Herb Simon: the first modern behavioral economist

Behavioral economics has become mainstream economics. Today, most investors are aware, for example, of the work that’s been done on overconfidence, loss aversion, and frame-dependence. While the field has come a long way in the past fifty years, it is Herbert A. Simon who, perhaps more than anyone, deserves the title of the first modern behavioral economist.

Recognizing that economics is about people, not automatons

Herb Simon’s central insight was the concept of bounded rationality, which is the idea that we are not always able, or not always willing to expend the effort, to solve complex problems. So we do the best we can. He favored the term “satisficing,” which captures the notion that we do not really seek the best, but rather we are generally happy to stop looking once we find something that is good enough.

Simon, on receiving a Nobel prize¹ in 1978, opened his prize lecture with the observation that “in its actual development… economic science has focused on just one aspect of Man’s character, his reason.” Important parts of the full domain of economic science were being overlooked.

It took a range of others, such as Richard Thaler, Daniel Kahnemann and Amos Tversky, to force recognition from the broader community of the importance of this field, but it all begins with the acknowledgement that economics is about people, not automatons.

Of course, few have ever argued that human beings really are perfect decision-makers. From Adam Smith, to John Maynard Keynes to Paul Samuelson, some of the most influential economic thinking includes statements to the effect that “animal spirits” (as Keynes termed it) drive much of our decision-making. But, in the words of Thaler², “it was too easy to brush aside bounded rationality as a ‘true but unimportant’ concept.”

“As if”

We see this, for example, in a 1948 paper by Milton Friedman and Leonard Savage. They pose the question “is it not patently unrealistic to suppose that individuals consult a wiggly utility curve before gambling or buying insurance, that they know the odds involved…, that they can compute expected utility… and that they base their decision on the size of that utility?”³ And then, rather than answering “yes, it is patently unrealistic,” they instead argue that is irrelevant, and that what matters is not whether people actually make decisions that way, but rather whether  “individuals behave as if they calculated and compared expected utility.”

To old-school economists, no matter how we actually go about solving complex problems, what counts is whether the answers we come up with are close enough to allow the rational man model to be useful.  It is obvious, for example, that not every individual buy- or sell-decision on every stock is based on a thorough analysis of all relevant information. But efficient market proponents don’t say that they are: just that the aggregate behavior of the whole market can be treated as if they are. Personally, I believe that most markets are pretty efficient most of the time, but no market is completely efficient. But whether your view of market efficiency is the same as mine or not, it’s clear that the question hinges as much on the as if issue as on your view of the rationality of individual market participants.

Today, there’s no longer any serious dispute that behavioral finance is both true and important, and most economists are comfortable with the idea that bounded rationality does change systemic behavior in at least some important ways. It was a long road to getting here, though, and some of the most important early steps were taken by Herb Simon.