In recent years, there has been a challenge to the classical economist’s interpretation of market behavior. From the earliest times of the field of economics, there has been proposed the existence of homo economicus, that is, the “economic man”, a being who is driven by self-interest to find the most efficient and cheapest way to fulfill his own needs and desires. The underlying premise is that humans are rational beings in their pursuit of self-interest.
More than a century after the founding of this American economic theory, championed by John Stuart Mill who built upon the prior work of such great thinkers as Adam Smith and Aristotle, we now find that the premises may have been fundamentally flawed. Rational behavior is presumed by rational thinkers who may not be themselves consumed in the irrationality which they are blind to observing.
Current research in “behavioral economics” and “neuroeconomics”, two new fields, study the physiological bases of human behavior associated with the economic decisions that are observed. The research results of these developing fields are more accurate in describing how a supposedly rational actor can make catastrophic decisions such as those found in our economic crises currently playing out.
For example, classic economic theory says that homo economicus will apply knowledge of market information to balance risk with reward, resulting in investments that yield returns most favorable of those to choose from, and thus the price of those investments will hover around the price which represents all the available information about the investment’s risk and potential reward. This is the concept of “efficient” markets. If this were true in practice, there never would have occurred the “bubbles” that we know all too well can indeed arise, soon to pop. These “bubbles”, named after a famous such debacle from 18th century England, have occurred regularly through the history of human economics. Neuroscience is lending its research techniques to find out why.
For example, studies in brain imaging have identified a neural location that is active during economic decision-making, the ventromedial pre-frontal cerebral cortex (VMPFC). This is an area of the brain just behind the center of your forehead, on the inside surface of one cerebral hemisphere.
Another brain location that is involved is associated with greed. The nucleus acumbens lights up whenever a person demonstrates an appetite for money that is far beyond what is rationally necessary for long-term survival and procreation. Interestingly, the nucleus acumbens is also associated with sexual arousal.
Using the developing knowledge of correlations between brain function and observable behavior, researchers at the University of Bonn, Germany, and the California Institute of Technology presented subjects with a “money illusion”. They were placed in a condition of earning money and a level of ongoing costs associated. Then they were presented with a rise in their earnings, and a concomitant rise in costs of equivalent amount. The subjects who erroneously perceived the rise in income as a “gain” had a higher degree of activation of the VMPFC. The research suggests that people may be predisposed to some degree of irrational estimation of economic information. Other research on decision-making is also finding that emotional content is included in all acts of choosing. The myth of a rational actor in economics may be just that.
We’ve all observed herd behavior and joked about the lemming-like actions of others. And then we go about making decisions on investments or purchases that follows suit. For example, when the dot.com era was booming, I heard a lot of people deriding the notion that the “new economy” purported to not require profits. Then these same people would complain about missing out on the explosion of wealth. Many bright people chased the goose that left golden eggs in its waddling trail. The goose turned out to be a weasel in a down jacket.
The research in the neurological bases for irrational economic decisions is beginning to give us some tools for developing safeguards against our own dumb, emotional, animalistic impulses. If we can design tethers to limit the damage that cognitive bias, money illusions and emotion can cause in our otherwise rational economic decision-making, perhaps the free market can continue to fluctuate but without the extremes of its pendulum’s arc. I believe in a free market, just like I believe in my right to choose where and when I drive. I also believe in seat belts, operable brakes, headlights, etc.
Our current federal administration has seen fit to employ some of these behavioral economists in its efforts to solve our economic woes, to find and apply the principles of homo bulbous, the true species of economic human. It is interesting and novel that the Executive Branch should apply such sophisticated tools. Government isn’t often cited as the most advanced example of human evolution.