Kahneman and schizophrenia in economics

I was at a fascinating session last night, with Nobel Laureate Daniel Kahneman in conversation with a leading thinker from the advertising world, Rory Sutherland of Ogilvy and Mather.  Kahneman was talking about his book Thinking Fast and Slow, a summary of his life’s work.

I am a great admirer of Kahneman.  Trained as a psychologist, along with his co-Laureate Vernon Smith, he more or less created experimental and applied behavioural economics.  He had the extraordinary idea (!) that instead of theorising a priori about how ‘rational’ people ought to behave, we should observe how people really do behave.

His work shows that, in general, people do not behave as the model of Rational Economic Person says they should.  His Nobel lecture is very accessible, written in English, and is available at http://www.nobelprize.org/nobel_prizes/economics/laureates/2002/kahneman-lecture.html.    He concludes that ‘people reason poorly and act intuitively’.

Yet despite his scientific standing, economic theory has so far made very little use of his results.  Theoretical journals are still replete with articles full of calculus, in which agents (economist-speak for ‘people’) are reasoning very well, and taking the ‘optimal’ decision.

So there is a schizophrenia in the profession of economics.  Nobel prizes are awarded to people whose work shows empirically that in general people do not optimise.  Theoretical work carries on in the same old way, assuming that they do.

Why is this?  Perhaps Kahneman’s own work gives us an insight.  He distinguishes between System 1 and System 2 thinking.  System 1 is when the brain is almost on autopilot.  He illustrated this in his talk last night.  ‘If I mention the word “vomit”, your brain reacts.  If I ask “what is 2 plus 2?”, the answer comes in your mind automatically’.  System 2 thinking requires much more effort – most people, he said, cannot multiply 24 and 17 whilst at the same time negotiating a right turn in heavy traffic.

Actually, I guess that most economists could do this.  Many of them could even carry out the maths required to optimise a particular function at the same time!  In other words, economists are so steeped in calculus, they have performed these mathematical operations so many time, that for them, the maths of calculus has become System 1 thinking.

So when economists approach a problem it has become second nature to write down some functions and to maximise (or minimise) them.  It is as instinctive as adding 2 and 2 is for more normal people.

But Kahneman’s empirical insights require hard System 2 thinking.  You are trying to understand a particular problem.  Well, exactly how do agents behave in this situation?  What rules are they following, how do we translate them into maths, can we solve the resulting equations or do we need numerical solutions?

In short, it is much harder to do Kahneman-inspired theory than it is to maximise a utility function.  In economic theory, System 1 thinking rules!