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Behavioral Economics: The More We Learn, The Less We Seem To Know

-- By MichaelDuignan - 06 Apr 2010

Neoclassical economics has, over a half century, come to exert great influence over legal structures. In positive terms, it lends mathematical precision to legal thinking. As a normative system, it shapes vast areas of law dealing with transaction and choice. Some wonder if its legal influence, however, has reached a zenith. As new tools enable researchers to demystify the human brain and its cognitive limitations, some economists now question the assumptions neoclassical economics made concerning human nature. If a social theory is ultimately valued by how well it explains the forces guiding human behavior, this essay considers how such questioning might affect normative principles anchored to the neoclassical model.

The Hand Formula

In the 1947 case of United States v. Carroll Towing Co., J. Learned Hand put forth his eponymous formula for negligence liability. Where the burden of avoiding harm is less than the probability of the harm times the loss associated with the harm (B < P x L), the defendant who chooses not to avoid harm acts without requisite care. In that Hand introduced the idea of cost-benefit analysis as a bright line rule of tort liability, Carroll Towing represents prescient use of rational choice theory to render consistent qualitative judgments in the law. And though the Hand formula was non-binding, it retains analytical significance; it presumes a reasonable person is always capable of making rational decisions before acting.

Does the Hand formula really presume this? It certainly may impose liability on those whose precautions it finds insufficient, but it says nothing about whether reasonable people are always capable of doing that math, themselves. And while it may not bear on your overall point, it might be interesting to note that the Hand formula (or, more generally, cost-benefit analysis of tort claims) tends to be a feature of appellate cases, trial results being commonly controlled by the jury and its variably-informed understanding of the reasonable person standard (On Determining Negligence at 815).

Rational Choice Theory and the Law

The contemporary debate is fiercest at U. of Chicago, with Richard Posner representing the traditional law and economics movement, and Richard Thaler leading the developing field of behavioral economics (developing, because, as of yet, the field is without a formal theory).

According to Posner, the full range of human psychology can be sufficiently explained within rational choice theory. Fellow Chicagoan Gary S. Becker in his 1976 paper The Economic Approach to Human Behavior said, “[A]ll human behavior can be viewed as involving participants who [1] maximize their utility [2] from a stable set of preferences and [3] accumulate an optimal amount of information and other inputs in a variety of markets." At 14. Though generally accepted, the universality of the rule has invited challenge ever since.

Thaler, along with Cass Sunstein and Christine Jolls in A Behavioral Approach to Law and Economics, counters that certain peculiarities of human nature, though predictable, lie outside the scope of the traditional model. In so many words, the more evidence one can produce showing human decisions do not mirror neoclassical presumptions, the less explanatory power the traditional model retains as applied to the law. At 1474.

It would seem to me that as long as these peculiarities of human nature are predictable, there remains hope for a single, unified theory encompassing the facts explained by both economic theories. In fact, while I can appreciate that the two schools of thought are approaching the same subject from different perspectives, I have trouble understanding why they're presented as though at odds. Much like Arnold's understanding of the constitution as capable of supporting opposing views simultaneously, shouldn't Economics with a capital "E" be big enough to hold a Posner and a Thaler without the appearance of conflict?

Reasonable Persons, In Spite of Ourselves

Dan Ariely, author of Predictably Irrational, delightfully exposed the relativity of choice in a social experiment. A group of 100 college students were given an advert from The Economist magazine and asked to select one of three annual subscription options: online-only for $59, print-only for $125, or print-plus-online for $125. A small portion opted for the first, none for the second, and the overwhelming majority for the third, print-plus-online option. Then, Ariely asked another group of students the same question, only this time he removed the second print-only option that no one wanted. When deciding between online-only for $59 and print-plus-online for $125, the majority of students opted for the cheaper package.

Note: Edited above paragraph to match image (reversed online- and print-only).

The shift in students’ subscription choices undermines Becker’s assumption that people make decisions from “a stable set of preferences.” Does it really? What if, say, their preferences were stable and the second, rarely chosen option served to improve their information (e.g. perhaps absent option two, the average person was underestimating the cost/worth of paper copies). Ariely demonstrates that people’s preferences are not always fixed and absolute, but can be dynamic and relational to the environment in which choice is permitted to occur. According to Ariely, the way to get people to choose option A over option B is to add option A', a clearly less desirable alternative to option A, thereby increasing the relative attractiveness of option A.

Choice as a Double-Edged Sword

Under rational choice theory, multiple consumption options increase the likelihood that a given consumer will be able to find a choice suitable to his or her fixed preferences. However, Ariely suggests that benefit may be illusory, because carefully designed choices may actually shape the preferences of the individual. Obviously, this idea bears great significance for generally accepted notions of personal autonomy essential to constitutional law. Can you say more about this? It sounds like you're about to drop a legal bomb in the midst of this discussion on theories of economics, but it doesn't actually go off. Perhaps because I'm not as familiar with law and economics, the connection you're making isn't as apparent to me as your prose indicates it should be. Yet, for anyone who's ever entered a supermarket with one item in mind, and left carrying something else altogether, the potentiality of relative preferences is not totally far fetched.

What if we are simply so overwhelmed by multiple choices that we are blinded to our true preferences? Or what if a range of choices sometimes animates dormant preferences that we could not see otherwise? Either way, the prospects are not good for neoclassical assumptions. Further, the discovery of relative preferences has begun to infiltrate the way new market regulations are proposed. And neoclassical adherents are successfully shouting down such heretical assertions by labeling them old news.

Is this to say that we were previously blind to our susceptibility to choice-shaping marketing techniques? That would seem a bit of a stretch. Based on the information you've provided, I get the feeling the proposed bill seeks more to scapegoat neoclassical economics post-financial crisis than to reflect the increasing influence of behavioral economics. Perhaps, however, those two motivations are inextricably bound.

General Implications for Normative Structures

As Thaler et al did not profess to have an answer to rational choice theory, the movement remains limited to poking holes in the neoclassical model. Neoclassical economists will likely respond with the tested Whac-A-Mole approach: reinterpret rational choice theory in increasingly clever ways to explain away behavioral economists' findings as they arise. Or, seen from another angle, incorporate useful elements of behavioral economic study into rational choice theory?

If continuity is an essential goal of a normative structure, then, ideally, this debate engenders productive results for the law and economics movement, by encouraging it to reconsider and revise its premises, thereby strengthening the structure and the legal principles that depend on it. However, Thurman Arnold in The Folklore of Capitalism posited, "[l]aws and morals and economics are always arrayed against new groups which are struggling to obtain a place in an institutional hierarchy of prestige." At 4. If one adopts this view, the escalating debate around rational choice theory might signal the rumblings of an intradisciplinary holy war through which a new set of economic principles emerges. As an aspiring lawyer, the latter scenario presents both an exciting and disconcerting prospect, in that neoclassical assumptions undergird great real estate beneath contract, criminal and property law. My plan is to stay tuned.

Even with my limited study of Economics, I enjoyed your paper immensely. What I'd have liked to see was more tying into what these developments mean to the legal world, and/or why scholars continue to treat them as in conflict with one another rather than attempt to unify them under a single heading. Concerning the latter, perhaps I require a fuller grasp of the situation to understand a limitation on that possibility that is as yet invisible to me. -- JohnJeffcott - 26 Apr 2010

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