Behavioral and Experimental Economics: We’re smarter when we work together.

In brief:

Humans are a lot less rational than traditional economics assumes. This means both markets and politics are imperfect. However, in certain arrangements humans cooperate and create things which are more than the sum of its parts. We are smarter together than we are alone.

What is it?

Traditional economics grew sophisticated alongside more and more strict assumptions about human rationality. For these models to provide meaningful predictions or solutions, people are often modeled like computers, with perfect memories, mathematical wizardry, and complete information about the past, present, and future.

If this seems like a stretch of your own day-to-day reality, you aren’t alone. Behavioral economists took the uneasiness that many felt (and many have criticized over the years) about the robot-like actors in economic models and made it into a serious academic discipline.

Behavioral economists ask questions like: Are people actually “lightning fast calculators of pain and pleasure?” Can they mentally solve the equations necessary to make ‘perfectly rational’ decisions in their day to day life?

It may not surprise you to find out that real human beings, studied in laboratories and in ‘economic experiments,’ fail to achieve the levels of ‘perfect rationality’ demanded in traditional economics.

Real human behavior deviates from traditional economic rationality in consistent ways that behavioral economists call ‘biases.’ For example, when faced with difficult questions or decisions, people are likely to choose whichever answer is the default, even if traditional economics predicts that they would choose something else. Behavioral economists call this ‘status quo bias’. The difficulty of doing the thinking necessary to make the ‘perfectly rational’ decision leaves many people opting for the default instead.

People also have common character flaws, like a lack of willpower, or shortsightedness. Behavioral economists have used studies of people trying to quit smoking or lose weight as examples of how real people fail to be ‘fully rational’ in their daily life.

This has naturally led many behavioral economists to challenge the validity and value of traditional economic models since they appear to clash with reality.

But things are more complicated still.

Even though individual humans clearly suffer from the biases discovered by behavioral economists, Nobel Laureate experimental economist Vernon Smith has found that traditional economics still can make accurate predictions of the behavior of groups of people.

While people may not know all of the information necessary to make ‘supply’ equal ‘demand’, groups of people with limited information can still reach the equilibrium price by trading – even with biased behavior and incomplete knowledge.

This may seem strange, since traditional economic models seemingly rely on the ‘perfect rationality’ of the modeled people to work. But in fact, people in experimental markets (and Smith argues by extension, real markets) are becoming ‘smarter’ through their spontaneous interaction.

The individual people have no idea that they are making supply equal demand, the outcome a traditional economic model would predict. But by simply trading and interacting they still create this overall effect. This has led Vernon Smith to refer back to the work of thinkers from the Scottish Enlightenment like Adam Smith, author of the Wealth of Nations, and Adam Ferguson. An order is being created “by human action, but not by human design.”

In other words, people don’t need to be hyper-rational calculating machines to ‘solve’ the complex equations necessary to bring markets into coordination. Human interaction, taken in aggregate, is ‘smarter’ than the sum of its parts.

What does Behavioral/Experimental economics mean for radical social entrepreneurs?

The biases that behavioral economists have discovered offer a fertile field for social entrepreneurs. For example, behavioral economist Richard Thaler started a program called Save More Tomorrow, which uses ‘status quo bias’ (the ‘irrational’ preference for default options discussed above) to help employees save more money for their retirement.

Other examples of entrepreneurship in behavioral economics include simple innovations like 100-calorie snack packs. This tiny change in packaging – which just takes a normal product and puts them in smaller stand-alone packs – helps people control their portions to lose weight.

More innovative are websites like “Stickk” which give people the ability to form commitment contracts. These are contracts which help you achieve your goals by deducting money from your bank account (you choose how much!) each time you fail to achieve a milestone.

So each time you don’t lose your desired weight, money is taken from your account and sent to a friend or a charity — or foe and ‘anti-charity’ that you can’t stand! In effect, these ideas are part of a market for helping people overcome shortcomings in willpower or foresight.

Behavioral and experimental economics also makes a deeper point about the limits of individual human cognition. Our economies and societies cannot be ‘designed’ – any individual human is simply not smart and unbiased enough to carry out the task. We need large networks of exchange, populated by good, radical social entrepreneurs, to coordinate our lives. In short, we need peaceful cooperation with each other to make the world turn.