In an interview with an official of the Nobel Foundation, Scottish-born Princeton economist Angus Deaton went to the core of economics: “You have to understand what makes people tick.” Because the discipline is the study of how human beings choose to use available resources to meet their needs and wants, understanding “what makes people tick” is indeed key.
For many decades, however, economists ignored fundamental research on how people actually think and respond to motivations in the real world. Instead, they based their theorizing on a century-old assumption that pure rationality dominated human choices. That assumption had been useful, indeed intellectually liberating, at one time; but as inferences based on it were stretched further and further, it became a pitfall rather than a bridge.
Deaton’s work is so broad and rich, it cannot all be covered here. He is not the only insightful researcher in contemporary microeconomics. Nor is he out to attack or undermine any particular set of thought. He simply seems interested in better understanding of human behavior as a scholarly end in itself.
Deaton’s Nobel, announced last week, along with several others awarded over the past decade, illustrates the healthy way in which the discipline is leaving naive generalizations about human nature behind and returning to studying actual behavior to draw economic conclusions.
Economics has two general rubrics: macro and micro. Macro is the study of resource allocation at the national and international level.
Headline stories on inflation, the Federal Reserve, unemployment, etc. are macroeconomics.
Micro deals with resource use decision-making by a single person or a family or a business. My choosing wheat puffs over eggs and toast this morning was a micro issue as were the price quotes to a friend for installation of a new water heater, as are the relative acreages of Minnesota farmland planted to soybeans and corn in response to changes in the prices of these crops, and of fertilizer, and diesel fuel.
Deaton’s work largely is micro. It consists of examining real-world behavior by individuals, households and firms.
In this, he harks back to another Scot, Adam Smith, an acute observer of day-to-day life in the late 18th century. Smith observed humans acting and interacting in pin factories and on fishing wharfs. From that, he generalized about human resource-use decisions and how such individual decisions aggregated to affect society as a whole.
Smith observed, but he did not measure. He did not return to the same people or companies again and again seeking concrete quantifications of results. His work was hugely insightful but based largely on anecdote.
Over time, this changed. Some 45 years after Smith’s major work, David Ricardo laid out much more formal theorizing along the lines of: “humans make rational decisions so as to get the most satisfaction of needs and wants possible. So what would a rational person do in this case? And how do the results of such rational individual decisions aggregate up to a nation?”
Throughout the 1800s, other thinkers made theorizing mathematical, utilizing algebra and then calculus and incorporating available quantitative data. In the 1900s, governments began tabulating such data. National series on consumer prices, employment and unemployment date to the Progressive Era impulses of the Wilson administration. Measuring output with GDP and other “national income accounts” came after World War II.
Up to the Great Depression, there was no macro-micro split. What was thought true for individual persons and companies led logically to an outcome for a whole country. That outcome concluded that little government action was necessary for an economy to be as well off as it could. Market forces produced an optimum, and departures from that were self-correcting.
The Depression seemed to refute that, and John Maynard Keynes argued, in effect, that economics suffered from a fallacy of composition, assuming falsely that what was true for an individual was necessarily true for a very large group. Actually, market forces that motivated individuals to efficient resource use did not always push a national economy toward prosperity.
Keynes’ ideas for national economic policies gained the upper hand within economics, at least for several decades. But they imposed the discomfort of using one set of assumptions about human behavior for microeconomics and a different set for macro.
As three decades of implementing Keynes’ ideas seemed to result in the “stagflation” of the 1970s, some economists, including several who later won Nobels, refuted Keynes. This “Rational Expectations” movement gained sway among younger economists in the 1980s and 1990s.
To the next generation, the long-prevailing assumptions about human decision-making were increasingly at odds with the best research by psychologists, especially work by Israelis Amos Tversky and Daniel Kahneman.
So we got a new cohort of economists who focused on understanding actual, rather than assumed, human behavior. Some “experimental economists” adopted laboratory methods. Some styled themselves as “behavioral economists.” And some, including Deaton, simply were very thorough microeconomists, trying to study human economic decision-making in the real world without prior assumptions.
This included research on methodology, how to determine the best ways of following behavior over time. These might be preferences in what people consume or how they divide money between savings and consumption. Did one have to select a group of specific people and follow those individuals over years? Or could one get reliable results drawing different samples from the same cohort of people at different times?
For a good summary of Deaton’s work, search for “Popular Information: Consumption, great and small” on the Nobel Foundation website. He does get into policy areas, notably in his assessment of the effectiveness of foreign aid. His argument that much such aid is ineffective does not go down well with everyone, including Bill Gates, who voiced sharp comments on news of Deaton’s award. Gates and his wife are distributing much of their fortune in such aid efforts. These differences may not be as deep as they appear, however.
Moreover, liberals who dislike Deaton’s position on aid may be very happy with his work on the causes and especially the effects of unequal income distribution. This approaches the topic from a very different angle than that of French economist Thomas Piketty but reaches some congruent conclusions. That, however, merits a column in itself.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.