Sunday, August 1, 2004


Ronald Henderson Oration, Melbourne
August 2004.

1. Introduction

The further I have strayed from my days as an undergraduate, the more convinced I have become of the importance of theory – not just to economics, but to any discipline. Theory is important because it is so pervasive in influencing the way we think, the way we analyse problems in our discipline and the nature of the solutions we favour. Often, we fall into ways of thinking about issues without fully appreciating the influence theory is having on us (Keynes 1936).

At a time when economic rationalists are so influential in government policy making, theory becomes highly relevant because economic rationalists can be defined as people who take conventional economic theory – the neoclassical model of markets, in its simplest form – and raise it to the status of religious doctrine.

In addition, I have become interested in some relatively recent developments in cognitive and social psychology. Psychology has become a lot more interesting to people interested in public policy since the advent of ‘positive psychology’, which has switched the focus from the study of mental illness to the study of people who are perfectly well (Seligman 2002; Kahneman et al. 1999: p. ix).

Two aspects of psychological research present significant challenges to conventional economics: the study of how people make decisions and the study of happiness or ‘subjective well-being’. I wish to draw out the respects in which these advances challenge various aspects of economic theory and the policy prescriptions conventionally flowing from the theory. The first challenge – concerning decision-making – is being taken quite seriously by the economics profession. The thriving school of economic thought it has given rise to is behavioural economics, and the psychologist who did most to inspire this school, Daniel Kahneman, was awarded the Nobel Prize in economics in 2002. The second challenge to conventional economics – from the burgeoning happiness research – is taking longer to win converts among economists. But I am enough of an optimist to hope that we are witnessing the early stages of another revolution in economics, one to match or even exceed the influence of the Keynesian revolution of the 1940s and 50s. Surprisingly, Keynes is now being hailed as one of the earliest behavioural economists (Akerlof 2002), though his contemporary followers largely ignored that aspect of his contribution.

2. Decision-making

2.1 Challenge to theory

Psychology’s first challenge to microeconomic theory strikes at one of its central elements: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. He or she always carefully evaluates all the options before making any decision, and always with the object of maximising his or her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume (Simon 1957). People are not rational, they are intuitive. And altruism is often an important consideration in their decision-making (Mullainathan and Thaler 2001; Frey and Meier 2002). People can’t chose correctly between three options where the best option is not immediately apparent (Simonson and Tversky 1992). Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases (Tversky and Kahneman 1974). People are often slow to learn from their mistakes (Mullainathan and Thaler 2001). They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ (packaged) differently (Kahneman and Tversky 1979). This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo (Thaler 1980). He does not ignore sunk costs as he is supposed to (Thaler 1980) and often cannot order his preferences consistently (Tversky and Kahneman 1974; Kahneman and Tversky 1979). He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level (Tversky and Kahneman 1981).

Unlike Homo economicus, Homo sapiens cares deeply about fairness (Kahneman et al. 1986). Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off (Kahneman et al. 1986). People are prepared to pay a price to punish others they consider to have been behaving badly towards the group (Fehr and Gachter 2000). Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up (Tyler 2000).

2.2 Policy implications

I believe this has powerful implications for the aspect of the neoclassical model that economic rationalists (particularly right-wing rationalists) find so attractive: its elevation and celebration of individualism. The individual should be free to choose, and governments should be most circumspect in how they constrain individuals’ freedom, including by taxing them to pay for the public provision of services and to redistribute income. This elevation of the individual and, by implication, denigration of a more communitarian approach, turns out to rest heavily on the assumption that individuals are rational. If individuals are rational decision-makers then it follows, as the rationalists keep asserting, that governments can never know what is good for you better than you know yourself. Governments should therefore tax individuals as little as possible, and maximise the private provision of such things as education and health care. If individuals are not particularly rational in their decision-making, however, then there may well be a case for government paternalism in certain circumstances. Add to this the findings that people’s decisions are often influenced by altruism, their concerns about fairness, their willingness to punish people who act contrary to the interests of the group, and that their behaviour is often influenced by the behaviour of those around them (Ormerod 1998: chap. 2), and you get a further argument in support of communitarian interventions and income redistribution.

A second strand of policy implications also flows from abandoning the assumption that people are rational. It calls into question economists’ adherence to consumer sovereignty – their belief that consumers should and do determine what producers produce. When consumers’ decisions can be influenced by the way propositions are framed, and when decisions are frequently influenced by emotions, producers can use advertising and other marketing to manipulate consumer demand. This contravenes a basic tenet of market economics that, in Keynes’s phrase, consumption is ‘the sole end and object of all economic activity’ (1936: chap. 8). If producers can use advertising to increase as well as manipulate consumption, this puts the cart before the horse, it reverses the direction of causation in the economic system, turning means into ends.

