The Economics of Brains

Traditional economic theory assumes that human beings behave rationally. That is, that they understand their own preferences, make perfectly consistent choices over time, and try to maximize their own well-being. This peculiar assumption has its roots in dusty essays like “Exposition of a New Theory on the Measurement of Risk” (from 1738) by Daniel Bernoulli and scholarly tomes like Theory of Games and Economic Behavior by John von Neumann and Oskar Morgenstern (published in 1944). The idea has some validity: traditional economic theory is good at predicting some market behaviors, such as how the demand for products like gasoline will change after a tax hike. But it’s not very good at describing more-complex phenomena like stock-price fluctuations or why people gamble against the odds.

The problem, of course, is that people don’t always behave rationally. They make decisions based on fear, greed, and envy. They buy plasma TVs and luxury vehicles they can’t afford. They don’t save enough for retirement. They indulge in risky behavior such as gambling. Economists understand this as well as anyone, but in order to keep their mathematical models tractable, they make simplifying assumptions. Then they try to adjust their equations by adding terms that account for “irrational” behavior. But if economists could develop models that accounted for the subtleties of the human brain, they might be able to predict complex behaviors more accurately. This, in turn, might have any number of practical applications: investment bankers could hedge against financial euphoria like the Internet boom; advertisers could sell products more winningly.

The idea that understanding the brain can inform economics is controversial but not new; for 20 years, behavioral economists have argued that psychology should have a greater influence on the development of economic models. What is new is the use of technology: economists, like other researchers, now have at their disposal powerful tools for observing the brain at work. The most popular tool, functional magnetic resonance imaging (fMRI), has been around since the late 1980s; but only in the past few years has it been used to study decision-making, which is the crux of economic theory.

The result is the emerging field of “neuroeconomics.” A flurry of recent papers in scientific and economic journals – reviewed in the Journal of Economic Literature by Caltech economics professor Colin Camerer and colleagues – shows how researchers are using the neural basis of decision-making to develop new economic models. At the January meeting of the American Economic Association, the world’s largest economics conference, the neuroeconomics sessions were reportedly standing room only. The hope seems to be that biological research will finally help economists make sense of irrationality.

Take recent brain-imaging experiments by Princeton University psychologist Samuel McClure. In the journal Science, ­McClure and colleagues report that when subjects choose short-term monetary rewards, different regions of the brain are active than when they choose long-term ones. People don’t “discount” future rewards according to a simple scheme, as many economists have suggested. It seems the brain actually makes short-term and long-term forecasts in different ways. The challenge for economists lies in translating this sort of scientific insight into, say, predictive models of how people plan purchases or make retirement fund decisions.

If successful, neuroeconomics could help unify the social sciences and natural sciences – all with great societal impact. “We are at the very beginning of something radically new,” says Daniel Kahneman, the Princeton University psychologist who won the 2002 Nobel Prize in economics. “Technologically, we can expect that within the next decade or two there will be huge developments. The network of knowledge about the brain is expanding at a tremendous rate. That will certainly affect marketing and political psychology, and it could create a common database that nobody will want to ignore.”

Decisions, Decisions
It’s an intriguing idea: to rethink economic theory from the ground up, taking into account the workings of the human brain. For now, though, neuroeconomics is far removed from the day-to-day concerns of most financiers or CEOs.

The first thing to remember is that the field is very, very young. Neurological tools are still relatively crude. Brain-imaging techniques such as fMRI and positron emission tomography (PET) measure changes in blood flow and hence reveal the collective activity of thousands of neurons over a period of seconds. An electroencephalogram (EEG) uses electrodes on the scalp to measure the brain’s electrical activity on the millisecond time scale, but its spatial resolution is so poor that its use is limited. What’s more, imaging studies point out only correlations between brain activity and behavior. One must be careful in drawing neuro­scientific conclusions and making economic predictions.

Because their field is so young, and because they are pursuing different goals, economists and neuroscientists working in neuroeconomics sometimes seem to be talking about different things. For instance, Camerer and his colleagues write that “The foundations of economic theory were constructed assuming that details about the functioning of the brain’s black box would not be known….[But now] the study of the brain and nervous system is beginning to ­allow direct measurement of thoughts and feelings.” Most neuroscientists would disagree with the second point. Direct mea­surement of how groups of neurons interact and which brain areas are active during which physical and mental tasks, yes. But thoughts and feelings are subjective (see “The Unobservable Mind,” February 2005) and observable only by interpreting data.

In a similar vein, neuroscientists and psychologists have at times equated economic utility – the subjective value of a good or service – with the notions of reward and pleasure. These ideas may be related, but they are certainly not interchangeable. Nevertheless, early mutual confusion about both fields’ technical terms and bodies of knowledge is being resolved. “We are rapidly approaching a common language,” says Gregory Berns, a neuroscientist at Emory University.

