Economics – The Neglected Department of Psychology

“It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as eventually his response aims.” – Ludwig von Mises

Economics – much to the detriment of economists – is just a branch of psychology. It is about individual behavior and with mass behavior. Many of its practitioners tried to hide its nature as a social science by applying complex mathematics, where common sense and direct experimentation would have yielded far better results.

The result has been an embarrassing divorce between economic theory and its subjects.

It is assumed that the economic operator is constantly engaging in the rational pursuit of self-interest. This is not a realistic model – only a useful approximation. According to this latter – rational – version of bleak science, people refrain from repeating their mistakes systematically. They are looking to optimize their preferences. Altruism can also be such a preference.

Still, many people are non-rational or only almost rational in certain situations. And the definition of “self-interest” as the pursuit of fulfillment of preferences is a tautology.

The theory fails to predict important phenomena such as “strong reciprocity” – the propensity to “irrationally” sacrifice resources to reward future partners and punish free riders. It even fails to account for simpler forms of apparent selflessness, such as mutual altruism (motivated by hopes of mutual benevolent treatment in the future).

Even the authoritative and mainstream 1995 “Handbook of Experimental Economics” by John Hagel and Alvin Roth (ed.) Admits that people do not behave in accordance with the predictions of basic economic theories, such as the standard theory of utility and the theory of general equilibrium. Annoyingly to economists, people change their preferences mysteriously and irrationally. This is called “preferential reversals”.

Furthermore, as is evident from their choices and decisions in carefully controlled experiments, people’s preferences are inconsistent. They tend to lose control of their actions or procrastinate because they place more weight (ie greater “weight”) on the present and the near future than on the distant future. This makes most people both irrational and unpredictable.

Either one cannot design an experiment to test sentences and assumptions in economics carefully and validly – or something is very lacking in the intellectual pillars and models in this field.

Neo-classical economics has failed on several fronts at the same time. This manifold failure led to despair and re-examination of basic commands and principles.

Consider this sample of outstanding issues:

Unlike other economic actors and agents, governments are given special status and receive special treatment in economic theory. The government is alternately cast as a saint who seeks to selflessly maximize social welfare – or as the villain who seeks to perpetuate and increase his power recklessly as per his. Public Electoral Theories.

Both views are caricatures of reality. Governments actually seek to perpetuate their threat and increase it – but they do most to redistribute income and rarely to self-enrichment.

Economics also failed until recently to explain the role of innovation in growth and development. The discipline often ignored the specific nature of knowledge industries (where returns increase rather than diminish and network effects prevail). Thus, current economic thinking is unfortunately insufficient to deal with information monopoly (such as Microsoft), path dependency and pervasive externalities.

Classic cost / benefit analyzes do not tackle very long-term investment horizons (ie periods). Their underlying assumption – the opportunity cost of delayed consumption – fails when applied beyond the investor’s economic life expectancy. People care less about their grandchildren’s future than their own. This is because predictions regarding the distant future are very uncertain and investors refuse to base current decisions on fuzzy “what ifs”.

This is a problem because many current investments, such as the fight against global warming, are likely to yield only decades. There is no effective method for cost / benefit analysis that can be used for such time horizons.

How is consumer choice influenced by advertising and pricing? No one seems to have a clear answer. Advertising is about disseminating information. Yet it is also a signal sent to consumers that a particular product is useful and qualitative and that the advertiser’s stability, longevity and profitability are safe. Advertising communicates a long-term commitment to a winning product by a company with deep pockets. Therefore, patrons respond to the level of visual exposure to advertising – regardless of content.

Humans may be too multidimensional and hyper-complex to be captured with econometric models. These either lack predictable powers or lapse into logical errors, such as “omitted variable bias” or “inverse causation”. The former deals with important unreported variables – the latter with mutual causation, when each cause is also due to its own effect.

These are symptoms of an all-consuming malaise. Economists are simply not sure what exactly constitutes their subject. Are economics around the design and testing of models consistent with certain basic assumptions? Or should it be about extracting data for new patterns, rules and “laws”?

On the one hand, patterns based on limited – or worse, sometime – datasets form a questionable foundation for any kind of “science.” On the other hand, models based on assumptions are also in doubt because they will be replaced by new models with new, hopefully improved, assumptions.

One way to get around this seemingly quagmire is to put human cognition (i.e. psychology) at the center of the economy. Assuming that being human is an unchanging and knowable constant – it must be entertaining for scientific treatment. “Prospect theory”, “bounded rationality theories” and the study of “afterwards bias” as well as other cognitive deficiencies are the results of this approach.

To qualify as a science, economic theory must meet the following cumulative conditions:

All inclusive (anamnetic) – It should include, integrate and incorporate all known facts of economic behavior.

