Someone Give this Rational Agent a Heart!

Economics as a discipline is a victim of huge misunderstanding. We are seen to be obsessed about utility maximization, profit maximization, efficiency and equilibria (to name a few among the many words in the economist’s vocabulary that appear to degenerate human behavior into some egotistical mathematical equation!). These perceptions are mostly true; however, the misunderstanding lies within the economist’s relationship with the homo economicus. Most people would think that economists are in love with the rational but fictional economic man.  However the truth is that economists are in some twisted love-hate relationship with this agent.

Economists love the rational agent, because it gives us an intuitive and powerful basis on which we can describe behavior. Economists hate the rational agent because he falls short of reality and is constantly under a siege of criticism from other economists and/or other stakeholders of economic theory. How can economists alleviate the shortfalls of the rational agent, so he can better represent reality? Behavioral economics.

Behavioral economics attempts to integrate insights from psychology with insights from neo-classical economic theory. Although the term ‘behavioral economics’ is quite unfamiliar to many, one must realize that economics and psychology have never been completely unrelated (a classic example of the relationship between economics and psychology would be Adam Smith’s “The Theory of Moral Sentiments”).

In more detail, the theory modeling behavior in economics has these characteristics: the agent maximizes some utility function using (in some appropriate way) all information that is available to him, he is affected only by his own payoffs and his decisions are temporally consistent.

A quick reality check should raise some eyebrows about these assumptions. For example, don’t we all sign up to the gym, thinking we will exercise every day, eventually offsetting the hundreds of dollars we spend on membership?  Don’t we procrastinate on Facebook for way too long, instead of writing that article due tomorrow? (sounds strangely familiar!).

An example would be the economics of altruism, which to some extent ameliorates the misunderstandings the discipline of economics faces. Altruism at a first glance seems somewhat misplaced in the aforementioned economist’s vocabulary, but in theory there is nothing that stops an agent’s utility function to be a function of another agent’s utility. In other words, a perfectly rational agent can also be altruistic, he can be motivated to give and donate, and while doing this he will be maximizing his own utility! This relatively minor adjustment to a rational agent’s utility function helps us (partly) explain the dynamics of charitable giving and altruism that would have been largely ignored in the neo-classical economics literature despite its obvious presence in reality.

Of the many examples from the field and laboratory that provide a case for deviation from the standard modeling assumptions there are issues such as: optimism and over confidence in beliefs, time-inconsistent decision paths and menu effects.

Behavioral economics is like adding the bells and whistles to your ordinary economic model. These bells and whistles help bring economics one step (perhaps quite a small step) closer to reality, and hopefully it will provide the rational agent the emotions and realism it has so often been accused of lacking.