A more fundamental issue for neuroeconomics is this: should economists care? Perhaps understanding how the brain works is more trouble than it’s worth. After all, some recent findings are not at first glance very economically enlightening. Anyone who has regretted an impulse purchase, for instance, would be unsurprised to learn that evaluations of immediate and delayed rewards use different parts of the brain. For now, neuroeconomics is subject to the criticisms that plague psychology: that its experiments show what is already intuitively obvious, and its models are descriptive, not quantitative. But Stanford psychologist Brian Knutson and psychiatrist Richard Peterson are trying to answer that criticism. Their paper in a forthcoming issue of Games and Economic Behavior reports that subjects seem to use different parts of their brains when they consider financial gains and when they consider financial losses; more recently, they have found that subjects use different parts again to evaluate the magnitude and probability of those gains and losses. Knutson and Peterson’s work is part of an increasing effort to figure out how economic utility may be coded quantitatively in various regions of the brain. If economists could track the different components of utility in a statistical way, they could understand why some people take risks and some don’t – and possibly predict their future behavior.

Protect Us from Ourselves
Suppose that the science and technology of neuroeconomics progress according to plan. (They won’t, of course, but let’s set that aside for now.) At some point in the future, our brains’ inner workings, our innermost thoughts, all of our decision-making processes, could be deciphered and displayed individually and unambiguously, like the hands of poker players in televised tournaments. What would we do with this information? How would we protect ourselves? Entire industries – finance, health care, advertising – stand to flourish or die based on the answers.

Let’s consider some early indications of what the social consequences of neuroeconomics could be. In finance, an initial attempt at using brain studies to model markets was put forth in a recent paper by the economist Andrew Lo. Lo, the director of MIT’s Laboratory for Financial Engineering, argues that the standard theory of “efficient markets” – which assumes investors have perfect information and behave rationally – should be replaced by an “adaptive markets” hypothesis that accounts for psychological factors and responses. He is currently working to formalize the hypothesis mathematically and to implement predictive models of equity risk premium and other stock-­market returns using high-performance parallel processors.

Lo is perhaps best known for a study published in 2002 in which he and Dmitry Repin of Boston University used a polygraph-like system to measure the physiological responses of securities traders as they did their jobs; the researchers concluded that emotions like anxiety and fear play a large role in financial decision-making, and that they may have more influence on less experienced workers than on seasoned veterans. “Within five years, neuroeconomics will become mainstream,” says Lo. “In 15 to 20 years, it will be fully accepted.”

Well before then, expect to see the influence of “neuromarketing” on advertising. Recent experiments have imaged people’s brains as they chose between brand names, even movie trailers. Researchers believe that by recording which brain areas are activated during choices, they are starting to be able to predict preferences based on brain scans alone. Some marketing experts believe such research could be used to supplement product surveys and might, eventually, indicate how to ignite pleasurable feelings in consumers at the prospect of rewards.

All of this raises questions about privacy and individual autonomy – and how society might wish to regulate much more effective advertising. “As corporations learn to take further advantage of our weaknesses, we may soon be asking for government to take on the role of protector and guarantor of our privacy, happiness, and savings,” says Peterson, who is a managing partner of San Francisco firm Market Psychology Consulting.

That may sound a little excessive. But neuroeconomists are thinking about the influence their work could have on public policy. One of the earliest neuroeconomics papers to address policy implications, “Addiction and Cue-Triggered Decision Processes,” by Stanford economists Douglas Bernheim and Antonio Rangel, makes some sensible recommendations. The researchers propose a mathematical theory of addiction (essentially, an economic model) that takes into account findings from brain scans of recovering addicts and physiological measurements from the reward pathways of animal brains. The theory provides a way to determine, for instance, the probability that a recovering alcoholic will drink, depending on the placement of beer cans in a supermarket. It also predicts the effects of addictive-substance policies on the welfare of addicts and casual users – which could be used to compare the socioeconomic consequences of, say, raising taxes on alcohol or subsidizing rehabilitation programs. According to Rangel, this kind of analysis might also apply to other behaviors, like compulsive shopping. The hope is that such models, grounded in the latest neurobiological thinking, will better inform policymakers and lead to more intelligent legislation.

Neuroeconomics seems to be a promising step toward a more unified theory of human behavior. Indeed, by opening up the brain and studying how its circuits produce economic decisions, scientists may provide answers to some of the questions debated by philosophers for centuries. Why do we make the choices we make? And why is it so hard to figure out what we really want?