Hayek and Behavioral Economics

R. Frantz, R. Leeson, R. Frantz, R. Leeson

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137278159
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

An exploration of Friedrich Hayek's contribution to the foundation of behavioural economics, and how his work interacted with and complemented that of his contemporaries. Chapters include detailed discussions of the concept of rationality, psychology and Hayek's philosophical theories as well as the historical context in which he lived and worked.

1

Frederick Hayek’s Behavioral Economics in Historical Context

Roger Frantz

I Introduction

In history of economic thought and comparative economic systems classes my lectures include Hayek’s Road to Serfdom and his part in the socialist-planning debate. Hayek gained much renown for his work on the socialist calculation debate, including his book The Road to Serfdom (1944). The book gained Hayek much notoriety but his belief that the book was too popular (there was a Readers Digest edition) and not rigorous enough led him to pursue something more “scientific” and “rigorous.” The result was The Sensory Order (1952), an investigation into the relationship of the brain and memory, and the nature of the human mind.

I knew that Hayek was an Austrian Economist and that he had a theory of the business cycle, and that he won a Nobel Prize in 1974 which he shared with Gunnar Myrdal for their work “for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena.” For years it did not occur to me that an “analysis of the interdependence of economic, social and institutional phenomena” was where much of his behavioral economics was embedded.

All in all, I knew very little about his work. However, he was always a curiosity, someone whose work I had wanted to research but always put off. Then I began re-reading his book Individualism and Economic Order for my History of Thought class. On almost every page there were similarities between what he was saying, and that of first generation¹ behavioral economists – Herbert Simon, George Katona, Harvey Leibenstein, Richard Nelson, and Sidney Winter. In many cases Hayek wrote about behavioral economic themes before them. The more of his works I read the more I was convinced that Hayek was also a first generation behavioral economist. For example, he contrasted the complexity of the economy and society with the “simple” phenomena studied by natural science. He thus rejected the notion that economists can mimic the method used by the natural sciences. Using the methods of the natural sciences in economics is an example of what he called scientism. The complexity of the economy also led him to reject the idea of homo economicus in favor of limited rationality and the use of customs and abstract, informal, unwritten, or abstract rules whose origins no one knows. He maintained that the most important aspect of knowledge is “unorganized,” or tacit: the knowledge of “particular circumstances of time and place.” This knowledge is widely distributed among the population and can’t be known or communicated by a central planning board. Hayek is also considered one of the founders of evolutionary economics, Richard Nelson and Sidney Winters being two very prominent evolutionary, and behavioral, economists.

So, there are large similarities between Hayek’s views on, say, human rationality, the nature of knowledge, and the best methodology for economics and those of the first generation behavioral economists.

The implications of Hayek’s research span not only (behavioral) economics, but politics, social theory, theory of mind, and philosophy (Gray, 1982). It is the contention of this paper that Hayek’s writings on these topics place him in the tradition of first generation behavioral economists George Katona, Herbert Simon, Harvey Leibenstein, Richard Nelson, and Sidney Winter.

II An introduction of Hayek’s behavioral economics

Let me discuss here two central aspects of Hayek’s behavioral economics: his definition of rationality, and his belief that economics should not try to mimic physics. On the topic of rationality, Simon says that Hayek was indispensable in the development of the concept of bounded rationality. Hayek’s defense of limed rationality was based primarily on the limits of the inner environment – the computational limits of human beings. The assumption of rationality is one of the cornerstones of modern economics. The first generation behavioral economists, including Hayek, attacked this assumption ferociously.

Computational limits rule out the ability to understand, master, and coordinate all the variables necessary to create and manage an institution such as the economy, or society itself. Hence, in The Sciences of the Artificial (Simon, 1996) Simon stated that “No one has characterized market mechanisms better than Friedrich von Hayek” (Simon, 1996, p. 34). In rejecting the rationality assumption, Hayek rejects the notion that any person or group is rational enough to organize and maintain society. The institutions of Western society, including the market system or economy, are thus “the result of human action but not the result of human design” (Hayek, 1945). The economy and society are simply too complex to be the product of human design. The information requirements for creating social order through a rational plan is unavailable to a single mind or the minds of a relatively few. The required amount of knowledge can only be obtained by decentralized human interaction through the trial-and-error process which is the market system.

