I have repeatedly been informed that the “economic man” is a poor description of individuals, and given this economic models provide a poor description of the world we live in.  As I have said previously, I don’t agree with this conclusion – and we really need to ask what an economic model is, and why we are using it, to understand the scope of economics and the appropriateness of the assumptions.

In essence my view is that we use economic models to describe, and in some way explain, tendencies that exist (from induction) using assumptions about choice that satisfy two conditions:

1. They are as weak and loosely binding as possible
2. They are appealing in the sense that, when I ask myself about my actions I can deduce laws that guide them.  I could go a step further and say that we can set up “ideal experiments” in our minds, but I’ll leave that for now.

This is all well and good.  But then someone will say “what about habit formation“.  This is an important issue, people obviously develop habits and these habits bind and constrain behaviour.

In fact, I would go as far as to say that habits, and the formation of habits, provide the key to tying together a lot of different strands in experiments and behavioural economics – and that an understanding of habits and habit formation is an important part of improving economists way to describe the world and give advice.

So how do we “describe habits”?

To be fair this is not an issue I have read on – and if there are experienced economists (or people from other disciplines who discuss habits) who look at this issue around, I would love to hear from you in the comments.

But through my own mind I can at least raise a through points.

The first thing is that economics has had a go at describing habits within its core – “habit formation” and “rule of thumb“.  Even macroeconomics is filled with these concepts – even though we know macro theory lags the rest of the discipline by at least 20 years at any point in time

The fact that we empirically observe habits, and so mention habit formation, and the fact that in some models we arbitrarily place these in as rules of thumb is not good enough [Note:  There could be plenty of work I haven't seen where they do explain why in more detail, this dig is more aiming at areas where the assumption is ad hoc].  Although I think economics is underappreciated for its methodological foundations – this is an area where we need to ask the important economic question of “why”.

“Because they do” is not an appropriate answer for an economist – we need to understand the process and give it life, in the same way we do with any choice.

One answer to this is to treat habits like investment.

Habits as an investment

A quick search on the first page of results to “habit investment” on google scholar gets me a whole bunch of macro and finance papers on habit persistence and its impact on investment.  As a result, I’m just going to note down a few points – leaning very much on the concept of rational addiction, but adding the idea of a “stock of habit”.  [Note:  James points me to a good summary paper of the habit persistence literature here, which offers similar points for the persistence of consumption etc]

If people have knowledge of the literature that invariably exists – even author names – could you please flick me a comment

We can think of habits as rules of thumb people put effort into developing for several reasons:

1. It lowers the cost of making choices
2. It allows people to precommit to actions
3. It frees up scarce cognitive capacity to make more important choices

These are great benefits, but like with anything forming a habit comes with costs:

1. It is costly to build up the habit (the cost of “investment”)
2. It limits peoples ability to change their actions when information/the situation around them changes.

Given these costs and benefits, we can describe observed habits, and the process of habit formation, using core economic principles.  Fundamentally, we can use the idea of market/government failures to discuss ways that we get too much/too little investment in habits – we can talk about shocks we observe and the cost of the habit in that case – we can talk about the adjustment of individuals following an economic shock as a process of disinvesting in a habit or investing in a new habit.

Adding the “why” layer, takes us past mere description of an empirical regularity – and helps us to understand the regularity, and how changes in policy and institutions can impact upon it!  Rather than just estimating a level of habit persistence, we can use these principles to understand the evolution of such persistence, and the impact of policy on this.

This is ridiculous, habits are built by choice – they are built by X

This is true, habits do not only evolve from the choice of individuals to invest in a habit.

Beyond this, society as a whole produces a “stock of habits” which people rely on to build their rule of thumbs.  In that sense the development of a habit across society may involve positive, or negative, externalities.

Furthermore, people may be endowed with a “stock of habits” from a young age – fundamental archetypes that drive human nature may produce underlying habits, and it is society and the choices of individuals that see habits move away from this initial endowment.

But even with these more general explanations – we are still using the core economic method.  Habits, their evolution, and their propagation through society, can be adequately placed in a general economic framework … if anything this result can be seen as “trivial”.

The HARD bit is separating empirical issues:  what is “habit” and what is “non-habit” when we observe a choice?  How do habits propagate through observed societies?  How do we clearly measure habits, and the outcomes associated with them?

Conclusion

So next time you here someone criticise economics of the basis that “they ignore habits and bounded rationality” you can tell them that this issue is well within the “economic core” – and that the economic method provides a useful way to describe, and eventually understand, issues related to this!