Adam Smith & Behavioral Economics

1. Introduction. Adam Smith is recognised in The Wealth of Nations as a proponent of self-interested behavior. Recently Ashraf et al (2005) have argued that, in Theory of Moral Sentiments, (TMS), Smith reveals himself to be an observor who anticipated much of modern behavioral economics. He also provided leads that modern economists can take up as a research agenda. These classroom notes (based on Ashraf et al. (2005)) explore these ideas. Comments are very welcome.

In TMS Smith adopted a ‘dual-process’ view of a human’s psychological perspective similar to that used in modern behavioral economics and neuroscience. The view is of an ‘impartial spectator’ who looks at individual behavior from the perspective of an outsider and also from the viewpoint of the ‘passions’ including emotions, fear, anger, sex and hunger drives as well as motivational factors such as pain. In terms of modern neuroscience, behavioral outcomes are a consequence of judgments made by different sections of the brain. The key elements involve the prefrontal cortex (the area just behind one’s forehead), which is concerned with planning and behavioral inhibition and the limbic system (located below the cerebral cortex) which is responsible for emotions and the way people feel.

Thus, to Smith, while much of human behavior was under the influence of the passions these passions could be moderated by an internal ‘voice of reason’, the ‘impartial spectator’, who allowed one to see one's own feelings and the pulls of immediate gratification from the perspective of an external observer.

In the area of self-control and self-governance, the ‘impartial spectator’ takes the form of long-term self-interest. Thus a potential drug user might think ‘I won’t snort that cocaine because it may lead me to do it tomorrow and so on, creating a long-term problem’. Here there is a conflict between passions and the impartial spectator. The conflict is important when studying savings decisions, since savings is exactly a decision to delay immediate gratification for a long-term interest, to stay the voice of a short-term pull for the voice of the ‘impartial spectator’.

For social interactions, the ‘impartial spectator’ allows us to see things from another's perspective and not to be blinded by our own needs.

2. Smith on Behavioral Economics. TMS contains numerous insights on the way the ‘impartial spectator’ and the passions interact to determine various choices with a paradoxical character.

Loss Aversion. In TMS (p.176-177) Smith argued that ‘Pain …is, in almost all cases, a more pungent sensation than the opposite and correspondent pleasure’. 200 years later Kahneman and Tversky (1979) called this loss aversion. Furthermore, brain imagining studies show that gains and losses are processed in different ways (O’Dougherty et al (2001). This can mean that opportunity costs will be weighted less heavily than out-of-pocket costs.

Impulsiveness and Self-Control. TMS (1759, p. 273) viewed the passions as essentially myopic. For the ‘impartial spectator’, in contrast, ‘the pleasure which we are to enjoy a week hence, or a year hence, is just as interesting as that which we are able to enjoy this moment’ (p. 272). These views correspond closely to what is now termed quasi-hyperbolic discounting where extra weight is placed on current rewards but, thereafter, consumptions are discounted at ‘moderate; exponentially declining rates (Laibson (1997)). Moreover, both Smith’s views, and the hyperbolic discounting hypothesis, are supported by neuroscience: The prospects of immediate rewards activate the limbic parts of the brain while longer-term issues are evaluated in the pre-frontal cortex (McClure et al. (2004)).

Overconfidence. Smith recognized optimism biases with most people being excessively optimistic (having an ‘overwhelming conceit’) about their prospects for rewards and understating chances of loss. Such views are replicated in modern behavioural economics into research on mergers and business failures and can be derived from evolutionary considerations (Postelwaite & Compte (2005)). Smith also understood that his claims regarding optimism applied only to those in ‘tolerable health and spirits’ the view also advanced in recent research suggesting, that optimism biases do not arise for the ‘clinically depressed’ (Taylor and Brown (1994)).

Altruism. At various points in TMS, Smith saw altruism as an important though fickle passion. Sometimes sympathy falls short of what is appropriate. Thus Smith noted that Europeans might undervalue the human costs of a catastrophic earthquake in China. Sometimes Smith saw sympathy as excessive, as for example, when we feel sympathy for the dead who themselves experience nothing.