Hayek and Gestalt Psychology: An Aside. The German word gestalt means to “put together” but is often translated as pattern or configuration. Ernst Mach’s theory of sensations is said to be the origin of gestalt theory (DeVecchi, 2003). Mach’s theory included the idea that humans perceive “wholes” or aggregates of sensory elements which can’t be reduced to the individual sensory elements. In other words, the whole is greater than the sum of its parts.

Hayek identifies the economy and society as complex phenomena. As such the whole of the economy or society is not identical with the parts from which the economy or society is derived. Again, the whole is greater than the sum of the parts. Society and the economy are spontaneous orders, more than the sum of the individuals involved. What we perceive as a movie theater is not simply the material which comprises both the outside and inside of the theater. We perceive something more – a movie theater as a whole, not merely the plastic, glass, lights, popcorn stand, etc.

Gestalt psychologists ask: why do the things of the world look to us as they do? One answer is that a given stimulus or set of stimuli affect our sensations in a pattern, not as individual stimuli. Our perception of things depends on their context. We perceive the “organized whole” rather than the parts. In The Sensory Order, perception is all about the placement of individual stimuli within the neural network.

According to Joaquin Fuster, a neuroscientist at U.C.L.A., “The first proponent of cortical memory networks on a major scale was neither a neuroscientist nor a computer scientist but, curiously, a Viennese economist: Frederick von Hayek ... A man of exceptionally broad knowledge and profound insight into the operation of complex systems ... Considering the neurobiological knowledge available even at the time of its publication, there is nothing dilettantish about that scholarly work ... By postulating that all perception – and not just a part – is a product of memory, Hayek carries ... one of the basic tenets of modern psychophysics” (Fuster, 1999, p. 87).

Cortical memory theory postulates that it is the connections among brain cells which creates specific perceptions. In other words, when it comes to perception, the whole is greater than the sum of the parts and not reducible to the parts. According to Hayek, every sensation we have is based on a prior experience(s), even if that experience was had by another person in the past and handed down from generation to generation via inheritance. Perception is about context – the placement of a specific perception within the neural network.

Hayek agrees that gestalt psychology has developed the idea of an “organized perceptual field,” but nothing about the “organizing capacity” of the mind (De Vecchi, 2003). The organizing capacity of the mind, according to Hayek, is “a kind of pre-sensory experience” (ibid.). Hayek attributed gestalt psychology with his ability to answer some of the questions he asked in The Sensory Order.

Hayek expresses his ideas on rationality in his distinction between true and false individualism. Individualism false derives from the Rationalist tradition of Rene Descartes, the French Encyclopedists, and Rousseau. In Discourse on Method, Descartes (1999) expresses the power of reason or rationality when he says that “a single human mind can comprehend as much as a much larger group and use their knowledge to organize society” (Hayek, 1945, p. 9). Descartes denies cognitive limits, an idea which Hayek calls “the fatal conceit” (Hayek, 1988) – a conceit which leads not to efficiency and equity but to socialism.

Individualism true, the “antirationalist” view of Mandeville, Smith, Hume, Edmund Burke, Adam Furgeson, and Josiah Tucker, regards man “not as highly rational (in the traditional economic sense) and intelligent, but as a very irrational and fallible being whose individual errors are corrected only in the course of a social process, and which aims at making the best of a very imperfect material ...” (Hayek, 1945, pp. 8–9; Hayek, 1967d). Despite being irrational and not highly intelligent, humans can achieve a significant amount through freedom and the market process, in which individuals know only about one or two things and rely on many others, each of whom also knows only a relatively few things. The workings of the market in creating social order is not intelligible to the human mind, but the market system is not irrational.

Foretelling perhaps the behavioral economic work of Kahneman and Tversky (Kahneman and Tversky, 1979; Kahneman, Slovic, and Tversky, 1982), Hayek says that “It may indeed prove to be far the most difficult and not the least important task for human reason rationally to comprehend its own limitations” (Hayek, 1979, p. 162).

Hayek’s second definition of rationality is the ability to be understood by others, to have behavior patterns which are predictable. Having patterned or predictable behavior allows others to have foresight about your behavior. The importance of this ability is that it is essential to the attainment of a multiple-person equilibrium. Human interaction and time are essential in economic affairs, including the attainment of equilibrium.

Equilibrium is attained when all participants appear to be part of a single plan. This requires that individuals have perfect foresight about the actions of others and that each person’s actions can be understood by others. “Every person’s plan is based on the expectation of just those actions of other people which those other people intend to perform and that all those plans are based on the expectation of the same set of external facts ... Correct foresight is then ... the defining characteristic of a state of equilibrium” (Hayek, 1945, p. 42).

