Behavioural Economics is Rational After All

There are some deep and interesting issues involved in the debate over behavioural economics. Greg Hill posted a comment on my previous blog where he says:
Now, you really have to ask yourself whether the kind of rationality involved in [Thaler's idea of a nudge], where a minimal change in cost results in a significant change of behavior, is same kind of rationality Lucas and Sargent have in mind.
That led me to explain my views a little further.

The most interesting issue [with behavioural economics] is whether we should continue to accept the neoclassical assumption that preferences are fixed. Let's go with that assumption for a moment.

If preferences are fixed, then we face a second question. What form do they take? For a long time, macroeconomists assumed that people maximize the discounted present value of a time and state separable von Neumann Morgenstern expected utility function. The narrow version of behavioural economics asserts that this assumption is wrong; but people are still utility maximizers.

Finance economists seeking to reconcile macroeconomics with finance theory have already taken up that challenge (see the survey here on Exotic Preferences in Macroeconomics). The dominant view in finance theory is that people maximize the present discounted value of a subclass of preferences first formalized by Epstein and Zin. These preferences drop one of the key assumptions of Von-Neumann Morgenstern; that the date at which information is revealed is irrelevant. There are also more radical possibilities. The original version of the Epstein Zin utility function also allows for dropping a more fundamental assumption, called the independence axiom.

My point here, is that neoclassical economics can absorb the criticisms of the behaviourists without a major shift in its underlying assumptions. The 'anomalies' pointed out by psychologists are completely consistent with maximizing behaviour, as long as we do not impose any assumptions on the form of the utility function defined over goods that are dated and indexed by state of nature.

There is a deeper, more fundamental critique. If we assert that the form of the utility function is influenced by 'persuasion', then we lose the intellectual foundation for much of welfare economics. That is a much more interesting project that requires us to rethink what we mean by individualism.

Greg also asks
“can we understand all the failures of classical macroeconomics without giving up both rational choice and the premise that all markets clear?” If anyone can make a persuasive case for the “yes” answer, I believe you can."
My response. Yes we can and should maintain rational choice, rational expectations and market clearing: but that requires a radical change in the way we define equilibrium. As I have done here.