Economists do not like talking about advertising. To make it fit their model they have to assume that it is purely informational, whereas we all know that smart advertisers sell the sizzle not the steak (Camerer 2003). Advertisers prey on our inadequacies and irrationalities (Layard 2005), subtly selling us propositions which become absurd as soon as someone puts them into words: that buying certain products will at last put us among the beautiful people or give us a healthy, happy family. But if advertising is antithetical to consumer sovereignty, why are economists usually so disapproving of proposals to limit or ban advertising?i

3. Happiness

3.1 Challenge to theory

There’s not a big difference between subjective well-being – happiness - and the economists’ goal of maximising utility or satisfaction (Easterlin 2001; Frey and Benz 2002; Frey and Stutzer 2002). So this is an area of research that ought to be of considerable relevance to economists. One common reservation they have, however, is that it is all so subjective – asking people to rate their satisfaction with life on a scale of one to 10. But psychologists have demonstrated that a person’s own assessment of their happiness has a high correlation with other people’s assessments of that person’s happiness and with physical measurements of brain electroencephalogram readings (Diener 1984; Veenhoven 1993; Davidson et al. 2000).

The most surprising finding of the happiness research, confirmed in an Australian study by Heady, Muffels and Wooden (2004), is that the link between life satisfaction and income and wealth is quite weak. It exists, but it is small. Once a nation’s income per person exceeds about $US15,000 a year (Inglehart and Klingman 2000; Helliwell 2003), the acquisition of further income is subject to rapidly diminishing returns. And, as was first pointed out 30 years ago by the economist Easterlin (1974), in the period since World War II the correlation between GDP and happiness has broken down in rich countries (Myers 1993). In America, for instance, real GDP per person has trebled while subjective well-being has been unchanged (Diener and Seligman 2004). Similar results are found for other developed countries where life satisfaction has been regularly measured (Blanchflower and Oswald 2000).

This is a devastating conclusion for economists – and particularly economic rationalists – whose whole practical motivation has been based on the assumption that helping the community raise its productivity and increase its production and consumption of goods and services will leave it unequivocally better off. There is no doubt that, materially, we are better off than we were even 10 years ago: our homes are bigger and better, our cars are better, our food and clothing are fancier and we have any number of wonderful new gadgets to save us labour or entertain us. But though we are better off, we do not feel better off. Why not? Why is it that the acquisition of income does so little to increase our satisfaction?

Psychologists (and a few economists) have proposed two main explanations. First, it’s a characteristic of humans that we adapt surprisingly quickly to our changed circumstances (Helson 1964; Frederick and Loewenstein 1999). We get a promotion, move into a better house or buy a new car and, for a while, we really feel better off. But all too soon we adapt to our new circumstances and absorb them into the status quo. People who win the lottery are no happier than normal within a few years but, by the same token, most accident victims who suffer paraplegia end up being no unhappier than normal (Brickman et al. 1978). The thing that is surprising about all this is our failure to learn from all the times the buzz from an acquisition has worn off so quickly (Schwartz 2004). We keep striving to acquire another new toy in the hope it will be the one that finally delivers nirvana. This amnesia – which, in terms of the economists’ model, constitutes a major information failure (Layard 2005) - is why psychologists describe us as being trapped on a ‘hedonic treadmill’ (Brickman and Campbell 1971).

The second part of the explanation for the diminishing marginal utility of money is rivalry (Duesenberry 1949; Hirsch 1976; Frank 1985, 1999; Solnick and Hemenway 1998; Easterlin 2001). The economic model assumes that what satisfies us is absolute increases in our income or wealth. This is because we’re all individualists, who not only don’t care about the well-being of others, but also don’t ever compare ourselves with others. In truth, we are highly social animals, obsessed by what those around us think of us and what we think of them. Remember Gore Vidal’s crack: when I see a friend succeed . . . a little part of me dies. Evolution has made us a species highly conscious of our social status. We care deeply about how we rank in the pecking order, and are always striving to advance our status – or avoid slipping back - by the promotions we get, the size of our incomes, the location and opulence of our homes, the newness and foreignness of our cars, the private schools we send our children to and the private hospitals we use when sick. In our mania for getting ahead of the Joneses, what we care about is not absolute increases in our income, but relative increases.

The trouble with this rivalry, however, is that it is a zero-sum game. To the extent that I succeed in making myself happy by moving up in the pecking order, those people I move ahead of suffer a loss of status that makes them unhappy. In economists’ language, my efforts to advance myself generate offsetting negative externalities for those I pass. And what is more, the whole leapfrogging game tends to leave us perpetually anxious about slipping back in the race for status.

3.2 Policy implications

There are many policy implications from this and I will only scratch the surface. Layard (2005) says that, beside adequate income, the research shows six main factors affect happiness: mental health, satisfying and secure work, a secure and loving private life, a secure community, freedom, and moral values.

So my first policy implication is that reducing unemployment should be given a much higher priority by the economic policy-makers. Research shows that being unemployed makes people particularly unhappy (Clark and Oswald 1994), a lot more unhappy than can be explained by the loss of income they suffer by not having a job (Di Tella et al. 2001). What people miss is the sense of identity and self-worth that comes from a job, and also, no doubt, the social contact. Economists may protest that they are already giving high priority to reducing unemployment but, in truth, their pursuit of this goal is conditional. Their concern with the efficient allocation of resources means they frown on any solutions (job sharing, job-creation schemes, public sector employment, for instance) that involve modest inefficiencies. The truth is that the overwhelming goal of economists is to hasten the growth in the economy’s production of goods and services, and the jobs generated in this process are just a fortunate by-product.

