A Brain-Focused Foundation for Economic Science

The history of economic thought has been one of an evolving methodological foundation for the discipline. In the late eighteenth century, Adam Smith saw “political economy” in broad terms, but mainly concerned with institutions and policies that encouraged maximum national economic growth. In the late nineteenth century, Alfred Marshall added analytical tools, such as supply and demand, but restricted the central concern of the discipline to the “ordinary business of life” and applied narrowly to the “business-like classes.” Lionel Robbins sought in the early-1930s to bring unity to the disparate analyses of economists (following in the methodological footsteps of Phillip Wicksteed who wrote in the early 1900s) by declaring “scarcity” to be the unifying core concern. Gary Becker, George Stigler, and many other economists have since the 1960s argued that economics is a “method of analysis” that can be applied without regard to past disciplinary boundaries.

Disturbed by what he considered to be a lack of central focus to the work of practicing economists, Lionel Robbins dismissed a number of competing definitions for economics offered by economists for being flawed in one way or another, mainly in terms of their general applicability to all that economists do. He proposed that across economists’ various investigations, one concern was at the foundation of all economic inquiries, the inevitable conflict that emerges whenever the available resources could not satisfy all demands. He argued that in order for people to achieve maximum welfare, they had to choose and behave “purposively.” Along the way, Robbins excluded matters of valuations as outside the domain of economics, and put such matters within psychology, which he considered a lesser discipline. He also opined against laboratory experimentation, because laboratories were artificial environments, intentionally so, for developing economic generalizations.

In the early 1950s, Milton Friedman canonized neoclassical economics for his era of economists by accepting Robbins’ concept of scarcity as a core disciplinary concern and insisting that economists’ main concern was with “positive economics,” solely concerned with “what is,” not with what “ought to be” (the domain of “normative economics). He argued that economists’ empirical research must be guided by simplified models that need not, and could not, pass the test of descriptive reality. Indeed, he argued that no theory could be fully descriptive. Accordingly, “perfect rationality” and “perfect competition,” while lacking egregiously, in descriptiveness, were acceptable devices for analyses, especially if they eased analyses and if the predictions drawn from the models past repeated empirical tests. Neither Robbins nor Friedman made the economy within the human brain a central issue.

As early as the late 1950s with the work of Herbert Simon, psychologists began questioning the value of unbounded rationality in economic modeling, noting that the human brain faced its own evolved limited and imperfect internal resources. Daniel Kahneman and Amos Tversky in the 1970s began calling into serious question the neoclassical methodological approach by running a series of laboratory and survey experiments that found substantial gaps between the predictions of economic models grounded in perfect rationality and the way real people behave or say they would behave. In the late 1980s and continuing into this century, Richard Thaler uncovered a small library of “anomalies” in people’s behaviors, as judged by predictions from neoclassical economics, grounded in contemporary times (but not in earlier eras) in perfect rationality. A growing cadre of behavioral economists have gone further, concluding that people are so frequently “irrational” that they are “predictably irrational,” suggesting that neoclassical economists should fold their analytical efforts.

There is a growing divide between neoclassical and behavioral economics. This divide can be partially reconciled by recognizing that the critically scarce resources in all economic inquiries are inside the human brain, mainly neurons and energy that need to be rationally allocated by the brain itself in order to maximize achievement of competing internal demands. The brain must resolve its internal optimization problems before it can optimize the allocation of external resources with alternative uses. Accordingly, the brain will never seek perfect rationality in decision-making, mainly because it could not have evolved to be perfectly rational, in neoclassical terms. Rather, it will refine (and only perfect) its decisions so long as the added value of doing so is worth the added cost. It will also devise decision rules (heuristics) that work as well as is economical, but which will lead to decision errors. Decision errors can be a source of decision efficiency and welfare enhancement above what would be achieved under perfect rationality (if perfect rationality were possible, which it can’t be).

“Brain-focused neoclassical economics” uses neoclassical analytical methods to predict a range of human decision and behavioral flaws documented by behavioral economists and psychologists. It helps explain (and predicts), through deductive methodological means, many presumed “irrationalities,” such as inconsistencies in choices. It also explains laboratory subjects’ failures to appropriately discount future costs and benefits, to ignore sunk costs, and to consider opportunity costs. It also provides an analytical foundation for Adam Smith’s presumption that people have a propensity to specialize and trade: specialization and trade free up the brain’s limited resources for other uses, increasing the potential rationality of decision-making. Overall, under a brain-focused methodology, many presumed “irrationalities” are not the welfare destroying decision errors in need of corrections that they have been made out to be. Rather, they can be reconstrued as welfare enhancing. Moreover, movements toward, say, freer trade can have efficiency and welfare benefits beyond those neoclassical economists have always considered: specialization and freer trade can improve the allocation of external resources, as conventionally argued, but they can also improve the allocation of internal neuronal resources, leading to more rational decisions in the allocation of external resources. Under strict neoclassical economics, instruction founded on perfect rationality is an economic waste. Under a brain-focused foundation for economics, the discipline has the potential for improving decision-making and, as a consequence, economic welfare, in much the same way that property rights, prices, and markets can.