A (Very) Brief History of the Origin of Behavioral Economics
Most historical accounts trace the origin of behavioral economics as far back as Adam Smith’s The Theory of Moral Sentiments, published in 1759 (Loewenstein, 1999; Camerer and Loewenstein, 2004; Angner and Loewenstein, 2012; Thaler, 2016).[1],[2] As Camerer and Loewenstein (2004) point out, Smith was the first to propose that we humans derive more disutility (i.e., unhappiness) from losses than we do utility (happiness) from gains, a conjecture of “loss aversion” that later formed the basis of Kahneman and Tversky’s (1979) Prospect Theory. And so, in the mid-18th century, just as economics began to be considered a separate discipline, it appeared as though economic thought would necessarily evolve in tandem with our understanding of human psychology. However, by the turn of the 20th century and the onset of the neoclassical revolution, economists began turning away from what was considered to be the inherently unscientific nature of psychological analysis, ultimately leading to the positivistic theories of human choice behavior posited by the likes of Veblen, Hicks, Stigler, Menger, Jevons, and Walras (to name but a few), and later the normative and descriptive models of expected and discounted utility proposed by post-war neoclassicists von Neumann, Morgenstern, and Samuelson.[3]
Because of the strong assumptions underpinning the expected utility and discounted utility models (e.g., the Independence Axiom and exponential discounting, respectively), critics such as Allais, Ellsberg, Markowitz, and Strotz had, by the middle of the 20th century, identifed anomalous implications associated with these models. These implications would later be demonstrated in the famous laboratory experiments of Kahneman, Tversky, and Thaler (Camerer and Loewenstein, 2004). At around the same time as Kahneman and Tversky were running their experiments, developments in the field of cognitive psychology—known as “behavioral decision research”—suggested promising new directions for explaining choice behavior as a consequence of the brain’s information-processing capability.[4] As described in Angner and Loewenstein (2012), this parallelism between advancements in cognitive psychology and economic experimentation, along with the fact that cognitive science as a separate field of inquiry arose in opposition to the field of behavioralism in psychology, suggests that the label “behavioral economics” is arguably a misnomer. Perhaps it would be more accurate to dub the field “cognitive economics.”[5]
- The Theory of Moral Sentiments was Smith’s lesser-known book. He is best known for The Wealth of Nations, published roughly 15 years later in 1776, where he coined the now famous term “invisible hand.” Other important works commenting on the psychological underpinnings and determinants of utility—the bedrock concept of early 20th century neoclassical economics—include Bentham’s An Introduction to the Principles of Morals and Legislation (1789) and Edgeworth’s Theory of Mathematical Psychics (1881) (Camerer and Loewenstein, 2004). ↵
- Heukelom (2006) traces the origin of behavioral economics back further to the gambling problems proposed by French nobleman-gambler Chevalier de Méré in 1654. Perhaps the most famous gambling problem, the St. Petersburg paradox, was coined by Daniel Bernoulli in 1738 in his Commentaries of the Imperial Academy of Science of Saint Petersburg. Bernoulli’s solution to this gambling problem—the maximization of expected utility—rested upon the assumption of diminishing marginal utility of wealth (Heukelom, 2006). ↵
- As Camerer and Loewenstein (2004) point out, economists such as Irving Fisher and Vilfredo Pareto still stressed the role of psychology in choice behavior in the early part of the 20th century. In the latter part of the century, economists George Katona, Harvey Leibenstein, Tibor Scitovsky, and Herbert Simon—fathers of what is affectionately known as “old behavioral economics”—similarly stressed the role of psychology and bounded rationality as constraints on choices (Angner and Loewenstein, 2012). As Heukelom (2006) points out, economics and psychology ultimately go separate ways, the former employing Friedman’s positive-normative distinction, the latter using Savage’s normative-descriptive distinction. ↵
- See Hastie and Dawes (2001) for a nice discussion of behavioral decision research. ↵
- Kahneman (2011) provides an accessible account of how our brain’s information-processing capability drives the misconceptions and miscalculations that ultimately lead to the fallible heuristics and biases that he, Tversky, and Thaler (among others) have both documented in their experiments and subsequently used as grist for their alternative theories of choice behavior. These theories, explored in Section 1 of this book, are in turn the mainstay of behavioral economics. ↵
