Certainly behavioral economics is all the rage these days. The casual reader might have the impression that the rational homo economicus has died a sad death and the economics profession has moved on to recognize the true irrationality of humankind. Nothing could be further from the truth.He continues,
The modern paradigmatic man (or more often these days woman) in modern economics is that of a decision-maker beset on all sides by uncertainty. Our central interest is in how successful we are in coming to grips with that uncertainty. My goal in this lecture is to detail not the theory as it exists in the minds of critics who are unfamiliar with it, but as it exists in the minds of working economists. The theory is far more successful than is widely imagined – but is not without weaknesses that behavioral economics has the potential to remedy.Levine goes on to point out that while laboratory experiments have shown up a number of anomalies with the standard theory, it should not be overlooked that the theory works remarkably well in the laboratory.
One of the most widespread empirical tools in modern behavioral economics is the laboratory experiment in which people – many times college undergraduates, but often other groups from diverse ethnic backgrounds – are brought together to interact in artificially created social situations to study how they reach decisions individually or in groups. Many anomalies with theory have been discovered in the laboratory – and rightfully these are given emphasis among practitioners, as we are most interested in strengthening the weaknesses in our theories. However, the basic fact should not be lost that the theory works remarkably well in the laboratory.Levine goes on to discuss areas where the theory works, such as voting, and areas where it doesn't, such as ultimatum bargaining. He then discusses learning and self-confirming equilibrium.
Learning and incomplete learning – whether or not we regard this as “behavioral” economics – are an important part of mainstream economics and have been for quite some time. An important aspect of learning is the distinction between active learning and passive learning. We learn passively by observing the consequences of what we do simply by being there. However we cannot learn the consequences of things we do not do, so unless we actively experiment by trying different things, we may remain in ignorance.Next Levine explains that while behavioural economics points to many paradoxes and problems with mainstream economics, their own models and claims are often not subject to a great deal of scrutiny. He then examines some popular behavioural theories and discusses the relationship between psychology versus economics. He notes,
As I indicated, the notion of self-confirming equilibrium from Fudenberg and Levine  captures this idea. A simple example adapted from Sargent, Williams and Zhao [2006a] by Fudenberg and Levine  shows how this plays a role in mainstream economic thought. Consider a simple economic game between a government and a typical or representative consumer. First, the government chooses high or low inflation. Then in the next stage consumers choose high or low unemployment. Consumer always prefer low unemployment, while the government (say) gets 2 for low unemployment plus a bonus of 1 if inflation is low. If we apply “full” rationality (subgame perfection), we may reason that the consumer will always choose low unemployment. The government recognizing this will always choose low inflation. Suppose, however, that the government believes incorrectly that low inflation leads to high unemployment – a belief that was widespread at one time. Then they will keep inflation high – and by doing so never learn that their beliefs about low inflation are false. This is what is called a self-confirming equilibrium. Beliefs are correct about those things that are observed – high inflation – but not those that are not observed – low inflation.
Much of behavioral economics arises from the fact that people have an emotional irrational side that is not well-captured by mainstream economic models. By way of contrast, psychologists have long been fascinated with this side of humankind, and have many models and ideas on the subject. Not surprisingly much of behavioral economics attempts to import the ideas and models developed by psychologists.In summary Levine has this to say,
The key difference between psychologists and economists is that psychologists are interested in individual behavior while economists are interested in explaining the results of groups of people interacting. Psychologists also are focused on human dysfunction – much of the goal of psychology (the bulk of psychologists are in clinical practices) is to help people become more functional. In fact, most people are quite functional most of the time. Hence the focus of economists on people who are “rational.” Certain kinds of events – panics, for example – that are of interest to economist no doubt will benefit from understanding human dysfunctionality. But the balancing of portfolios by mutual fund managers, for example, is not such an obvious candidate. Indeed one of the themes of this essay is that in the experimental lab the simplest model of human behavior – selfish rationality with imperfect learning – does an outstanding job of explaining the bulk of behavior.
A useful summing up is by considering the main theme of this lecture: that behavioral economics can contribute to strengthening existing economic theory, but, at least in its current incarnation, offers no realistic prospect of replacing it. Certain types of “behavioral” models are already important in mainstream economics: these include models of learning; of habit formation; and of the related phenomenon of consumer lockin. Behavioral criticisms that ignore the great increase in the scope and accuracy of mainstream theory brought about by these innovations miss the mark entirely. In the other direction are what I would describe as not part of mainstream economics, but rather works in progress that may one day become part of mainstream economics. The ideas of ambiguity aversion, and the related instrumental notion that some of the people we interact with may be dishonest is relatively new and still controversial. The use of models of level-k thinking to explain one-time play in situations where players have little experience works well in the laboratory, but is still unproven as a method of analyzing important economic problems. The theory of menu choice and self-control likewise has still not been proven widely useful. The theory of interpersonal (or social) preferences is no doubt needed to explain many things – but so far no persuasive and generally useful model has emerged.Read the whole thing, its worthwhile.