These views are replicated in modern thinking. When people are controlled by their passions one might expect to see both callousness and extreme generosity. In addition altruism may be greater towards a ‘identified victim’ than a statistically equally probable though unknown victim (Small & Loewenstein (2003)). Also, when people know something about people the amount they tend to give increases, but has greater variance. This suggests greater sympathy when knowledge is obtained but also more snap judgments about who deserves (Bohnet & Frey (1999)).

Smith claimed this variability would be reduced by the ‘impartial spectator’ who would act to exert more discrimination in establishing a case for altruism.

Fairness. Smith saw altruism as an erratic force but ‘fairness’ as having a more reliable civilizing role. Fairness was an intrinsic human emotion that was the source of ideas about justice. Contemporary research suggests that fairness is an important emotion even in non-human primates (Brosnan & de Waal (2002)). The ‘impartial spectator’ or the ‘man within’ would internalize other people’s sense of fairness. Acting without respect to the ‘sacred’ rules of justice would lead to an individual being subject to the ‘contempt and indignation’ of others. Indeed:

‘There is no commonly honest man who does not more dread the inward disgrace of such an action, the indelible stain which it would for ever stamp upon his own mind, than the greatest external calamity which, without any fault of his own, could possibly befal him; and who does not inwardly feel the truth of that great stoical maxim, that for one man to deprive another unjustly of any thing, or unjustly to promote his own advantage by the loss or disadvantage of another, is more contrary to nature, than death, than poverty, than pain, than all the misfortunes which can affect him, either in his body, or in his external circumstances’. (TMS, p. 138)

Trust. For Smith transactions required a mix of concern for fairness (reinforced by fear of negative appraisal by the ‘impartial spectator’), altruism and trust to facilitate initial gains-from-trade in situation where agents had not previously traded. For example moral values can drive voluntary exchange rather than violence when two agents meet for the first time and exchange is an option. Smith believed that trust and a concern for fairness, were vital for the functioning of a market economy. Trust and reciprocity were foundations for the early beginnings of the market, allowing reciprocal gift exchange to emerge, and leading to trade.

One might think that the need for trust and trustworthiness diminishes as a market develops, but if anything the opposite is true. For example we trust managers to carry out the interests of shareholders. While we can build contracts to align manager incentives with those of shareholders we are never able to completely contract on all the things we care about and want to enforce. Implicitly, then, we hold a belief that managers have internalized the values we care about, and trust them to act on those, particularly when they might come in conflict with their own interests.

There are similarly other professions where individuals are entrusted to serve, like doctors, teachers, auditors, but cannot be monitored fully. We rely on individual professionalism and honor (or ‘enlightened self interest’) to carry out their occupations.

Across organizations, in the marketplace, factors like brand reputation and warranties help facilitate transactions without requiring complete trust. Within organizations, the issue of trust and trustworthiness, of employees to their bosses, of managers to each other and to shareholders, becomes even more important, and even more difficult to replace by market forces or better incentives and contracts.

Moreover there are costs of breaking trust and of risking reputation. The costs of sacrificing ethical standards of conduct are much larger than any individual might imagine, precisely because they decrease trust and affect organizational and market functioning as a whole

These insights are demonstrated in modern experimental economics where positive reciprocity can create trust even where there are moral hazard reasons for supposing it should not arise (see Camerer (2003, chapter 2)). In addition trust has been shown in numerous surveys to be correlated with economic growth (Knack and Kiefer (1997)) while anthropology surveys suggest the sharing is more equal in ultimatum games conducted in market-based economies (Henrich et al (2004)).

Materialism and Happiness. In TMS Smith argued that economic development was driven by the illusion that material wealth would bring about permanently greater happiness. Equally personal catastrophes (such as loss of a limb) were not seen by Smith has inducing permanent unhappiness since people adapt to circumstances. He saw both pain and pleasure as transient phenomena. In particular the anticipation of status from wealth was much better than the realization.

Contemporary research supports these views. Frederick & Loewenstein (1977) review various studies showing that ongoing health and wealth issues have little impact on subjectively perceived happiness. Moreover people generally believe, as Smith recognized, that pleasure and pain will actually last longer than it does (Loewenstein et al (2003)).

Smith also believed that while the accumulation of great wealth deceives the rich by not bringing them welfare gains, it would, generate overall economic development and by an ‘invisible hand’ (TMS (p. 184)) advantage the poor.