“When there is only one person in the society then equilibrium is assured. When there are two or more participants equilibrium requires that the actions of one person are consistent, in agreement with, the actions of others. This, means that each person correctly anticipates, has correct foresight about, the actions of others.” Therefore, foresight is essential because “For Hayek the assumption of perfect knowledge, perfect foresight about the future with respect to the actions of every other participant, assumes away the nature and purpose of the market, that being a process of discovery taking places over time.” In addition, each person must base their behavior on the same external circumstances as the others so that their expectations are the same. For Hayek, “the passage of time is essential to give the concept of equilibrium any meaning” (Hayek, 1945, p. 37). This is because “equilibrium is a relationship between actions, and since the actions of one person must necessarily take place successively in time.”(ibid.)²

The emphasis on foresight is part of Hayek’s wider point that the data or “facts” in social sciences including economics “are merely opinions, views held by the people whose actions we study” (Hayek, 1979, p. 47). Being subjective they are mental, not physical. In The Counter-Revolution of Science (Hayek, 1979) he says that “Neither a ‘commodity’ or an ‘economic good,’ can be defined in physical terms but only in terms of views people hold about things” (Hayek, 1979, p. 53). What is important in economic affairs is mind-reading – one person knowing what others are thinking. Further, “Unless we can understand what the acting people mean by their actions any attempt to explain them ... is bound to fail” (Hayek, 1979, p. 53). Economic facts, therefore, can’t be described by exact formulae. Exhaustive descriptions or exact predictions in economics are, therefore, impossible. Enter behavioral economics.

A second aspect of Hayek’s behavioral economics is his insistence that economics should not try to mimic physics.³ For Hayek, the nature of the world which matters most to economists – economic and social phenomena – are complex phenomena. The degree of complexity is measured by the “minimum number of distinct variables a formula or model must possess in order to reproduce the characteristic patterns” discovered (Hayek, 1967a, p. 26). The number of distinct variables necessary to understanding patterns in the social sciences is very large, “often insurmountable” (ibid., p. 27). By contrast, physics deals with simple phenomena. While prediction is clearly possible in physics, in social and economic affairs, “the ideal of prediction and control must largely remain beyond our reach” (ibid., p. 34). Because the number of relevant variables and their interaction are often insurmountable, our conscious minds are not equipped to deal with an analysis of the phenomena. We must, therefore, use our unconscious mind – what Hayek refers to as the “supra-conscious,”⁴ – intuition, know-how, tacit knowledge, and physiognomy perception. Because we make use of the supra-conscious, the rules we use in decision making are rules we don’t consciously understand. This limits our ability to understand economic phenomena. What we can understand is general patterns of economic behavior, but not particular events at a particular time. Hayek calls this an “explanation of the principle” (Hayek, 1976, pp. 42–43).

In a short paper, “Two Types of Mind” (Hayek, 1978b), Hayek distinguished “master of his subject” from “puzzlers” or “muddlers.” Hayek considered himself a puzzler/muddler. The characteristics of a puzzler are that they ma...

Table of contents

• Cover
• Title
• 1  Friedrich Hayeks Behavioral Economics in Historical Context
• 2  A Hayekian/Kirznerian Economic History of the Modern World
• 3  Was Hayek an Austrian Economist? Yes and No. Was Hayek a Praxeologist? No.
• 4  Error Is Obvious, Coordination Is the Puzzle
• 5  Hayeks Contribution to a Reconstruction of Economic Theory
• 6  On the Relationships between Friedrich Hayek and Jean Piaget: A New Paradigm for Cognitive and Evolutionary Economists
• 7  Cognitive Autonomy and Epistemology of Action in Hayeks and Merleau-Pontys Thought
• 8  Hayeks Sensory Order, Gestalt Neuroeconomics, and Quantum Psychophysics
• 9  Mindscapes and Landscapes: Hayek and Simon on Cognitive Extension
• 10  Hayeks Complexity Assumption, Ecological and Bounded Rationality, and Behavioral Economics
• 11  Subjectivism and Explanations of the Principle: Their Relationship with Methodological Individualism and Holism in Hayeks Theory
• 12  Satisficing and Cognition: Complementarities between Simon and Hayek
• 13  The Oversight of Behavioral Economics on Hayeks Insights
• 14  Complexity and Degeneracy in Socio-economic Systems
• Name Index
• Subject Index