Economics is often viewed as a highly mathematical science and there are certainly many brilliant mathematicians who study economics. I argue, however, that economics is better understood as applied psychology. The question that economists strive answer is “How can we convince people to behave in such a way as to maximize the benefit to all?”. The focus on behavior is a direct link to the science of psychology.
A basic premise of many mathematical models is the concept of Homo economicus or Economic Man. First coined in the 19th century economic man is a being who is assumed to have complete knowledge, act rationally, and always act out of self-interest to maximize their personal “utility function”.
Under these assumptions, the math is valid but in reality Homo economicus does not exist. Humans rarely have complete knowledge, don’t always act rationally, many times are driven by forces other than self-interest, and in fact rarely understand what their utility function is let alone how to go about maximizing it. I argue that unless the behavioral part is correct, all the elegant differential equations in the world will be doomed to failure.
There are many reasons that certain aspects of psychology impact economics. Humans, in fact animals in general, will often emphasize short-term gain over long-term benefit. Lotteries often give winners the choice between an immediate cash payment or a much greater amount that gets disbursed over a long period of time. Almost everyone takes the immediate cash in contrast to the predicted actions of Economic Man and almost everybody would be better off if they had chosen differently. In the same way loggers might be tempted to clearcut an entire forest for immediate gain rather than harvest it sustainably over the long-term. In fact the focus of investors on immediate return on their money is an incredibly perverse incentive that leads to repeated cycles of boom and bust and ultimately a net decrease in the combined societal utility function.
Humans are emotional creatures with strong drives other than money. Anger, jealousy, love, religious fervor, etc can all cause people to act irrationally. It has been said that the true value of an engagement ring is that it is something that has absolutely no rational value to men. It is completely useless and thus has value to women in that it indicates that their boyfriend must be very much in love in love with them if they are willing to do something so costly and irrational. The physical needs of hunger, thirst, and pro-creation can also drive people to take their eyes off their personal utility function. The amount of irrational behavior undertaken by horny people is virtually unlimited.
Humans tend to be optimists, one might even say to have delusions of grandeur. They tend to think of themselves as smarter, stronger, and more responsible than they really are. One hundred million handgun owners will tell you that they are responsible law-abiding citizens protecting their families. Statistics show that they and their families are 4 times more likely to be fatally shot then non-gunowners so clearly many of them are wrong, but they all believe it. Studies indicate that 40% of Americans believe that they will be millionaires before they die but only 1% actually will. This irrationality permits a political environment far more amenable to the wealthy than otherwise. Likewise 47% of Americans earn so little that they are exempt from federal income taxes but only 20% of Americans believe that they are so there is a tendency to look down upon the “takers” in society that is far greater than can be supported by reality. Every high school sports star believes they can be a professional athlete but very few make it. One could go on and on. As a rule we are not as smart, creative, strong, responsible, and ethical as we believe we are, and other people are generally not as dumb, weak, irresponsible, and unethical as we perceive them to be. This discrepancy with reality leads to poor economic decision making.
The opposite side of the coin is fear. Just like we have inflated views of ourselves and the things we know best we are far more fearful of things that we are unfamiliar with than is justified. Every few years there is an outbreak of Ebola in Africa that kills 10 or 100 or so Africans and every year 36,000 Americans die of the flu but Ebola is more terrifying. You are far more likely to die of an illness contracted by a mosquito bite than a shark attack, even if you spent half your life in the ocean, but sharks terrify us. Your child is more likely to be crushed by a falling television than to be shot in school. In fact they are less than half as likely to be shot today than they were 20 years ago but every time there is a school shooting we react gutturally and emotionally and call for more laws to be enacted and resources to be spent while the TV gets ignored. Part of it is media-driven to be sure but most of it stems from our innate fear of the unknown that causes us to act irrationally.
Finally, although Homo economicus is assumed to act out of their own self-interest and not in service to others, there are many biological and psychological reasons why we might act in the service of others. History is full of people who sacrificed their personal health and wealth in the service of others. Even those among the vast majority who are not given to altruism may balk at doing something that causes immediate harm to others even if it is in their own best interest. Sadly, this shared virtue of empathy is lacking in a certain segment of the population. Even sadder is that many of these sociopathic personalities can succeed wildly in a capitalist economy precisely because they are unfettered by empathy, fear, stress, and other emotions. As a result they tend to have greater wealth, greater power, and consequently greater influence on our economy than the rest of us. Even if they are rare (and I suspect they are less rare than commonly thought), capitalism is so vulnerable to cheating that they can do incredible harm.
Economics as a science needs to do a better job at including IRRATIONAL human behavior in its mathematical models if it wants to improve its predictive value.