Levine’s Is Behavioural Economics Doomed?

David Levine’s Is Behavioural Economics Doomed? is a good but slightly frustrating read. I agree with Levine’s central argument that rationality is underweighted in many applications of behavioural economics, and he provides many good examples of the power of traditional economic thinking. For someone unfamiliar with game theory, this book is in some ways a good introduction (or more particularly, to the concept of Nash equilibrium). And for some of the points, Levine shows a richness in the literature that you don’t often hear about if you only consume pop behavioural economics books.

But the book is also littered with straw man arguments. Levine often gives views to behavioural economists which I am not sure they generally hold, and he often picks strange examples. And when it comes to explaining away behaviour that doesn’t fit so neatly with the rational actor model, Levine is not always convincing.

As an example, Levine provides an overview of the prisoner’s dilemma, a classic game demonstrating why two people might not cooperate, even though cooperation leads to a better outcome than both players defecting. Levine uses it to argue against those who suffer from the fallacy of composition - inferring something is true of the whole because it is true of the parts - and wonder why we can have war, crime and poverty if people are so rational. But who are these people that Levine is arguing against? I presume not the majority of the behavioural economics profession who are more than familiar with the prisoner’s dilemma game.

Levine’s introduction to the prisoner’s dilemma is good when he discusses what happens with different strategies or game designs. But when it comes to the players in experiments who don’t conform to the Nash equilibrium - such as those who don’t defect in every period if there is a defined end to the game - he hand waves away their play as “rational and altruistic” rather than seriously exploring whether they made systematic errors.

Similarly, when discussing the ultimatum game, Levine simply describes the failure to maximise income as “modest”. He does make the important point that it is rational for first movers to offer more than the minimum if there is a possibility of rejection (and since they don’t have opportunity to learn, they will get this wrong sometimes). But he seems less concerned about the behaviour of player 2 who rejects a material sum. Yes it might be a Nash equilibrium, but the behavioural view might shed some light on why we end up at that particular Nash equilibrium.

Levine is similarly dismissive of the situations where people make errors in markets. “Behavioural economics focuses on the irrationality of a few people or with people faced with extraordinary circumstances. Given time economists expect these same people will rationally adjust their behaviour to account for new understandings of reality and not simply repeat the same mistakes over and over again.” But given how many major decisions are one-shot decisions with major consequences (purchasing cars, retirement decisions etc.), surely they are worth exploring.

One of the more bizarre examples is where Levine addresses the question of why people vote despite having almost no chance of changing the outcome. Levine gives an example of a voting participation game conducted in the lab where he found that participants acted according to the predicted Nash equilibrium, reflecting their costs of voting, the benefits of winning and the probability of their vote swinging the result. But he doesn’t then grapple with the clear problem that this limited experiment doesn’t translate to the real world. Funnily enough, only pages later he cautions “[B]eware also of social scientist [sic] bearing only laboratory results.”

Levine also  brings out the now classic question of why couldn’t economics predict the economic crisis. He points out that crises must be inherently unpredictable as there is an inherent connection between the forecaster and the forecast. If a model that people believed predicted a collapse in the market of 20% next week, the crash would happen today (Let’s ignore for the moment that there seems to be an economist predicting a crash almost every day).

In defence of the economists, Levine pulls out a series of (well-cited) papers that he believes already explained the crisis, such as providing for the possibility of sharp crashes and the effect of fools in the market. Look, the shape of the curve by this random paper is the same! But was that actually what happened? Was that the dominant theory? Levine seems to believe mere existence of literature in which crises are present is an indication that the profession is fine, even if that wasn’t a dominant or widely believed model.

Having spend most this post complaining about Levine’s angle of attack, there are many good points. His discussion of learning theory is interesting - people don’t know all information before they undertake an action and learn along the way. Selfish rationality with imperfect learning does a pretty good job of explaining much behaviour. Some of this throwaway lines also make important points. For example, if a task is unpleasant, it can be rational to leave it to the last moment. Uncertainty can make the procrastination even more rational.

Some of Levine’s critiques of the experimental evidence are also interesting. One I was not aware of was whether the appearance of the endowment effect in some experiments was due to people misunderstanding the Becker-DeGreeot-Marschak elicitation procedure. (People state their willingness to pay or accept and a random draw of the price is made. If the price is lower than the willingness to pay, they pay it.) Levine points to experiments where, if people are trained to understand the procedure, the endowment effect disappears. As I mentioned in a previous post, Levine also points to some interesting literature on anchoring.

Levine closes with a quote from Loewenstein and Ubel that is worth repeating:

… [behavioral economics] has its limits. As policymakers use it to devise programs, it’s becoming clear that behavioral economics is being asked to solve problems it wasn’t meant to address. Indeed, it seems in some cases that behavioral economics is being used as a political expedient, allowing policymakers to avoid painful but more effective solutions rooted in traditional economics.

Behavioral economics should complement, not substitute for, more substantive economic interventions. If traditional economics suggests that we should have a larger price difference between sugar-free and sugared drinks, behavioral economics could suggest whether consumers would respond better to a subsidy on unsweetened drinks or a tax on sugary drinks.

But that’s the most it can do.

Underneath Levine’s critique you sense this is what is really bugging him. Despite the critiques, traditional economic approaches still have a lot of power. And for some people, that seems to have been forgotten along the way.