Background

Economics is, essentially, the study of human choice and behaviour. As such, various general theories of how humans make choices have been analysed and discussed within economics.

Classical, 1800-1850

Classical economists did not focus a great deal on the behaviour of individuals, being more concerned with "political economy". However, they laid the foundations for later study. Adam Smith famously wrote in The Wealth of Nations "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."¹⁶ So Smith argued that people usually act in their own interest. This view of humans as broadly self-interested has persisted as the default assumption in economics, although even Smith realised that people were not always selfish; in The Theory of Moral Sentiments he wrote that "How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it."¹⁷

Neoclassical, 1870-1900

Neoclassical economists, particularly William Stanley Jevons, built on Smith's view of humans as self-interested to produce their theory of human behaviour. They also built on the concept of "utility", which had previously been discussed by the philosopher Jeremy Bentham and Classical economist and philosopher John Stuart Mill.¹ Utility was essentially a measurement of pleasure; the foundation of neoclassical economics' theory of behaviour is that people act to maximise their utility. An important contribution was the concept of diminishing marginal utility: the utility gained from the second product a person buys is less than the amount they gain from the first. This limits the quantity of a good that people will buy, as each item has the same cost. Jevons went on to explain that the ratio of marginal utility - the utility from consuming one more unit - between two goods for a particular person must be equal to the ratio of their prices; if not, the person could increase their utility by buying more of the good with the lower relative price and less of the other, until the marginal utility changed (because of diminishing marginal utility) to meet this rule. The basic neoclassical perspective is that humans act rationally - they take whatever action maximises their utility - based on all relevant information. This is often referred to as rational choice theory. ⁸

Other applications of rational choice theory, 1950 -

In the second half of the 20th century, various economists began to apply the neoclassical concept of human behaviour to non-economic fields. The most notable of these was Gary Becker. Becker applied rational choice theory to explain marriage, discrimination, crime, addiction, and various other non-economic areas of human behaviour. Although they often seem simplistic at first glance, many of Becker's theories are well supported by evidence. Another application of rational choice theory is public choice theory, which assumes that politicians and people in government are rationally self-interested, and uses this to study effective institutions and the avoidance of corruption. These theories have significantly changed our understanding of human behaviour, although they are frequently criticised by other social sciences for using economic theories in inappropriate contexts.^{1, 19}

Criticisms of rational choice theory, 1950 -

Rational choice theory, while it might be a useful baseline, is clearly not a completely realistic model of human behaviour. From around 1950 onwards, many formal modifications to this model were made. One of the first was the concept of bounded rationality. This had been touched on by Keynes but was formalised by Herbert A. Simon in the 1950s. It stressed that people do not in real life have access to all relevant information about their decisions, but have to make decisions based on uncertain and incomplete information. Additionally, even if they have a great deal of information, the amount of time and effort required to process this and come to a rational decision may be prohibitive, which means that people have to use heuristics - simple rules that make approximately rational choices, but are not always accurate - to come to their decisions. These concepts were developed in the 1970s and 80s by later thinkers. The psychologists Daniel Kahneman and Amos Tversky documented many heuristics and examples of irrational behaviour, creating the field of behavioural economics, which tries to modify rational choice theory to fit with actual human behaviour. Additionally, George Akerlof, Michael Spence and Joseph Stiglitz all analysed the effects of markets where one participant has more access to information than another, a situation known as asymmetric information. These developments have produced interesting results, but there is no comprehensive theory of human behaviour to replace rational choice theory.

The future

The recent developments presenting an alternative to rational choice theory have produced some very interesting results. These theories are based on sound empirical evidence, and are more realistic than simple rational choice theory. Behavioural economics has been used to influence public policy, in particular through Richard Thaler's Nudge theory. There is also a role for behavioural theories in macroeconomics, particularly in business cycle models, as irrational behaviour may be at the heart of many recessions; this avenue of research has not yet been fully explored. However, the lack of a simple model of irrational behaviour is an obstacle to its further use in economics. The asymmetric information approach also usefully explains many features of real world markets.