An Intellectual Revolution

An Intellectual Revolution

Berkeley-Haas marks the 30-year milestone of trailblazing the discipline of behavioral economics

By Sam Zuckerman

For the past 30 years, UC Berkeley has been home to an intellectual revolution that has transformed the field of economics. Rather than focus on the rational machines of standard economic theory, scholars at Berkeley-Haas and in the Department of Economics toppled the wall separating economics and psychology. They came to study humans as they really are, prone to biases and unconscious influences, prey to emotions, and vulnerable to manipulation.

The result was a new field of study—behavioral economics—combining the insights of psychology with the powerful analytical methods of economics. And economics was better for it, moving away from the ivory tower toward a more realistic view of why people act the way they do.

In May, faculty, alumni, and leading economists from around the world met at Berkeley-Haas to pay tribute to the university’s role in advancing this intellectual movement. “Thirty Years of Behavioral Economics at Berkeley” commemorated the anniversary of a pioneering interdisciplinary PhD course taught in spring 1987 by two future Nobel Prize winners—economist George Akerlof and psychologist Daniel Kahneman. The event, organized by Professors Ulrike Malmendier and Stefano DellaVigna, was part celebration, part reunion of former Berkeley faculty and PhDs who are now spreading the methods of behavioral economics far and wide, and part declaration that this way of understanding the world has come of age.

The featured guests at the spring celebration were the two men who taught that class 30 years ago: Akerlof, now professor emeritus of economics at Berkeley, and Kahneman, professor emeritus in psychology at Princeton University. In their remarks, they noted that it wasn’t easy for this mode of thought to get established. “The behavioral economics fish was just beginning to crawl out of the sea,” Akerlof quipped. “But the task was more difficult than we thought.”

A New Discipline Emerges

Like all scholarly revolutions, what happened at Berkeley then did not take place in a vacuum. A few economists at scattered institutions, including Akerlof and his wife, now Federal Reserve Chair and Haas Professor Emeritus Janet Yellen, had begun to question utility theory—the field’s article of faith that people in their roles as workers, investors, entrepreneurs, and consumers generally make logical choices in their own best interests. An even smaller number, like Richard Thaler, then at the University of Rochester, were starting to delve into psychological literature to better understand human behavior.

Berkeley-Haas became a center for behavioral finance, an area that was fertile ground for psychological analysis in an era of asset bubbles and market crises.

Kahneman, then at the University of British Columbia, had crossed the disciplinary divide to debunk utility theory’s core tenets in a groundbreaking 1979 article, “Prospect Theory: An Analysis of Decision Under Risk,” co-authored with his frequent collaborator Amos Tversky. “Coming from psychology, the notion that people are rational was sort of funny,” Kahneman says of his early forays into economics. His well-aimed barbs flamed the imaginations of those trying to inject psychological realism into the field. But, throughout the 1980s, these insurgents were virtual outcasts working at the margins of the profession, and the rational choice model continued to hold sway.

It was at Berkeley, with its culture of intellectual ferment and readiness to question academic orthodoxy, that behavioral economics first gained a foothold. Kahneman joined the Department of Psychology in 1986 and found that some of the university’s economists were open to using psychological methods to analyze economic problems. Terrance Odean, BA 90 (statistics), MS 92, PhD 97, the Rudd Family Foundation Chair in Haas’ Finance Group, recalls that Kahneman steered him away from a career in psychology into what was then virgin territory. “When Danny suggested I go into finance, nobody in the Haas Finance Group was doing behavioral work in it,” says Odean. “But there was an atmosphere of intellectual curiosity and a willingness to give someone enough room to try something.”

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Berkeley-Haas Professors Ulrike Malmendier and Stefano DellaVigna flank Nobel Laureates and one-time Berkeley professors Daniel Kahneman and George Akerlof.

With the arrival of Matthew Rabin in 1989, behavioral economics truly began to flourish at Berkeley. Rabin, a game theory specialist with a restless mind, a self-deprecating sense of humor, and a doctorate from MIT, followed an unconventional path that would have consigned his tenure file to the trash bin at most institutions. He collaborated with psychology faculty to understand fairness, explored the economic implications of addiction, and developed a theory of procrastination to explain why people often don’t save enough for retirement. “He gambled his career in order to establish behavioral economics as a field,” Malmendier noted in her introduction of Rabin at the Haas event.

In his remarks Rabin, now a professor at Harvard, explained his goal was “improving the psychological realism of economics but maintaining conventional techniques like formal modeling and econometrics.” At Berkeley, the brilliance and boldness of his ideas won him recognition—a MacArthur Fellowship in 2000 and the John Bates Clark Medal in 2001, awarded to an economist under age 40 who has made a significant contribution to economic thought. Rabin’s achievements were major milestones in behavioral economics’ rise to respectability and cemented Berkeley’s reputation as the heart of innovation in the field.

