April 18, 2005


Why Logic Often Takes A Backseat: The study of neuroeconomics may topple the notion of rational decision-making (Peter Coy, 3/28/05, Business Week)

Neuroeconomics, while still regarded skeptically by mainstream economists, could be the next big thing in the field. It promises to put economics on a firmer footing by describing people as they really are, not as some oversimplified mathematical model would have them be. Eventually it could help economists design incentives that gently guide people toward making decisions that are in their long-term best interests in everything from labor negotiations to diets to 401(k) plans. Says Harvard University economist David I. Laibson, another leading researcher: "To understand the real foundations of our behavior and our choices, we need to get inside the black box."

Neuroeconomics could also give economics an alternative theoretical framework. Since the early 1900s, economists have mainly assumed that people have a stable and consistent set of preferences that they try to satisfy. When faced with an apparently illogical outcome -- such as the cancellation of the hockey season -- they try to explain it as the result of a reasoned decision process. Such top economists as Gary S. Becker, Milton Friedman, and Robert E. Lucas Jr., all Nobel prize winners, have argued that discrimination, unemployment, and stock market gyrations can have rational origins.

In recent years, the assumption of rationality has taken some hard shots as economists have shown that people often lack self-control, are shortsighted, and overreact to the fear of losses. But to date, these attacks on rationality -- under the broad heading of "behavioral economics" -- have seemed more like a grab bag of anomalies than a consistent alternative theory. So the assumption of rationality survives.

By linking economic behavior to brain activity, however, neuroeconomics may finally supply the model that knocks mainstream economics off its throne. The new theory should fit better with reality, but it won't be as mathematically clean -- because the brain is a confusing place, with different parts handling different jobs. Says Camerer: "You are forced to think about a brain which has many somewhat modular circuits."

One of the most fruitful avenues of neuro research is "time inconsistency." When people decide about the distant future, they're roughly as rational as economic textbooks assume. But when faced with a choice of whether to consume something now or delay gratification, they can be as impulsive as chimps. Harvard's Laibson coined "quasi-hyperbolic discounting" to describe the behavior, but that was just a label, not an explanation.

So Laibson and others scanned people inside MRI machines and discovered two parts of the brain operating in radically different ways. For decisions about the far-off future, the prefrontal cortex takes a long-term perspective. But for decisions such as whether to buy another chocolate bar right now, the limbic system takes over and demands immediate gratification. Last year the journal Science published the research by Laibson, Princeton University neuroscientists Samuel M. McClure and Jonathan D. Cohen, and Carnegie-Mellon University economist George Loewenstein.

How does it help to know that you're literally "of two minds"? You could arrange your affairs to make sure that your rational brain stays in control -- for example, by committing now to saving a certain percentage of your paycheck each month in the future. Many people already do that. Trouble is, long-term commitments can be too rigid if circumstances change. Ideally, you'd like to wait to commit to a savings plan until you see whether you can afford it -- but not wait so long that your animal brain takes over and you lose the will to save. The new research could help get that balance right.

A key tenet of standard economics is that making people happy is a simple matter of giving them more of what they like. But neuroscience shows that's not true. The brain's striatum quickly gets used to new stimuli and expects them to continue. People are on a treadmill in which only unexpected pleasures can make them happier. That explains why happiness of people in rich countries hasn't increased despite higher living standards.

Odd to think you could both be a human being and believe men to be rational actors.

Posted by Orrin Judd at April 18, 2005 11:00 PM
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