Wednesday, February 14, 2007

Akerlof and Behavioral Economics

The Economist's Free Exchange has an article about behavioral economics. Behavioral economics is a fascinating field that demonstrates how human behavior can deviate from the model of a "rational actor". I always felt though, as many do, that the proponents of Behavioral economics go a bit overboard - many say that Behavioral economics refutes the basis of the economic orthodoxy and that the work done in the field of economics over the last three centuries is therefore largely built on sand. True economics, they say, would be centered on how people actually act, instead of simplifying human beings into rational, utility maximizing creatures.

I always brushed aside this criticism. For me, Macroeconomics was always just a model. In a field like physics, it is largely understood that certain concepts - energy, force, gravity are just simplified models what the world actually is that are created in order to better understand how the world works. A model airplain is nothing like a Boeing 747, but you can learn a whole lot about Aerodynamics from watching the thing fly.

So I always thought Behavioral economics was an interesting exercise in Microeconomics, with little application to actual policy.

Then I read George Akerlof's Missing Motivations in Macroeconomics. It is, in a word, brilliant. Robert Lucas's (now discredited) theory of Rationas Expectations gained a whole lot of noteriety in the 1970s because it unified commonly accepted theories in Microeconomics with Neoclassical Macroeconomics. Akerlof, in the same way, unifies Neo-Keynesian economics with the findings of Behavioral economics.

Read the paper. It's highly readable and no snippet could do it justice.

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