Finding the Missing Link between Economics and Psychology

Behavioral Investment Theory connects economics with psychology.

Posted Jun 05, 2015

Despite the fact that acquiring and spending money is one of the most central features of modern life, as a discipline psychology more or less completely neglects the topic of money and markets. Leaf through an introductory psychology textbook and you will be hard pressed to find much on information on how people generate, spend and save capital. One of the reasons for this neglect is that this topic is covered by a separate field, economics. I am listening to an Econ 101 course in my car and it has covered the law of supply and demand, the power of the free market to generate complex growth, tensions between free markets and government control, interest rates and the future value of money, positive and negative market externalities, and a whole host of other topics related to monetary exchange and the generation of wealth.

Apart from an offhand joke made by the professor in the beginning of class about the relationship between the brains of economists and psychologists, there literally has not been a single word about the field of psychology uttered in the course. From the vantage point of the unified approach, this absence of connection is truly remarkable. Economics is generally defined as the science “which studies human behavior as a relationship between ends and scarce means which have alternative uses”. If we consider that psychology is the science of behavior and mental processes (see here for how we should technically define psychology), then the fact that the basic version of each discipline completely neglects the other means that there is a major missing link in our map of human knowledge.

More advanced treatments of the two disciplines do result in interconnections between them. Indeed, over the last twenty years there has been an explosion of growth in the field of “behavioral economics”, which can be considered to be a hybrid discipline between psychology and economics. (See here for an interesting interview with PT Blogger Adam Grant on why he tends to be identified as a behavioral economist rather than an organizational psychologist). Much of the foundational work in behavioral economics was sparked by the cognitive psychologist Daniel Kahneman and Amos Tyversky, who brilliantly explored how humans make decisions based on framing and heuristics. As reviewed in depth here, this work has had a huge influence on micro-economic theory. Much of the groundwork for Kahneman and Tyversky was laid by Herb Simon, a polymath who was interested in human cognition and decision-making who demonstrated that people make decisions based on information that was deemed good enough rather than optimal. Although both Kahneman and Simon were primarily focused on human cognition and decision-making, it is worth noting that they both won Nobel Prizes in Economics—part of the reason being that there is no Nobel Prize in Psychology.

The reason why psychological research has begun to have a significant impact on economic theory becomes apparent when one considers the theory of human behavior on which economics has been traditionally based. Classic economics is grounded in the idea that humans are purely rational creatures who are motivated and able to make optimal decisions about maximizing their own economic interests and subjective desires. This is a picture of human nature that is sometimes called homo economicus. Although many economists do not believe this to be a fully accurate picture of human behavior, this conception was used because it was valuable to economists for many reasons, including the fact that it allowed them to provide a framework for the law of supply and demand (pricing in free markets can be understood as the process by which people are, in aggregate, maximizing their economic interests) and to generate mathematical equations that represent utility maximizing functions, which indeed do describe and predict aggregate economic patterns.

As a psychologist interested in a broad, consilient view of human knowledge, I have always found the view of homo economicus to be a curious one. First, as made famous by the likes of Simon and Kahneman and Tyversky, it is clear that humans do NOT always behave in a way that maximizes their economic interests, at least not an absolute, straightforward sense. If I am at a store and I see a shirt for $25 and someone tells me that 10 minutes down the street another store is selling that same shirt for $15, I likely to take the time to go get the shirt and save ten bucks. However, if I am buying a car for $19,995 and someone tells me the same car is selling for $19,985 down the street, I don’t worry about it. Yet, this is confusing from the view of homo economicus because it is the same amount of money saved for the same amount of time! Likewise, we know people are much more upset if they lose $10 than they are happy to gain $10. These examples are just some of many I could give showing that homo economicus is off base at the level of how people actually behave in economic contexts.

Of course, outside economic contexts homo economicus offers a completely unworkable view of human nature. I am a clinical psychologist who has spent many hours doing psychotherapy with troubled souls. The notion that humans are completely rational, all-knowing utility maximizers seems about as far off base as one could imagine in the context of the therapy room. And it offers nothing to say about individual differences or intrapsychic structure or the cognitive-affective processes that are presumably involved in the rational, self-interested, economic calculation.

Another big problem with homo economicus is the question of where this capacity for rational economic self-interest actually comes from. The model exists as if a primitive species of Homo sapiens, who for eons lived in hunter-gatherer groups with no monetary exchange, one day woke up, invented money, and then completely changed their motivational set, such that now they behaved based on completely rational, economic self-interest.

The point here is that economics is clearly missing its foundation. It hangs there in intellectual space, anchored to an obviously flawed, simplistic model of human nature. Economists invented Homo economicus because that conception works reasonably well as an aggregate-level description of human decision-making and exchange. Get people together, get them exchanging goods with a currency and they work to maximize the return on their investments. Such a conception grounds the fundamental law of supply and demand, which is clearly a foundational principle for describing the emergence and fluctuation of market behavior.

And yet psychologists know that at the level of the individual human behavior and the human mind, homo economicus is a very weak framework, especially for understanding personality and individual differences. And homo economicus is completely lacking in terms of evolutionary history. The evolution of money and markets took thousands of years, and the evolution of the behavioral systems upon which money and markets are built took hundreds of millions of years. Thus, there clearly is a massive missing link between psychology and economics.

According to the unified appraoch, the missing link is provided by Behavioral Investment Theory (BIT). A central piece of the unified approach, BIT is an integrative theory of animal behavior that combines the modern evolutionary synthesis with cognitive neuroscience and Skinner’s conception of behavioral selection into a coherent framework. The key insight of BIT, as suggested by the name, is that free movement is the central feature of being an animal, as contrasted with other multi-celled organisms like plants. The second key feature is that animals must acquire energy from other organisms and that this energy is acquired via movement. When these insights are combined, the conclusion is that behavior is a form of commerce the animal engages in, whereby the energy expended in the action must be assessed relative to the energy acquired by that action relative to other costs.

If this is the fundamental evolved problem of animal behavior, then, as the “organ of behavior”, it follows that the nervous system functions as an investment value system that computes the costs and benefits of “spending” actions. Consistent with this formulation, the first principle of BIT is the principle of energy economics, which is the notion that, to survive and reproduce animals must, on average, acquire more workable energy from their behavioral investments than those behaviors cost.

Why is this relevant for economic theory? Because the general idea of behavioral investment provides a foundational framework for understanding the emergence of economic patterns across aggregates of actors, as seen in the law of supply and demand. Free markets behave according to the law of supply and demand because the human nervous system evolved as a function of being shaped by the first principle of BIT, the principle of energy economics. As laid out by the unified approach, this conception is deeply consistent with many basic paradigms in animal behavior (e.g., operant theory, optimal foraging theory, and so on), and it is consistent with what we know about human psychology.

Thinking about the base of human psychology as an evolved system of behavioral investment that was shaped via evolutionary processes according to the principle of energy economics is a much more accurate and workable conception that homo economicus. Such a view provides a foundational framework for understanding the processes that give rise to emergent phenomena like the law of supply and demand, which emerge as a function of human behavioral investors operating in aggregate in free markets. Thus, it solves the basic gap for which homo economicus served as a placeholder. But it does so via a deep connection to evolutionary and learning theory, rather than an obviously fictional and unworkable account of human nature as a pristine economic calculator.