‘It is this deception which rouses and keeps in continual motion the industry of mankind. It is this which first prompted them to cultivate the ground, to build houses, to found cities and commonwealths, and to invent and improve all the sciences and arts, which ennoble and embellish human life; which have entirely changed the whole face of the globe, have turned the rude forests of nature into agreeable and fertile plains, and made the trackless and barren ocean a new fund of subsistence, and the great high road of communication to the different nations of the earth. The earth by these labours of mankind has been obliged to redouble her natural fertility, and to maintain a greater multitude of inhabitants. It is to no purpose, that the proud and unfeeling landlord views his extensive fields, and without a thought for the wants of his brethren, in imagination consumes himself the whole harvest that grows upon them. The homely and vulgar proverb, that the eye is larger than the belly, never was more fully verified than with regard to him. The capacity of his stomach bears no proportion to the immensity of his desires, and will receive no more than that of the meanest peasant. The rest he is obliged to distribute among those, who prepare, in the nicest manner, that little which he himself makes use of, among those who fit up the palace in which this little is to be consumed, among those who provide and keep in order all the different baubles and trinkets, which are employed in the oeconomy of greatness; all of whom thus derive from his luxury and caprice, that share of the necessaries of life, which they would in vain have expected from his humanity or his justice. The produce of the soil maintains at all times nearly that number of inhabitants which it is capable of maintaining. The rich only select from the heap what is most precious and agreeable. They consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose from the labours of all the thousands whom they employ, be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species. When Providence divided the earth among a few lordly masters, it neither forgot nor abandoned those who seemed to have been left out in the partition. These last too enjoy their share of all that it produces. In what constitutes the real happiness of human life, they are in no respect inferior to those who would seem so much above them. In ease of body and peace of mind, all the different ranks of life are nearly upon a level, and the beggar, who suns himself by the side of the highway, possesses that security which kings are fighting for’. (TMS, p.184).

Thus cross-sectional differences in income will bring about only small changes in happiness because the rich dissipate increased wealth on trinkets while the distribution of necessities is more equal.

3. Smith’s Unexploited Ideas. Smith’s TMS provides promising leads for future research. They isolate four ideas.

Desires to be Well-Regarded by Posterity. While modern economists have considered bequest motives, Smith in TMS (p. 115-116 ) was more also concerned with people’s desire to maintain a reputation during the period where they are dead even at the expense of their welfare while alive.

‘Men have voluntarily thrown away life to acquire after death a renown which they could no longer enjoy. Their imagination, in the mean time, anticipated that fame which was in future times to be bestowed upon them. Those applauses which they were never to hear rung in their ears; the thoughts of that admiration, whose effects they were never to feel, played about their hearts, banished from their breasts the strongest of all natural fears, and transported them to perform actions which seem almost beyond the reach of human nature. But in point of reality there is surely no great difference between that approbation which is not to be bestowed till we can no longer enjoy it, and that which, indeed, is never to be bestowed, but which would be bestowed, if the world was ever made to understand properly the real circumstances of our behaviour.’ (op cit).

Negative Reactions to Being Misjudged. Smith recognizes that people care not only about outcomes but the source of outcomes. In particular they derive strong disutility from an ‘unmerited reproach’ (TMS, p. 121).

‘Unmerited reproach, however, is frequently capable of mortifying very severely even men of more than ordinary constancy. Men of the most ordinary constancy, indeed, easily learn to despise those foolish tales which are so frequently circulated in society, and which, from their own absurdity and falsehood, never fail to die away in the course of a few weeks, or of a few days. But an innocent man, though of more than ordinary constancy, is often, not only shocked, but most severely mortified by the serious, though false, imputation of a crime; especially when that imputation happens unfortunately to be supported by some circumstances which give it an air of probability. He is humbled to find that any body should think so meanly of his character as to suppose him capable of being guilty of it.’ (op cit).

Contemporary research confirms that procedural fairness in legal proceedings is important as well as outcomes (Lind & Tyler (1988)). While the probability of suing for wrongful dismissal is correlated with a workers belief that the dismissal was unjust (Lind et al. (2000)).

Thus people react negatively to being misjudged presumably has strong implications for principal and agent analysis if a principal understates the effort by an agent.