Coherence – It must be chronological, structured and causal. It should, for example, explain why a particular economic policy leads to specific economic results – and why.

Consistency – It has to be self-consistent. Its under “entities” cannot contradict each other or go against the grain of the main “theory”. It must also be consistent with the observed phenomena, both those related to economics and those related to non-economic human behavior. It must adequately deal with irrationality and cognitive deficiencies.

Logical Compatibility – It must not violate the laws of its internal logic and the rules of logic “out there”, in the real world.

Insightfulness – It should cast the familiar in a new light, my patterns and rules from big data mining (“data mining”). Its insight must be the inevitable conclusion of logic, language and theory.

Aesthetics – Economic theory must be both plausible and “real”, beautiful (aesthetic), not cumbersome, not awkward, not discontinuous, smooth and so on.

Parsimon – The theory must use a minimum number of assumptions and entities to explain the maximum number of observed economic behaviors.

Explanatory Powers – It must explain the behavior of economic actors, their decisions, and why economic events develop as they do.

Predictable (prognostic) powers – economic theory must be able to predict future economic events and trends as well as future behavior of economic actors.

Prescriptive Powers – The theory must provide political prescriptions, just as physics provides technology. Economists must develop “economic technology” – a set of tools, drawings, rules of thumb and mechanisms with the power to change the “economic world”.

Impressive – It must be considered by society as the preferred and guiding organizing principle on the economic sphere of human behavior.

Elasticity – Economic theory must possess the inherent ability to self-organize, reorganize, make room for new schemes, accommodate new data comfortably and avoid rigid responses to attacks from within and from outside.

Many current economic theories do not meet these cumulative criteria and are thus only glorified narratives.

But meeting the above conditions is not enough. Scientific theories must also pass the crucial barriers to testability, verifiability, return, forgery and repeatability. Yet many economists go so far as to claim that no experiments can be designed to test statements of economic theories.

It is difficult – perhaps impossible – to test hypotheses in economics for four reasons.

Ethics – Experiments should involve human motives, unaware of the reasons for the experiments and their goals. Sometimes, even the very existence of an experiment must remain a secret (as with double-blind experiments). Some experiments may involve unpleasant experiences. This is ethically unacceptable.

Design Problems – The design of experiments in economics is awkward and difficult. Mistakes are often unavoidable, regardless of the careful and meticulous designer of the experiment.

The Principle of Psychological Uncertainty – The current mental state of the human subject may (theoretically) be fully known. However, time and sometimes the experiment itself has an effect on the subject and changes his or her mental state – a problem known in economic literature as “time inconsistencies”. The actual processes of measurement and observation affect the subject and change it.

Uniqueness – Experiments in economics therefore tend to be unique. They cannot be repeated even when the SAME individuals are involved simply because no human subject remains the same for long. Repeating the experiments with other experimental products casts doubt on the scientific value of the results.

The sub-generation of testable hypotheses – Economic theories do not generate a sufficient number of hypotheses that can be subjected to scientific testing. This has to do with the fabulous (i.e. storytelling) nature of the discipline.

In a sense, economics has an association with some private languages. It is a form of art and as such it is self-sufficient and self-sufficient. If certain structural, internal constraints and requirements are met, a statement in economics is considered to be true, even if it does not meet external (scientific) requirements. Thus, the standard theory of utility is considered valid in economics despite overwhelming empirical evidence to the contrary – simply because it is aesthetically and mathematically practical.

So what are economic “theories” good for?

Economic “theories” and narratives offer an organizing principle, a sense of order, predictability and justice. They postulate an inexorable drive towards greater welfare and usefulness (ie the idea of ​​progress). They make our chaotic world meaningful and make us feel part of a larger whole. Economics strives to answer “why is” and “how is” in our daily lives. It is dialogic and prescriptive (i.e. delivers behavioral prescriptions). In some ways it is akin to religion.

In his catechism, the believer asks (let’s say, a politician): “Why … (and here follows an economic problem or behavior)”.

The economist answers:

The situation is so, not because the world is cruelly cruel, irrational and arbitrary – but because … (and here follows a causal explanation based on an economic model). If you had to do this or that the situation is bound to improve. “

The believer feels reassured by this explanation and by the explicit affirmation that there is hope if he follows the precepts. His belief in the existence of linear order and justice, administered by a supreme, transcendental principle, is restored.

This sense of “law and order” is further enhanced when the theory makes predictions come true either because they are self-fulfilling or because a real “law” or pattern has emerged. Alas, this rarely happens. As “The Economist” notes bleakly, economists have the most disheartening record of failed predictions – and prescriptions.