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Behavioral Economics and Complexity

Contemporary behavioral economics has its roots in mid-twentieth-century social science. Pioneering sociologists such as Stanley Milgram and Robert K. Merton conducted wide-ranging experiments and analyzed data to develop new insights into human behavior.

Robert K. Merton’s most famous contribution was the formalization of the idea of the self-fulfilling prophecy. The idea is that a statement given as true, even if initially false, can become true if the statement itself changes behavior in such a way as to validate the false premise. Intriguingly, to make his point Merton used the example of a run on the bank in the days before deposit insurance. A bank can begin the day on a sound basis with ample capital. A rumor that the bank is unsound, although false, can start a stampede of depositors trying to get their money out all at once. Even the best banks do not maintain 100 percent cash on hand, so a true bank run can force the bank to close its doors in the face of depositor demands. The bank fails by the end of the day, thus validating the rumor even though the rumor started out as false. The interaction of the rumor, the resulting behavior and the ultimate bank failure is an illustration of a positive feedback loop between information and behavior.

Merton and other leading sociologists of their time were not economists. Yet in a sense they were, because economics is ultimately the study of human decision making with regard to goods in conditions of scarcity. The sociologists cast a bright light on these decision-making processes. Former Bear Stearns CEO Alan Schwartz can attest to the power of Merton’s self-fulfilling prophecy. On March 12, 2008, Schwartz told CNBC, “We don’t see any pressure on our liquidity, let alone a liquidity crisis.” Forty-eight hours later Bear Stearns was headed to bankruptcy after frightened Wall Street banks withdrew billions of dollars of credit lines. For Bear Stearns, this was a real-life version of Merton’s thought experiment.

A breakthrough in the impact of social psychology on economics came with the work of Daniel Kahneman, Amos Tversky, Paul Slovic and others in a series of experiments conducted in the 1950s and 1960s. In the most famous set of experiments, Kahneman and Tversky showed that subjects, given the choice between two monetary outcomes, would select the one with the greater certainty of being received even though it did not have the highest expected return. A typical version of this is to offer a subject the prospect of winning money structured as a choice between: A) $4,000 with an 80 percent probability of winning, or B) $3,000 with a 100 percent probability of winning. For supporters of efficient market theory, this is a trivial problem. Winning $4,000 with a probability of 80 percent has an expected value of $3,200 (or $4,000 × .80). Since $3,200 is greater than the alternative choice of $3,000, a rational wealth-maximizing actor would chose A. Yet in one version of this, 80 percent of the participants chose B. Clearly the participants had a preference for the “sure thing” even if its theoretical value was lower. In some ways, this is just a formal statistical version of the old saying “A bird in the hand is worth two in the bush.” Yet the results were revolutionary—a direct assault on the cornerstone of financial economics.

Through a series of other elegantly designed and deceptively simple experiments, Kahneman and his colleagues showed that subjects had a clear preference for certain choices based on how they were presented, even though an alternative choice would produce exactly the same result. These experiments introduced an entirely new vocabulary to economics, including certainty (the desire to avoid losses, also called risk aversion), anchoring (the undue influence of early results in a series), isolation (undue weight on unique characteristics versus shared characteristics), framing (undue weight on how things are presented versus the actual substance) and heuristics (rules of