The New Generation of Behavioral Economists

The path-breaking work of Akerlof, Kahneman, and Rabin, and support from sympathetic senior economists like Daniel McFadden, the 2000 Nobel Laureate in economics and director of Berkeley’s Econometrics Laboratory, and Hal Varian, Haas professor emeritus and a specialist in the economics of information technology, paved the way for others. The result was a flowering of behavioral economics at the university in the 2000s.

Event organizers Malmendier and DellaVigna, another husband-and-wife team who arrived at Berkeley during this time, themselves represent the vanguard of a new generation of behavioral economics researchers. Together, they co-direct the Initiative for Behavioral Economics & Finance, a joint project of Berkeley-Haas and the Department of Economics.

Modes of analysis developed by behavioral economists are now widely used in fields as diverse as politics, medicine, and law.

While past studies looked at the behavior of individual investors and consumers in and of themselves, Malmendier, the Edward J. and Mollie Arnold Professor of Finance at Berkeley-Haas, investigates how individual biases affect corporate decisions, stock prices, and markets in general. One study, for example, looked at overconfident CEOs who overestimate their ability to carry out successful mergers and acquisitions. Her work has earned her a Guggenheim Fellowship and the American Finance Association’s Fischer Black Prize, a biennial award modeled after the Fields Medal in mathematics and the Clark Medal in economics that honors the top finance scholar under age 40.

DellaVigna, who holds a joint appointment with Haas and Economics, has developed new ways to examine media bias and political persuasion. His 2006 paper showed that Fox News swayed viewers to vote for George Bush over Al Gore in the 2000 presidential election, for example.

The Berkeley-Haas Influence

For its part, Berkeley-Haas became a center for the study of behavioral finance, an area that was fertile ground for psychological analysis in an era of asset bubbles and market crises. Odean, whose dissertation focused on individual investor behavior, persuaded a discount brokerage to give him access to the de-identified trading records of 10,000 individual investors. The data confirmed investors’ wealth-destroying penchants for trading too actively as well as selling winning positions and holding on to losers. “People were behaving with their own money the way psychologists predicted rather than the way economists assumed,” Odean explains.

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Haas Professor Terry Odean, MS 92, PhD 97 (right), gets gelato with John Williams, president and CEO of the Federal Reserve Bank of San Francisco, during the daylong celebration of Berkeley-Haas’ influence on behavioral economics.

Assoc. Prof. David Sraer has investigated investor behavior and speculative bubbles. Professor John Morgan, the Oliver E. and Dolores W. Williamson Chair of the Economics of Organizations, founded Haas’ Experimental Social Science Laboratory (XLab) for conducting experiment-based research. He has focused some of his work on inattention to shipping costs in eBay auctions and on behavioral biases in voting.

Other Haas scholars have applied psychological principles in other business areas. Don Moore, who holds the Lorraine Tyson Mitchell Chair in Leadership and Communication, has investigated overconfidence in decision making to learn what happens when people think they’re smarter than they actually are. Asst. Prof. Ned Augenblick is an expert in online markets who studies people’s preference for immediate rewards even if future payoffs might be greater.

Infiltrating the Mainstream

Today, rational models no longer rule the roost and top economics departments around the world have hired behavioral scholars. Modes of analysis developed by behavioral economists are now widely used in fields as diverse as politics, medicine, and law. A few years ago, the Financial Times lent additional validity when it declared “behavioral economics has never been hotter.”

For example, Harvard behavioral economist Sendhil Mullainathan served as the first research director of the federal Consumer Financial Protection Bureau. The idea that consumers can be manipulated to make financial decisions that run counter to their interests, by taking on too much credit card debt, for example, is fundamental to the agency’s work. And President Obama issued an executive order in 2015 that behavioral science should be taken into account in setting governmental policy, citing “research findings from fields such as behavioral economics and psychology.”

Berkeley’s leadership helped give psychological ideas legitimacy and propel behavioral economics into the mainstream. Behavioral economics took hold largely by being correct, Odean says. “Over time, people accepted that which was true, which is that human beings are not hyperrational,” he says.

For all its advancements, Berkeley’s behavioral economists stress that the field is still in its adolescence. “There are plenty of areas where behavioral economics still has huge inroads to make,” DellaVigna says. For example, behavioral insights are just beginning to be applied in areas like macroeconomics, exploring questions such as what psychology tells us about attitudes toward inflation.

As behavioral economics deepens our understanding of human motivation, the insights researchers learn become that much more valuable. In his remarks at the Haas 30th anniversary event, Akerlof cited research showing that capuchin monkeys will eat sweet roll-up tacos with marshmallow fluff until they get anxious and sick. He suggested the megacaloric Cinnabon is the equivalent temptation for humans. “People have two types of taste—what is good for them and what they choose,” he said. “We all have monkeys on our shoulder when we make economic decisions, and somebody is going to be there to sell you a Cinnabon.”

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