Wednesday, March 23, 2005

A Defense of Economics

Economics Wins, Psychology Loses, and Society Pays by Max Bazerman, Deepak Malhotra

The short version of the Bazerman and Malhotra chapter is that the authors believe that economics has come to dominate (to the exclusion of other fields) the social sciences and political arena. (Somewhat analogous to the idea that rational economics has dominated in finance to the detriment of psychology and behavioral finance).

The authors identify "five predominant myths, adapted from pervasive economic assumptions, which serve as guiding policy principles and serve to destroy value in society. These myths include:

1) Individuals have stable and consistent preferences
2) Individuals know their preferences and they pursue known preferences with volition
3) Individuals make decisions based on all of the evidence available to them
4) Free markets solve economic problems
5) Credible empirical evidence consists of outcome data, not of mechanism data"

While I have reservations about each of these, I will concede some truth in their views. For instance, Does psychology matter? Undoubtedly (see for instance their discussion of spending increases had the term "bonus" been used instead of "rebate" with respect to taxes).

However I disagree with much of the paper. Rather than being the norm, I would argue that it is only the rare close-minded financial economist who does not understand that other social sciences also have roles to play (even the most ardent of financial economists now concede some things to behavioral finance). That economics, and by extention finance, has become dominant is because it has shown it to be the best way we have of dealing with problems and limited resources.

Are there problems with economics/finance/free markets? Yes. Do some rights get trampled? Yes. Should we consider other models? Sure. Given enough time, we should consider all things, but given limited amounts of time and resources, we could do MUCH worse than relying predominantly on economic principles!

And in that spirit, I hope society grows more (and not less) economic in our thinking. That is not to say growth for growth sake. That is not even to say always growth--retrenchment can be value maximizing. But ideally growth through positive NPV investments. Where all costs and benefits are considered. Why? Because with a proper assigning of property rights (including environmental, intellectual etc), economics does work.

Suggested Citation
Bazerman, Max and Malhotra, Deepak K., "Economics Wins, Psychology Loses, and Society Pays" (2005). Harvard NOM Working Paper No. 05-07.

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