Does Behavioral Economics Offer Anything New and True?

21 May 2010 at 11:53 am Peter G. Klein 26 comments

| Peter Klein |

One of my frustrations with behavioral economics is that it often seems to restate common, obvious, well-known ideas as if they are really novel insights (e.g., that preferences aren’t stable and predictable over time). More novel propositions are questionable at best (e.g, the paradox of choice).

Dan Ariely’s column in this month’s HBR is particularly frustrating. He claims as a unique insight of behavioral economics that when people are evaluated according to quantitative measures of performance, they tend to focus on the measures, not the underlying behavior being measured. Well, duh. This is pretty much a staple of introductory lectures on agency theory (and features prominently in Steve Kerr’s classic 1975 article). Ariely goes on to suggest that CEOs should be rewarded not on the basis of a single measure of performance, but multiple measures. Double-duh. Holmström (1979) called this the “informativeness principle” and it’s in all the standard textbooks on contract design and compensation structure (e.g., Milgrom and Roberts, Brickley et al., etc.) (Of course, agency theory also recognizes that gathering information is costly, and that additional metrics are valuable, on the margin, only if the benefits exceed the costs, a point unmentioned by Ariely.)

Ariely says firms should not evaluate CEO’s on stock price, but on a variety of measures. What, for example? Here the story gets a bit murky:

Ideally, they’d vary by industry, situation, and mission, but here are a few obvious choices: How many new jobs have been created at your firm? How strong is your pipeline of new patents? How satisfied are your customers? Your employees? What’s the level of trust in your company and brand? How much carbon dioxide do you emit?

Ariely seems unaware that stock price is the most frequently used measure of firm performance precisely because it is a composite measure that captures all of those things. Stock price reflects the best available information about current and expected future performance — products, jobs, customer satisfaction, etc. Is it a perfect measure? Hardly. But it isn’t obvious how owners or Boards can create their own quantitative, composite measure by by picking their favorite elements, proxies, weighting schemes, and so on, in a way that provides better overall assessments of performance than market valuations. Boards, after all, may be predictably irrational too.

Entry filed under: - Klein -, Corporate Governance, Management Theory, Methods/Methodology/Theory of Science, Myths and Realities, Strategic Management, Theory of the Firm.

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26 Comments Add your own

1. Nicolai Foss | 21 May 2010 at 12:34 pm

Gosh!!! Such a series of blunders. I actually have colleagues who maintain that getting something into HBR is about as good as a paper in a top management research journal. Ha!
2. Anouar El Haji | 21 May 2010 at 4:45 pm

Although in this case I agree much with Peter writes, I have to disagree with the title. The beauty of neoclassical economics and other theoretical subfields of economics is that we have a very deep understanding of how preferences can work in ways that are not intuitive to the simple mind. For example, theoretical social preferences were well studied by figures such as Gary Becker. Unfortunately, most economists have deferred the question of actual preferences for a long time, which behavioral economics tries to answer. Behavioral economics, in my view, is nothing more than unraveling the scope of actual human preferences and their regularities. For example, we know that discounting matters for a long time but behavioral economics goes a step further and asks the question of how people actually discount. Pending answers are not straightforward such as the suggestion that people ‘use’ a quasi-hyperbolic discount function.
3. Anouar El Haji | 21 May 2010 at 5:23 pm

Furthermore, I think Dan’s point was more subtle although he refrained from making it explicit: people care about metrics even when there are small or no monetary incentives to do so. Admittedly, that’s very intuitive but still a topic not studied in the literature that Peter cites.
4. Snarky | 21 May 2010 at 6:04 pm

If only Dan Ariely had studied economics or management…which, of course, he hasn’t. He studied psychology and marketing, and knows very little about the agency literature (to cite one example.) Classical principles of political economy are also not his strong suit.
5. Peter Korchnak | 21 May 2010 at 7:04 pm

I share your frustration with behavioral economics and you make valid points in reference to Dan Ariely’s.