My second policy implication is that governments and employers could do a lot to raise subjective well-being if they put more emphasis on the enrichment of jobs – increasing job satisfaction by giving workers more personal control, opportunity to use their skills, variety in tasks, respect and status, and contact with others. Taken literally, the economists’ model assumes that all work is unpleasant – a disutility – and is undertaken purely to gain the money to buy the things that bring utility. Like the rest of us, economists know that, in reality, work carries much intrinsic satisfaction. But they don’t follow this realisation through to their policy prescriptions. They are perpetually advocating labour market reform aimed at ensuring labour is used more efficiently, treating labour as though it were just another inanimate economic resource, and ignoring the feelings of the human beings attached to the labour. Various of the ways labour can be used more efficiently make life unpleasant and even unhealthy for the workers involved: ever-changing casual hours, rolling shift work, split shifts and firms continually moving their staff to different cities. When we pursue efficiency at the expense of people, economists have got things round the wrong way, trashing ends so as to advance means.

A third implication is that economic policy-makers should recognise the benefit of stability. People like stability – it makes them feel secure and happy. What’s more, it breeds a highly valuable commodity: trust. People don’t like continuous change. Macroeconomic management is aimed a stabilising the rate of growth in demand, and that’s good. But microeconomists perpetually advocate change (‘reform’) aimed at increasing efficiency, raising productivity and quickening the production of goods and services – the very objective we now know doesn’t make people any happier. Often, micro reform involves ‘displacing’ workers from the reformed industries where their labour wasn’t being used efficiently. This is a process that causes no heart searching among economists because their model: first, assumes alternative employment will be readily forthcoming; second, ignores the intrinsic satisfaction from work and, third, assumes unemployed workers will have a whale of a time enjoying all their new-found leisure.

A fourth policy implication is that the thing economists celebrate as ‘competition’ and are always trying to encourage because it acts as a spur to efficiency and growth, is actually ‘rivalry’ that creates losers as well as winners and thus generates roughly as much unhappiness as happiness. Rivalry is hardwired into our brains, but a case can be made that social comparison is not something we should be encouraging (Layard 2005). Seen in this light, we should think twice about the unceasing calls for us to do this or do that to preserve or improve the economy’s international competitiveness. But why? It is just rivalry on a global scale. It is saying, we must make sure foreigners do not get richer at a faster rate than we are, or even, God forbid, overtake us on the league table.

Fifth, instead of merely unquestioningly promoting consumption, economists should be doing something they rarely do: studying it (Scitovsky 1976). They need to see whether there are some forms of consumption that that yield more satisfaction than others. It may be that, in our striving for social status, we are devoting too much of our time and income to the purchase of ‘positional goods’ (Hirsch 1976) - conspicuous consumption – and too little to activities empirical research now tells us would yield greater satisfaction. Frank (1999) says the ‘gains that endure’ are more likely to include social life, time with our children, less travel time to work, more job security and better health care. Layard (2005) says we should be spending a lot more on fighting glaring evils – and sources of profound unhappiness - such as depression.

Sixth, the evidence that income is subject to diminishing marginal utility strengthens the case for redistributing income from rich to poor, since such transfers should increase total happiness. As yet, however, there is mixed evidence on the question of whether people who live in countries with a narrower gap between rich and poor are happier. Alesina et al. (2001) find that income inequality has a large negative effect on happiness in Europe, but not in the United States.

Finally, we should look sceptically at the incessant calls for lower tax rates to encourage people to work harder. By its very nature, the economists’ model assumes away all non-monetary motives for work. We do it only for the money. But the reminder of the intrinsic satisfaction we derive from work also reminds that higher income-earners in particular have powerful non-monetary motives for working long and hard: job satisfaction and the pursuit of power and status. Reducing tax rates would merely allow us to run faster on the hedonic treadmill, whereas I think we should slowdown. The drive for reduced government spending and lower taxes would leave people with more disposable income they could use to purchase education and health care privately, in the hope that these positional goods would enhance their social standing. Layard (2005) warns we should worry lest leisure, public goods and inconspicuous consumption (consumption that is not compared with the consumption of others) are under-produced because people focus so much on conspicuous consumption.

4. Conclusion

My conclusion is not that economics should be abolished but that it, rather than the economy, is what is in desperate need of radical reform. Neoclassical economics is a product of the state of man’s knowledge during the 18th and 19th centuries, and has actually lost some of its human subtleties since then as it has been made more mathematical (Frey and Benz 2002). It needs to assimilate our now vastly superior understanding of human decision-making and motivations. The community will always need the advice of people who specialise in studying the economic aspects of our lives, but those specialists need to rebuild their models using more realistic assumptions about human behaviour. This would give us an economics fit for humans.


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