For the longest time, Economics is believed to be the “Physics” of all social sciences. Among social scientists, economists are well known for their fascination in using mathematical equations and models to explain various economic phenomena that have shaped the modern world. In fact, most winners of the prestigious Nobel Prize in Economic Sciences are also known mathematicians.
In recent decades, mainstream economics is being criticized because of its excessive use of sophisticated modeling techniques that dilute the realism of economic analysis. The term “physics envy” was coined to describe the deliberate use of complicated mathematical analysis in academic workings of economists to imitate the rigors of mathematics-based fields like Physics. Moreover, critics of the field also questioned the standard neoclassical assumption that people are generally “Homo-Economicus”, or to put it simply, that humans are rational and self-interested well-beings pursuing their subjectively-defined ends optimally. These critics believe that in reality, a human mind is prone to systematic errors that cause some deviation to the prediction of the standard rationality framework.
The criticisms of the standard neoclassical model of economic decision-making marked the emergence of behavioral economics—a method of economic analysis that uses psychological insights in understanding human behavior and their decision-making process. Even though some people appear to think that fusing psychology concepts makes economics a woolly discipline, we cannot deny the fact that economics and psychology are inseparable. There is a notion that the classical and early neoclassical schools of thought were developed outside the scope of psychology and sociology. This notion is rather inaccurate; in fact, Adam Smith wrote a book entitled “The Theory of Moral Sentiments” in 1759. This book foreshadowed the use of behavioral concepts in economics—specifically explaining how emotions can impact human decision-making process.
There was a time in the 19th century where a number of neoclassicists explored the use of mathematical tools to improve the academic rigor of the discipline; however, achievement of mathematical sophistication in Economics occurred at the expense of behavioral considerations. In the early part of the 20th century, the advent of advanced computational methods further influenced economists to become even more obsessed with the use of mathematical and econometric methods. The quest to provide a more rigorous grounding to economic analysis came with a price of imposing over simplifying behavioral assumptions that make economic models oftentimes unrealistic.
The latter part of 20th century marked the resurgence of behavioral consideration in Economics. Daniel Kahneman and Amos Tversky published an article entitled “‘Prospect theory: An analysis of decision under risk” in 1979. These two psychologists set the foundation of Behavioral Economics in the arena of economic sciences. In fact, their work is the most cited journal article of Econometrica, inspiring modern economists—including Vernon Smith and Alvin Roth—to further expand this budding area in Economics.
Even though Behavioral Economics challenges the current landscape of mainstream economics, it must not be treated as a nemesis of the standard framework of economic analysis. Colin Camerer, a known supporter of behavioral economics said that “It is important to emphasize that the behavioral economics approach extends rational choice and equilibrium models; it does not advocate abandoning these models entirely”. Thus, the development of Behavioral Economics does not aim to replace mainstream economics, but rather, it just seeks to increase the explanatory power of economics by using more realistic psychological foundations.