THINK LIKE AN ECONOMIST

MAKE SMART CHOICES: AN HISTORICAL INTRODUCTION

Let’s Review

We have proposed that one of the key parts in defining economics is CHOICE. That is, we must
make decisions. Individuals, both small and large businesses, governments, and societies all
make choices which are necessary because resources are scarce. And, when a choice must be
made, there is automatically a trade-off or an opportunity cost. In evaluating these trade-offs,
decision-makers will try to maximize their own utility or payoff and will weigh both positive and
negative incentives to achieve their selfish objective. And, they will behave rationally when
making this choice. What do we mean by rational? The decision-maker will follow a
logical, systematic process with the end goal of looking out for number one…themselves.

A Little History: Neo-classical vs Behavioral Approaches

The assumption that decision-makers are rational is the key trait that defines the Neo-
classical camp of economists. This assumption that decision-makers are rational maximizers--
like the Spock character from Star Trek-- can be traced back to 1776 and Adam Smith’s book
Wealth Of Nations which still forms the mainstream economic thinking presented in economic
textbooks today.

Historically, this rational optimizer assumption has been quite convenient for the neo-classical
believers. When optimization is the goal, the economist can then revert to Newton’s calculus to
predict outcomes. Even today a student of advanced economics courses will be required to use a
heavy dose of mathematics. The economist in academia love the use of higher mathematics to
prove their field of study as it makes them feel like real scientists such as physics, chemistry, etc.
In fact, you can get a Nobel Prize in Economics but you can’t get one for say Psychology which
is also a field of study that researches how people make choices. However, the field of
Psychology does not assume that people will be rational—in fact, they might actually assume
people are irrational. And, without the rational assumption you lose the certainty of mathematics
and something akin to Newton’s Laws. And, without the certainty, a field of study like
Psychology will not be considered a real science but instead a social science.

Now, can you imagine the fun in my office where I hang out with my colleagues teaching
Psychology? As an economics instructor, I can pump out my chest and raise my nose to claim
that I am superior because I can use complicated math to prove my theories. Predictably, this
arrogant approach invites closer scrutiny and by the 1970s experimental psychologists had
consistently shown in research that people were NOT always rational. This research eventually
formed the foundation of what we now call Behavioral Economics. Behavioral economists
suggested that decision-makers had bounded rationality. This assumption proposes that
although decision makers want to be rational and achieve a good outcome, either: (1) they
do not have the ability to complete the problem-solving process that Neo-classical theory
assumes—i.e. they lack the skills/education, (2) they are not willing to do so---i.e.
behaviorist call this limited reasoning or what I call being lazy.

Although the Neo-classical economists are very slow to give up their rational assumption, the
thinking of Behavioral Economics has continued to gain acceptance as the research from
experimental psychologists such as Dr. Daniel Kahneman continues to document many examples
of irrational behavior. Dr. Kahneman won a Nobel Prize in Economics for his research which
generated the foundation of his book Thinking Fast And Slow.

Personally, I believe the behavioral ideas must be considered when making decisions. I would
consider Dr. Kahneman’s book a required read for anyone who wants to become a better
problem solver and decision-maker. These ideas are especially helpful when considering choices
through a microeconomic lens. In addition, I believe we should consider ideas from the area of
social psychology. From this area of psychology, we know our interaction with others as well as
our role/position in society influences our own behavior as well as choices. Thus, it is helpful to
consider how these macroeconomic variables influence our choices. Unfortunately, in most
economic textbooks today, the vast majority of the material is still the Neo-classical theory while
the Behavioral material if covered at all might include only a paragraph.

Please don’t get me wrong. As I will share later, I believe the rational model is still a very good
process to try using if you want to enjoy greater success. In fact, the Think Slow part of Dr.
Kahneman’s book will also suggest the benefits of thinking rationally. However, as we will see,
the process of getting our brains to think rationally, rests with our skills in self-discipline to
overcome the natural tendency for most of us to make irrational decisions. In my experience,
part of the challenge in developing this self-discipline is to recognize that you are actually being
irrational. In order to make better choices, a good decision-maker should be self-aware about
where they are prone to make mistakes. Once you are brave enough to acknowledge
when/where you are prone to make errors, you can then derive strategies to stay away from those
error inducing environments.

Next Step

Against this historical background, we now need to start looking at ways some of the tools/ideas
from economics can help us improve our decision-making and choices. That is, How ToThink
Like An Economist.

We will start this next section by briefly reviewing the Behaviorist’s research on System One vs
System Two decision-making. After this review, we will proceed with a general review of
situations where many people make mistakes in their decision-process. If you are in a
Microeconomics course, we will focus more on Kahneman’s research and biases highlighting an
individual’s tendency to make decision errors. If you are in a Macroeconomics course, we will
highlight a few key ideas from social psychology where our decision to engage in trade forms
groups and helps define our role or comparative advantage in society which in turn influences
our biases, behaviors, and choices. We will see that these mistakes will happen when relying on
our System One thinking. With the acknowledgement of making mistakes, we also have the
opportunity to learn of ways we can get better choices. Dr. Kahneman refers to this as System
Two thinking which in my opinion dovetails quite nicely with the Neo-classical idea of rational
thought. Hopefully, by becoming aware of where we are likely to form biases and make decision
errors, we can learn how to utilize System Two style thinking to develop strategies to reduce our
chances of committing these errors.