists started looking at what people actually did, when given choices. Perhaps the main proponent of this view was Vilfredo Pareto who developed a theory of ordinal utility where what mattered was the relative demand between bundles of goods. This relationship is often represented in terms of indifference curves which aim to explain why consumers will choose between any two consumer goods given a specific budget.

“Ordinal” here is opposed to “cardinal”. Cardinal utility presupposed that you can measure the difference in utility between bundles. Ordinal utility only requires that we rank them in preference order. When you're dealing with something you can't even define the difference between measuring and ranking is everything. At any point in time I know whether I prefer snails to burgers, but I can't tell you by how much.

The Economics of Snail Eating

The critical thing about this line of reasoning is that it allowed economists to analyse why a rational consumer would make choices based on utility without needing to actually measure the amount of utility involved – or understanding what “utility” actually was, an important point now that hedonism was ruled out on the grounds of being too close to psychological principles. This idea subsequently evolved into revealed preference theory which, as we described in Gross National Happiness, allows the underlying preferences to be discovered by looking at what people actually do without, of course, attempting to understand why they do this.

Taken to its extreme this suggests that if I go to a restaurant and order flambéed escargot then the next time I arrange to visit, if the menu hasn’t changed, the chef should be revving up the snail burners before I even get there. I have revealed my preferences, maximised my utility and rationally I have no reason to change my mind.


Which, of course, means that when I actually ordered a burger and fries I completely wrecked the whole of classical economics, as well as sending the maître d’ into a whirl. Naturally, such an observation wasn’t beyond many of the remarkably clever people involved in developing these theories but allowing such evidence to stand would, of course, have re-introduced the idea of mental processes back into economics and, frankly, burgered up the whole thing.

As this paper by Shira Levin, which offers a far more comprehensive review of the whole sorry story, concludes:
“By declaring independence from psychology economists evaded institutionalist criticisms and redefined their position so as to make it explicitly irrefutable and tautological. People chose what they wanted and what they wanted was defined to be what they chose. The theory said no more and, therefore, it could not be falsified”.
Psychology's Cognitive Revolution

By this point, mid way through the twentieth century, a number of psychologists were beginning to have grave doubts about the behaviourist agenda in their subject. In particular Noam Chomsky ripped apart Skinner’s analysis of language acquisition, arguing that behaviourist type reinforcement couldn’t possibly explain the lexical explosion seen in young children as they develop speech: there had to be some internal mental structures to start with. As Chomsky argued:
“The fact that all normal children acquire essentially comparable grammars of great complexity with remarkable rapidity suggests that human beings are somehow specially designed to do this, with data-handling or "hypothesis-formulating" ability of unknown character and complexity”
Chomsky’s arguments kick-started a cognitive revolution in psychology as researchers started to attempt to peer inside the mind and to analyse why we make choices. At more or less the same time some economists began asking some awkward questions.

Economics' Cognitive Revolution

Firstly Herb Simon pointed out that expected utility theory offered an impossible model of a perfectly rational human being, something likely to be unrealistic given limited brain power. Secondly Maurice Allais showed people’s preferences were affected by the uncertainty of the choices, even when the actual risks were unaltered, an anomaly within the mainstream.

As it happened the world’s economy had entered a period of unusual calm in the wake of the Second World War and in those circumstances the empirical evidence of the actual markets supported the theories of the mainstream economists. As is so often the case it took a major external shock to force people to revisit their assumptions and to start thinking seriously about Simon's bounded rationality and the evidence of the Allias Paradox.

As we'll see, in Part 2 of this essay, Economics & Psychology: Reconciliation? where psychology led, economics was about to follow, into its own cognitive revolution, but in a uniquely off-key fashion.

Related articles: On Incentives, Agency and Aqueducts, Gross National Happiness, B.F. Skinner's Stockmarket Slot Machines


  1. You're not allowed to tell the truth about our economic troubles in public comments, Tim. Did you not get the memo?


  2. Divorce is a concept that is all too common in America today. In fact, more than half of the marriages in this country end in divorce. Psychologists and other mental health professionals are inundated with this startling and troublesome statistic. One of the major reasons divorce has become so popular is that it has become so easy and socially acceptable to get one.