Dismal No More: The Evolution of Economics

Despite being nicknamed the “dismal science”, economics has a lot to offer. Once you move beyond its theoretical postulates, economics can be applied to an enormous variety of problems. This article traces the development of economics from a theory of value to a discipline that incorporates insights from psychology, sociology and anthropology to describe human behaviour. Furthermore, the results of economics research enrich our understanding of and provide solutions for public policy issues.

Originally, economics was mainly concerned with the value of commodities. Adam Smith’s Wealth of Nations is the first treatise that conceptualised the value created in exchanges as subject to market forces. Out of this foundation, and partly in response to it, grew what we now know as modern microeconomic theory, with its emphasis on marginal utility, the satisfaction gained from the last unit consumed. The initial supply and demand models were expanded to account for general equilibrium, not just the equilibrium in one market. These tools were in turn used to tackle problems of efficiency and the allocation of scarce resources. After World War II, economists like Paul Samuelson formalised the assumptions of microeconomic theory, intending to explain human behaviour through mathematical optimisation techniques. Furthermore, John Maynard Keynes’ General Theory was combined with the neoclassical microeconomic foundations to account for macroeconomic concepts such as price level, employment and interest rates. However, this rapid formalisation of the discipline left economics vulnerable to one extremely important matter: the way people actually behave. Ironically, Adam Smith wrote extensively about the way in which factors other than market forces influence human behaviour. In his first book, The Theory of Moral Sentiments, Smith describes how behaviour is determined by “passions”, such as anger and anxiety. In his view, people are in a constant struggle between passions and the perspective of the “impartial spectator”, who scrutinises every decision from a long-term perspective. A modern version of this can be found in Daniel Kahneman’s distinction between thinking fast (impulsive and emotional) and slow (logical and deliberative). Kahneman is a psychologist who won a Nobel Prize in Economics for his research on loss aversion, heuristics, and biases. These concepts form the foundation of much of an exciting sub-discipline of economics: behavioural economics.

Behavioural economics uses insights from psychology to explain human behaviour, and the conclusions of its research can be used to guide public policy. The recognition that people do not always act in accordance with rationality is crucial to this field. Although Herbert Simon introduced the idea of bounded rationality in the 1950s, behavioural economics really took off when economist Richard Thaler started asking some unconventional questions in the late 1970s. Why do people not ignore sunk costs? If additional consumption can only make someone better off, why do people regret eating too much? Thaler answered these questions by relaxing some of the assumptions of economic theory, as well as incorporating ideas from research by Kahneman and other psychologists. Humans, Thaler argues, are not rational, and use shortcuts that result in suboptimal decisions. Over the last thirty years, behavioural economics has become incredibly popular, generating a large body of academic literature. Furthermore, insights from behavioural economics have been employed extensively to improve public policy. Thaler’s book Nudge argues that small interventions, or nudges, can have large, beneficial effects for individual and collective wellbeing. Thaler even helped set up the Behavioural Insights Team, informally known as the “nudge unit”, a UK government institution that applies behavioural science to public policy. For example, the wording in the letter sent to people who do not pay their taxes on time was changed to “You are currently in the small minority of people who have not paid their taxes on time”. This nudge resulted in a substantial increase in subsequent payments. There is some debate about the ethical implications of nudging, as it is argued that this interferes with people’s freedom of choice. However, if nudges are small and harmless changes with genuine benefits, it seems that a slightly more limited set of choices is a small price to pay.

Research in economics has even progressed beyond the above mentioned advances in behavioural economics. A new strand of research within behavioural economics imports insights from sociology and anthropology to accurately account for the social determinants of behaviour. Economic actors are enculturated, shaped by aspects of social context, such as language and social identities. Social context does not only matter at the moment of decision-making, but also influences preferences and experiences at a more fundamental level. It determines how an individual perceives the world, and if a certain perspective becomes well-established in a particular society, its inhabitants will be more or less forced to act in accordance with it. An application of these ideas can be found in research on the growing levels of wealth inequality in industrialised economies. It has been shown that societies with high levels of wealth inequality tend to develop a high level of consumerism, which results in a disproportionate cultural emphasis on an individual’s relative level of consumption in comparison to his or her peers. Those who are materially successful become role models, and those who have fallen behind take unwarranted financial risks to keep up. This could result in even higher levels of wealth inequality, and could have substantial repercussions in terms of collective wellbeing through rising debt levels.

Economics has become extremely important to our understanding of human behaviour, and the discipline is still developing. Recent interdisciplinary approaches include neuroeconomics, which aims to explain human decision-making through the lens of economics, psychology, and neuroscience. It is this type of cross-fertilisation that truly unlocks the full potential of economics as the study of human choice.

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