Making economics even better Economics

Making economics even better

Economics isn't a finished product. It's evolving and moving forward. Right now it's incorporating a more sophisticated psychology. Matthew Rabin of Berkeley has been an important figure in this process. Here's an interview with Rabin on what psychology has to offer. Key economic approaches are kept:

" Q: Economists usually assume that each person knows what she wants, and that these preferences don't conflict with each other and don't change much over time, and that s/he "rationally maximizes" those preferences. What have we learned from Psychological Economics that challenges this? Have you found that this isn't necessarily true? No, virtually all of that is substantially true, and nothing in my work, or that of other behavioral economists, says that this is not true. It's just not the whole truth. The pioneers of Psychological Economics, people like (Danny) Kahneman and (Amos) Tversky, thought people were very rational, that virtually all human decision making and judgement is driven by reasonable heuristics-people trying to be smart, trying to think intelligently about what they're doing, but in certain types of things people screw up and make mistakes."

So economists are right that people behave purposefully - but their psychological premises are incomplete or mistaken. That means that models can't explain a lot of things that are really interesting - or get things wrong.

"Q: There is another area that you are looking at-how people systematically evaluate their self-interest differently from the way we might think they do. The time-preference, self-control issue, is an area that I'm working on with Ted O'Donoghue. In many ways it may be the most active area for research in economics because it's been formalized. We're starting to understand some of the principles, and it's so right. The phenomenon is about how we trade off well-being one day to the next. When those two days are today and tomorrow, we care a whole lot more about our well-being today than we do about our well-being tomorrow. But you wouldn't say to yourself "Hmm, I could do something 300 days from now or I could do something 301 days from now. Sure it would be a little bit more effort if I did it 301 days from now, but I really don't feel like doing it 300 days from now." People don't think like that. Three hundred days from now and 301 days from now are the same, as far as you're concerned. But if you were choosing between today and tomorrow, even though you know it may be a little bit more effort if you put if off until tomorrow than it would be if you did it today, you still have this gut instinct to put if off until tomorrow, or if it's some pleasurable activity, you have a tendency to do it today.
We call this "time inconsistent preference," and it's hard to convey how categorically, how unambiguously economists have been wrong about this. Economists have assumed a time-consistent discounting, that to whatever degree we care more about today than tomorrow, we care that same amount more about 7 days from now than about 8 days from now. Every single study done by psychologists, studying humans, rats, pigeons, always shows this other kind of discounting, this hyperbolic discounting which captures time-inconsistent preferences, the fact that we care much more about today than tomorrow, that that's a bigger difference to us than how much more we care about 7 days from now vs. 8 days from now. This alternative notion about the way people discount pleasures and pains and make trade-offs between time periods has been formalized and, as you might think, it matters immensely in economics.

Q: This seems to go against the whole notion of a constant discount rate, which we apply as a constant over as long a time period as we want.
The notion that the discount between one day and another is independent of whether that day is now or in the future is just wrong. The idea of time inconsistent behavior can help explain credit card behavior which, if you look at the data on credit card behavior in the United States, is nuts. (We as economists are trained not to be judgmental about people's behavior, but the amount of interest people pay on their credit cards is nuts.) The amount of debt Americans have, and the amount they're paying interest on, is truly phenomenal. There's a trillion dollar industry in people making these very weird tradeoffs, people paying 18 or 19% interest on these debts, implicit in which is this tremendous time preference for consumption now versus later that is not consistent with people's own long-run preferences. People don't wish upon themselves that they be borrowing so much in the future, and they probably swear to themselves that they'll stop doing this. This can help explain that type of behavior and, more generally, the consumption-savings tradeoff--why people arguably save too little."

The site with the interview has links to a lot of Rabin's papers. You may also want to try Rabin's home page. I learned about this from Tyler Cowen.