Economic Behavior and Behavioral Economics

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What are the motivations behind economic actors’ decisions to save or spend their income? Or to invest in productive capital or to refrain from taking the risk? What motivates governments’ choices about taxing and spending? The financial crisis of 2008 and the long and painful recovery have made answering these classic economic questions even more pressing. Economic analysis of necessity must include assumptions about human behavior alongside the analyses of the institutional dynamics that constrain economic choices, but those assumptions have varied drastically. Adam Smith assumed that people were motivated by a complex combination of self-interest and “sympathy” for the plight of others. Jeremy Bentham, in contrast, argued that only self-interest mattered, as people strived to “maximize pleasure, minimize pain.” Karl Marx emphasized the ways that human choices and human potential were limited by the logic and imperatives of the economic system. John Maynard Keynes attributed entrepreneurs’ willingness to invest in the face of uncertainty to “spontaneous optimism” and an “urge to action rather than inaction.” Modern neoclassical economics has largely based itself in Bentham’s utilitarian view, relying upon a simplified model of humans as “individual rational maximizers,” one-dimensional beings sometimes referred to as “homo economicus.” These differing assumptions about human behavior matter, because they lead to different understandings of how an economic system functions, how human well-being can be achieved (and even what is meant by well-being), and what roles government policy can play. In recent years, a new focus on economic behavior has combined insights from economics, psychology, and biology with a growing body of empirical study to examine more closely the motives and behaviors behind economic activity. These studies are revealing human behavior to be both more multidimensional and more contradictory than the simplified assumptions behind “homo economicus.” For example, people are self-interested but also can be generous, including to others that they don’t even know. They can exhibit convictions about ethics and fairness in their economic choices and will, at times, go against their own interests in order to discipline someone who has behaved against the ethical rules. Their choices may also violate narrow assumptions about rationality, as research shows that people may find it difficult to act in their own long-term interest, even when it is their stated intention—finding it much easier, for example, to plan to save tomorrow than to actually save today. This course will examine the development of economic arguments about human behavior, beginning with Smith and moving to the present. We will then investigate the studies of the behavioral economists to see how their findings have affected public policy, with a particular emphasis on the financial crisis and its aftermath.