When you think of economists, the picture that likely comes to mind is a professor or government employee or corporation executive working out equations describing gross domestic product for various countries, predicting what the market will be the next year for coal, or advising the Federal Reserve about how to set rates for overnight loans. Work on such a large scale is called macroeconomics. Economists who do that kind of work are not getting as much respect lately as in times past. We have it on the authority of the Nobelist Paul Krugman that no economist predicted the Great Recession of 2008. (Except for one who had successfully predicted nine of the previous five recessions!) Indeed, some critics claim that erroneous mathematical models by economists in investment banks and the ratings companies contributed to the circumstances that made the recession possible.
A pair of economists won the Nobel Prize in 2013 for showing that the stock and bond markets are utterly accurate and rational. Stocks and bonds are always worth exactly what they are selling for at any given moment; consequently it’s impossible to beat the market by trying to time it. Another economist won the Nobel the same year for showing that markets are less than completely rational and driven in part by emotional overreactions; consequently it’s quite possible to make money by timing the market successfully! (I have economist friends who tell me these positions aren’t really contradictory. I just pass that along.)
Regardless of which economists are right about the big-picture issues, it’s not likely that you need to know much about macroeconomics in order to live your life in the most effective way. There is another branch of economics, however, that is concerned with how to live your life. Microeconomics is the study of the way individuals, corporations, and entire societies make choices. Microeconomists are also in the habit of telling us how we should make decisions. Both descriptive microeconomics and prescriptive microeconomics are embroiled in controversy. Over the last hundred years or so, many different descriptive theories of choice and many prescriptive theories of choice have been proposed. The field has been near agreement on these matters from time to time, but then someone comes along with a new paradigm and battles begin anew.
The most recent microeconomic warfare has resulted from cognitive psychologists and social psychologists entering the fray. The field of behavioral economics is an amalgam of psychological theories and research and novel economic perspectives. This hybrid seeks to overturn traditional descriptive and prescriptive theories of choice. And behavioral economists are beginning to move into the business of helping people to make choices. They’re not only telling you how to make choices, they’re engineering the world so that you make choices they believe to be optimal. If this sounds Orwellian, it really isn’t. The tongue-in-cheek name that some behavioral economists use to describe their enterprise is “libertarian paternalism.” These economists will tell you how to make choices and arrange the world so that you’ll be likely to make good ones. But they’re not forcing you. You can always choose to ignore the choices they steer you toward making.
As you might expect, the entry of psychologists onto the economic scene has brought along some of the basic assumptions discussed in the previous chapters. These include the contention that we don’t always know why we make the choices that we make, and that our choices, like other behaviors, are not always fully rational. That’s why you need some help, according to behavioral economists.
Chapter 4 presents some fairly traditional economic theory about how people make choices and how they should make them. Most of the material there is accepted by most economists, including those of the maverick behavioral sort. Chapter 5 shows the kinds of errors that people can make across the entire spectrum of daily choices. Knowing about those errors will improve how you approach the innumerable choices you face every day. Chapter 6 presents the behavioral economic view of how we make choices, how we should make choices, and why it’s a good idea for experts to nudge you in the direction of superior choices.