Written by Amer Goel
“We could solve all our problems if only we were the efficient, rational human beings of standard economic theory,” said Jeremy Grantham, British investor and CEO, as he speculated on the base assumption of every modern economic theory: a purely rational society. In a world where everyone is rational, motivated by self-interest, the magic of incentives would create a perfectly innovative and efficient society – if not always equitable.
Unfortunately, today’s neuroscience tends to suggest that Grantham’s utopia is as unrealistic as any other, because humans are often not rational economic actors. In fact, the presence of irrationality is so prevalent in human decision-making that economic theorists have recently created a new interdisciplinary field of economics and psychology: behavioral economics. When fundamental assumptions about economic rationality prove untrue, economic models decompose quickly. Supply and demand slope incorrectly and uncertainty plays a much bigger role. In order to correct these assumptions in their models, economists have started to explore psychology.
At the cutting edge of behavioral economics is neuroeconomics, which extends psychology into neurology. Instead of looking at patterns of human behavior to interpret economics, it looks at unambiguous, indisputable brain structures and processes to see how and why those decisions are made. This field, although largely experimental and very new, could produce some concrete, definitive and groundbreaking results about how economic actors make decisions. Neuroeconomics could provide some long overdue answers to questions about rationality, proving once and for all that economics is grounded on correct, reasonable assumptions and that the models can predict behavior accurately. This article will look at two important examples of neuroeconomics from a study by Colin Camerer, George Loewenstein, and Drazen Prelec called “Neuroeconomics: How Neuroscience Can Inform Economics” to show the usefulness of the field, as well as prospective topics it could address.
There are two applications of economics to which neural analysis is particularly useful: decision making, especially under risk and uncertainty; and game theory/strategic interactions. In both of these topics, researchers use functional magnetic resonance imaging (fMRI) and other imaging techniques to measure neural activity in different areas of the brain, revealing to them which parts of the brain are involved in different economic activities.
Decision making under risk and imperfect information is one of the most studied topics in neuroeconomics. Traditional economics sees decision making under risk as a probability distribution, where each choice has a certain value (positive for rewards, negative for costs). Economic actors evaluate each decision, and act under the risk if their expected value is positive, and abstain if it’s negative. However, neural analysis has called this philosophy into question.
It’s likely that the actual thought process involves emotions involved with gain and loss, rather than an objective analysis of possible outcomes. It is especially dependent on the amygdala, the part of the brain responsible for fear and anger. It is the amygdala that creates a phenomenon contrary to traditional economic analysis: loss aversion. The sadness people feel from losing $1 is greater than the happiness they feel by gaining $1. This means that people are more risk-averse than previously thought, because the prospect of loss is worse than the prospect of gain. People will no longer take a fair bet, even though they have an equal chance of winning and losing the same amount.
The amygdala is especially sensitive to stimulus. It exhibits a behavior called “fear learning” by which it remembers past losses and avoids similar situations (44). This means some people are more risk averse, depending on their previous life experience, because a bad past experience makes them more fearful of making the same decision.
Also, the amygdala tends to overreact without enough information. This means that when given two equal decisions, but one with complete information and one with incomplete information, the amygdala will almost always choose the one with more information- even though traditional economics would logically be indifferent between them. Take the used car market as an example. Buyers of used cars have less information about the car they’re buying than the seller does, and almost no information about how honest the seller will be, which leads them to distrust the seller. Many people decide because of this to buy used cars from friends and family, even if the same car is available at a dealership. They have more information about the trustworthiness of their friends and family, which makes their brain more comfortable with the purchase.
The second application to which neuroeconomics is most useful is game theory. Game theory, or strategic decision making, involves making decisions that are dependent on other people’s decisions. Like most economic models, it assumes that people will only choose what’s best for themselves independent of others. Recent studies of brain function shows that this assumption is not completely true for two main reasons.
People are sometimes unable to make the best, rational decisions for themselves. When they are inebriated, sleep deprived, or disoriented, they may make an “irrational” decision. In a study of circadian rhythms, for example, the researchers found that when people were in an nonoptimal mental state, they made worse decisions (48). They also found that these people would cooperate less, making them less trustworthy.
Additionally, people are not as self-centered as traditional economics sees them. Oxytocin is a powerful hormone that “rises during social bonding” (48). It can provide a biological incentive for players to think about others’ payoffs along with their own, because they’re rewarded when they bond with the other player. This could incentivize them to give up their own payoffs, showing trust and cooperation in an effort to bond. In the classic prisoner’s dilemma, for example, two prisoners betray each other for their own personal gain, at the expense of the other. In an uncharacteristic show of optimism in economics, however, it’s possible that these prisoners collaborate, even if it’s not intentional, because they are biologically inclined to help their fellow human being. It’s a possible show of hope, providing sound economic knowledge for the presence of altruism.
Neuroeconomics is a biological approach to economic decision making. Brain imaging technology has allowed researchers to provide some more concrete insight to ambiguously defined topics and their assumptions. It is shown that people tend to be over-reactive to risk and uncertainty, and that strategic players are not always rational and selfish. All of these upset the traditional economic framework, which is dependent on an assumption of self-interested “rationality.”
Neuroeconomics is new, but it could completely restructure how we think about economics. It has been lending evidence, confirmatory or contradictory, to key assumptions underpinning modern western economic theory and could bring economists closer to a complete understanding of human behavior. With the advancement of imaging technology, economics is merging further with life sciences, creating a new, interdisciplinary field with unprecedented results.
References
Baumeister, Roy F., et al. “Does High Self-Esteem Cause Better Performance, Interpersonal Success, Happiness, or Healthier Lifestyles?” Psychological Science in the Public Interest, vol. 4, no. 1, 2003, pp. 1–44., https://doi.org/10.1111/1529-1006.01431.
Camerer, Colin, et al. “Neuroeconomics: How Neuroscience Can Inform Economics.” Journal of Economic Literature, vol. 43, no. 1, 2005, pp. 9–64., https://doi.org/10.1257/0022051053737843.
Chen, James. “What Is Neuroeconomics?” Investopedia, Investopedia, 6 Sept. 2021, https://www.investopedia.com/terms/n/neuroeconomics.asp.
Knowledge, HBS Working. “Neuroeconomics: How Brain Science Matters to Business.” Forbes, Forbes Magazine, 27 Feb. 2014, https://www.forbes.com/sites/hbsworkingknowledge/2013/02/11/neuroeconomics-how-brain-science-matters-to-business/?sh=a70ab1c7854c.
Postrel, Virginia. “Economic Scene; Looking inside the Brains of the Stingy and the Openhanded.” The New York Times, The New York Times, 27 Feb. 2003, https://www.nytimes.com/2003/02/27/business/economic-scene-looking-inside-the-brains-of-the-stingy-and-the-openhanded.html.