Pathology

I hate it when people say that trying to use micro and game theory approaches to explain how people act are wrong because people don't behave rationally. At least in my own thinking, I always try to make adjustments based off of how people actually act, whether or not that's traditionally rational (if I wanted to I could make a profit based off of knowing people's irrationality).

I explain it by widening the definition of rationality. Given all circumstances, irrational biases, and psychological ticks, you can still get a tweaked rough cost benefit analysis done and explain what people will do. In this framework, the only irrational act would be someone consciously knowing what is best and subconsciously driven to perform one act, yet doing something completely different.

For example, it is known that people are loss averse. The negative effect of a loss is greater than the positive effect of a gain if both amounts are the same. This is something that could be easily quantifiable and taken into account if you knew how loss averse someone was.

I like David Gruen's explanation a lot better however. It seems to take what I'm saying a step further, and think about how this thinking will affect Macroeconomics in the future. Pathologies are the perfect way of injecting irrationality into economics. This sort of thinking does not lead to the conclusion that people are irrational and therefore unpredictable. Rather, the conclusion is a list of pathologies that people, whether in groups or as individuals, fall prey to. It complicates economics, but it doesn't destroy it.

The end of the article is particularly insightful in how economic thinking may change:

In an asset price bubble, Gruen points out, investors expecting to earn 15 or 20 per cent returns on their funds are unlikely to be deterred by increases in official interest rates of half a percentage point.

''If you tighten monetary policy early and the bubble keeps growing, what do you do then? You've managed to slow the economy down, unemployment has risen a bit, and the bubble is still growing.

This sounds like any macroeconomic problem! Business cycles happen when we alternate between trying to control inflation and trying to control unemployment. Pathologies can easily be inserted into macroeconomic problems, and be balanced along with the classic macroeconomic variables.