Economic Theory

Behavioural economics and human imperfection: A bad case for government control

One thing that has always struck me about behavioural economics are the parallels to arguments about market failure (such as externalities). Much of behavioural economics shows us that economic agents are not the rational utility-maximisers of standard economic theory (as does much of psychology, of course). But what this result implies for economics and policy depends upon whose hands the results are in. One school of thought seems to say, “A-ha! Agents don’t act like our ideal models of behaviour, therefore agents fail to behave in the way necessary for those models to work.”

Thus, in this view, “agent failure” leads to “market failure.” And notice the parallel structure of the two “failures:” in both cases, failure is defined as not matching the idealised, perfect result, either perfect rationality or perfect competition/general equilibrium. The remedy, of course, is some combination of paternalism and intervention to bring the failed agent or market closer to the modelled ideal.

In the hands of some others, especially those working in the Vernon Smith tradition, the “agent failure” discovered by behavioural economics becomes not a cause to castigate the real world for not matching the model, but an opportunity to explore how imperfect agents do in fact learn sufficiently well to generate outcomes that, while still imperfect, are much closer to rational than any alternative. In Smith’s concept of “ecological rationality,” it is our institutions that do (to use Pete Boettke’s phrase) the “heavy lifting” of generating social order, not the behavioural assumptions we make about agents. In other words, the imperfections of agents are an opportunity to use market institutions to achieve outcomes comparatively superior to any alternative set of institutions (though those results are still “imperfect”).

Rather than condemning agents for their imperfections (“failure”), we should ask how order still gets generated despite those imperfect agents and whether that order is better or worse than alternatives. Notice how this too parallels the market failure literature. The response by various approaches (e.g. UCLA, Virginia, Austrians, NIE) to externality arguments has been to see such supposed market failures not as cause for condemnation but as an opportunity to do one of two things:

  1. Engage in comparative institutional analysis and ask whether “failed” markets are still better than “failed” government intervention.

  2. View market “failures” as opportunities for entrepreneurs to step in with ways of solving the externality problem and reducing the relative imperfection of the market outcome.

Both solutions are not only possible, they are compatible: part of what makes imperfect markets better is that welfare-enhancing entrepreneurial action is more likely there than in politics. It would also be interesting to see whether the move to behavioural economics in recent years is the result of market failure arguments not being as persuasive in light of decades of criticism of the sort noted above.

If one wants to be more cynical, one might see the failure of market failure theories (there’s a great paper title!) as the motivating force to turn away from markets and toward agents as the element that fails to match the model, and thereby brings down, in the eyes of the externality crowd, the argument for the market.

Part of the problem here is language. We need to jettison the language of “market failure” and perhaps replace it with “market imperfections.” At least the latter suggests there is still a functioning market there capable of correcting its imperfections. A “failed” market would not seem to be capable of self-correction. Or to use some language Dick Wagner has used: an “imperfect” market still is capable of “becoming,” while a failed market is just “being” failed.

Similarly, we should be sure to avoid using the results of behavioural economics to talk about the equivalent of “agent failure.” As we’ve known since Carl Menger, human beings are imperfect actors, caught between alluring hopes and haunting fears and stumbling and bumbling our way through an uncertain world. We “fail” all the time, and it is because of the institutions of the market, such as property rights, contracts, prices, and profit/loss – and the possibility of economic calculation that they bring – that we are able to overcome our limits and produce the order that we do.

Where externality theory sees market failure and behavioural economics sees agent failure, Austrians and others see the normal imperfections of human life and the opportunity to understand how the rules and institutions of the market are resilient enough to enable us to overcome those imperfections and get Paris fed.

Prof Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University. This article was first published by the Foundation for Economic Education (FEE).