Mistaken Beliefs in the Objectivity of Tastes. People do have different tastes based on culture and experience but typically underestimate such determinants and wrongly suppose such preferences are objective.

‘Few men have so much experience and acquaintance with the different modes which have obtained in remote ages and nations, as to be thoroughly reconciled to them, or to judge with impartiality between them, and what takes place in their own age and country. Few men therefore are willing to allow, that custom or fashion have much influence upon their judgments concerning what is beautiful, or otherwise, in the productions of any of those arts; but imagine, that all the rules, which they think ought to be observed in each of them, are founded upon reason and nature, not upon habit or prejudice. A very little attention, however, may convince them of the contrary, and satisfy them, that the influence of custom and fashion over dress and furniture, is not more absolute than over architecture, poetry, and music’. (TMS, p.195)
Ross & Ward (1996) refer to the propensity of people to see their beliefs as more widely shared than they are as naïve realism. Naïve realism has implications for gift-giving, negotiations, principal agent problems and so on. It can also lead to cultural conflict. For example, Australians see Japanese consumption of whales as barbarism.

Sympathy for the Great and Rich. Finally, while there is a prevalent sympathy to sympathize with those less fortunate there is also a propensity to sympathise with the great and the rich:

‘When we consider the condition of the great, in those delusive colours in which the imagination is apt to paint it. it seems to be almost the abstract idea of a perfect and happy state. It is the very state which, in all our waking dreams and idle reveries, we had sketched out to ourselves as the final object of all our desires. We feel, therefore, a peculiar sympathy with the satisfaction of those who are in it. We favour all their inclinations, and forward all their wishes. What pity, we think, that any thing should spoil and corrupt so agreeable a situation! We could even wish them immortal; and it seems hard to us, that death should at last put an end to such perfect enjoyment. It is cruel, we think, in Nature to compel them from their exalted stations to that humble, but hospitable home, which she has provided for all her children. Great King, live for ever! is the compliment, which, after the manner of eastern adulation, we should readily make them, if experience did not teach us its absurdity. Every calamity that befals them, every injury that is done them, excites in the breast of the spectator ten times more compassion and resentment than he would have felt, had the same things happened to other men. It is the misfortunes of Kings only which afford the proper subjects for tragedy. They resemble, in this respect, the misfortunes of lovers. Those two situations are the chief which interest us upon the theatre; because, in spite of all that reason and experience can tell us to the contrary, the prejudices of the imagination attach to these two states a happiness superior to any other. To disturb, or to put an end to such perfect enjoyment, seems to be the most atrocious of all injuries. The traitor who conspires against the life of his monarch, is thought a greater monster than any other murderer. All the innocent blood that was shed in the civil wars, provoked less indignation than the death of Charles I. A stranger to human nature, who saw the indifference of men about the misery of their inferiors, and the regret and indignation which they feel for the misfortunes and sufferings of those above them, would be apt to imagine, that pain must be more agonizing, and the convulsions of death more terrible to persons of higher rank, than to those of meaner stations’. (TMS, p. 51-52).

The fascination with the lives, deaths and clothing of celebrities is an instance of this. Smith saw it as a moral mistake but one that is necessary to maintain the stability of an elitist social structure:

‘This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments. That wealth and greatness are often regarded with the respect and admiration which are due only to wisdom and virtue; and that the contempt, of which vice and folly are the only proper objects, is often most unjustly bestowed upon poverty and weakness, has been the complaint of moralists in all ages’. (TMS, p61-62).

Thus while people suppose that average citizens don’t seek to tax the wealthy at very high rates because they expect to become rich themselves it might also be that they also target the welfare of the rich

4. Final Remarks. Economics has had success as a field of scientific inquiry because it's been able to develop tractable models with strong predictive capacity; in other words, it simplifies the complex phenomena of human decision-making, interaction, and exchange into its barest form and makes predictions based on those. This has meant that economists have often had to sacrifice realism for tractability. Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith and others had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls and so on.

Smith’s economic actors are realistic human beings. They have emotional and more rational sides to their character. They weigh out-of-pocket costs more than opportunity costs, have self-control problems and are overconfident. They have erratic attitudes of sympathy but are more consistently concerned with rationality and fairness.

References.

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