Behavioural economics is becoming increasingly fashionable. Does it represent a revolution in economic thinking? Or does it merely provide a few handy insights into the more irrational behaviours of individualsby Pete Lunn / September 28, 2008 / Leave a comment
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NO Tim Harford
Dear Tim 12th August 2008
These are exciting times to be an economist. The whirligig of international finance has come crunching to a halt. The British housing market inflated until we could hardly bear to watch, then popped in a destructive, sticky instant. The prices of food and oil are yo-yoing on speculative strings. And the textbooks still tell us that markets populated by rational, selfish, independent agents allocate resources efficiently.
Meanwhile, a revolution is under way in economic thought. Behavioural economics is no bell or whistle on the contraption of traditional economics; it is a big departure which will deliver a revolutionary new way of understanding the world. The founding assumptions of orthodox, neoclassical economics—that people can be thought of as rational, selfish and independent—are collapsing under the weight of empirical refutations.
Here is one example: the “ultimatum game,” which typifies the story of behavioural economics with a curious yet simple experiment. As you know, in this two-player game, the “proposer” is given a sum (say £10) on condition that he or she offers a proportion to the “responder.” If the responder accepts the offer, each player gets the amounts agreed. If he or she rejects it, both get nothing. Orthodox economics says players are selfish, and so predicts that the proposer will offer just a penny and the responder, preferring a penny to nothing, will accept. But this is not what happens. The most common offer is half the total sum, and offers of less than 30 per cent are almost always rejected. If the proposer’s offer is seen as unfair, the responder will decline free money.
What do you make of this violation of orthodox theory? In my experience, most economists argue that the proposer is currying favour, or that the responder will turn down a few quid for the sake of revenge. But the results described above hold when players are anonymous and when the sum involved is up to three months’ income. When offered unfair shares, we have a strong economic instinct to say: “you can keep it.”
This experiment reveals an instinct that might apply to any transaction where one side proposes the price or wage. So we might expect to see large deviations of prices and wages from their supposed equilibrium between supply and…