However, there’s a big disconnect between people like Dan stating the obvious and those who should adopt the information to change their behavior accordingly. In other words, it would seem the need for continuing to state and restate the obvious will persist until it’s no longer necessary to keep saying what everyone should know and act upon.
6. Warren Miller | 22 May 2010 at 4:16 pm

I think a broader inference from your observation about Ariely’s article is the egregious decline in the quality of articles appearing in HBR in recent years. Quality took a precipitous nosedive when former editorial director Walter Kiechel made the boneheaded decision to try to jack up ad revenue by changing from semi-monthly to monthly. I noticed immediately a whole bunch of articles that would probably have been fodder for tabloid publications than serious business reading. I just don’t think there’s enough HBR-level material out there to support a monthly publishing platform. Presumably the downturn in recession-related ad revenue has really socked HBR hard. Good.

I saw recently where it had dropped its subscription price by about 1/3. Man, that Kiechel guy was a genius, wasn’t he? They taught him well @ Time-Life. Ever since former editor-in-chief Suzy Wetlaufer decided to bed Jack Welch as part of an “HBR interview,” HBR has declined steadily. Perhaps the NY Times could purchase it and really accelerate its downward spiral.
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8. bee | 22 May 2010 at 7:13 pm

Dan is a commercial success and people (including Dan) confuse it with a material intellectual contribution.

Behavioral economics is not about economics, its about psychology. Economics is the study of exchanges, while behavioral economics is often simply the characterization of cognitive biases that arise in certain settings. Its primary limitations are (1) that is weak on both offering a cognitive basis for the phenomena under investigation; and (2) context is atypical. Behavioral economics should return to its old moniker Behavioral Decision Theory.

Economic theory uses the assumptions about actors to understand exchanges. This is true for classical economics, Agency theory, Game theory, Transaction Action Theory, ect. The challenge is to employ simple assumptions about the actors to make exchange level inferences. What never ceases to amaze me is how economic inferences operate with such stylized assumptions like rationality.
9. srp | 24 May 2010 at 3:49 pm

Amen on HBR’s decline. My favorite example is the embarrassing Booz & Co. article on strategy execution in their June 2008 issue. They recently placed this thing in their “must reads” greatest-hits collection, which is pretty funny since the collection is funded by Booz and the current chief marketing officer at Booz is the guy who edited HBR when the article was printed.

The most amazing part about this article is that it uses a research design for which you would flunk an undergraduate–trying to measure a variable that only varies across firms by using within-firm data. They end up running regressions where all the variation on the right-hand side is due to measurement error, by construction. There are other show-stopping biases as well, but the research design is the one with real Dunning-Kruger implications.
10. CB | 25 May 2010 at 9:56 am

So, behavioural economics is critisized, mainly based on a HBR paper. Simultaneously the blog (different blogger though) critisizes HBR as being a not-serious-journal.

So, why offer critique of a theoretical tradition based on a paper in a “poor” journal? It’s making things a bit too easy, isn’t it?
11. Peter Klein | 25 May 2010 at 3:04 pm

We like easy.
12. cosas | 30 May 2010 at 10:28 am

Good point you made in your post!!!!!, but stock price it is not a panacea either, subprime mortages crisis is the ultimamte result of firm’s management pursuing the holy grail of stock price paradise doing stupid things, not to mention Goldman Sach practice of selling financial products to their clients and at the same time betting against those same products, all these nonsense in the name of stock price….so there must be better ways of working out these management’s incentives and their maesures.
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14. Dirk F. | 1 June 2010 at 8:07 am

More from Ariely:
http://blog.ted.com/2010/05/dan_ariely_asks.php
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17. Bob from Business Courses | 24 August 2011 at 2:04 am

For any business, there must be some form of measurement to be able to quantify if a CEO is efficient or not. Saying one has “good” management skills is subjective if not backed by facts and figures.
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