16 Jan 2006  Research & Ideas

Adam Smith, Behavioral Economist?

Adam Smith is best known for The Wealth of Nations, but professor Nava Ashraf believes another of his works, The Theory of Moral Sentiments, presaged contemporary behavioral economics.

 

Adam Smith's The Wealth of Nations, first published in 1776, helped create the discipline of economics with its conjuring of the invisible hand, self-interest, and other explanations of market forces that have influenced academics, governments, and business leaders ever since. But it's the insights from one of Smith's earlier works, The Theory of Moral Sentiments, that caught the attention of Harvard Business School professor Nava Ashraf and coauthors Colin Camerer and George Loewenstein.

In "Adam Smith, Behavioral Economist," published in the summer 2005 edition of The Journal of Economic Perspectives, the authors find that Smith's insights from 1759 can contribute to modern thinking on everything from our fascination with celebrity to the theory of loss aversion. In fact, says Ashraf, Moral Sentiments presages the emerging field of behavioral economics.

We asked Ashraf to discuss her research and the enduring power of Adam Smith's ideas.

Ann Cullen: How did you and your coauthors come to be interested in this lesser known publication of Adam Smith?

Nava Ashraf: Several years ago while taking a graduate course at Harvard on the Scottish Enlightenment, I wrote a paper called "The Morals of a Market Society" focusing on the virtues Smith wrote about in The Theory of Moral Sentiments (TMS). Once I started more research in behavioral economics, I realized how closely Smith's work from TMS related to this emerging field. Indeed, it looked very much like the field of behavioral economics, which economists usually think of as a "new" field, was in fact rigorously studying the very factors that Smith, arguably the "father" of modern-day economics, had always thought were critical in human behavior and interaction.

Simultaneously, both my esteemed coauthors, Colin Camerer and George Loewenstein, had been exploring TMS and had mentioned in their own work how important it was for economists to read this lesser known work. So it was great fun for the three of us to write this paper, to bring together Smith's insights with advances in behavioral economics research. Our hope is that it encourages people to go back to TMS and read it for themselves—it's a truly wonderful book.

Q: What do you think Adam Smith's impression would be of the current formal academic study of behavioral economics?

A: I think he'd probably be thrilled! Smith's two main works—The Wealth of Nations (WN) and The Theory of Moral Sentiments (TMS)—show him to be a brilliant economist and arguably a brilliant psychologist, but he was never fully able to bring the economics and psychology together. In TMS, he describes the psychological factors that underlie human decision making, motivation, and interaction, which of course have strong implications for what drives consumption and savings decisions, worker productivity and effort, and market exchange. Only rarely did he make deep links to this work in WN.

Smith's advice to business leaders would likely be that they should weigh carefully the costs of breaking trust and of risking reputation.

The formal study of behavioral economics exactly relates psychological factors to economic behavior, and even more recently has been exploring the market-level implications of consumers and firms who may be subject to varying levels of psychological influences. Although the importance of psychological factors may be something that business leaders have long understood, the field of economics has only relatively recently been equipped with the tools to be able to study such phenomena rigorously and—importantly—to be able to make predictions about where such factors may be more or less important, when market forces can diminish or exacerbate these factors, etc.

Q: According to your article, Smith's Theory of Moral Sentiments argues that behavior is determined by a struggle between "passions" and the "impartial spectator." What did he mean by this?

A: Smith believed that much of human behavior was under the influence of the "passions"—emotions such as fear and anger, and drives such as hunger and sex—but these passions were moderated by an internal "voice of reason," which he called an "impartial spectator." The impartial spectator allows one to see one's own feelings and the pulls of immediate gratification from the perspective of an external observer. In the area of self-control and self-governance, the impartial spectator takes the form of a long-term interest (i.e., I won't have that cookie today because I can see that I will regret it down the road). In the area of social interaction, the impartial spectator allows us to see things from another's perspective rather than to be blinded by our own needs.

The conflict between the passions and the impartial spectator is the most fascinating part of Smith's TMS for me. The conflict is particularly important when studying savings decisions, since savings is exactly a decision to delay immediate gratification for a long-term interest, to stay the voice of a short-term pull for the voice of the impartial spectator.

With my coauthors I applied this framework to designing a savings product for a bank in the Philippines that helps clients act in line with their long-term interests. In this "commitment savings product," clients sign a contract with the bank that doesn't let them withdraw their own money until a certain amount or date has been reached. It gives their control over to the bank to help them overcome short-term impulses to spend. The product had a large and significant effect on clients' total savings, helping clients to buy land, improve their businesses, pay for large educational expenses, etc.

Q: Why has it taken so long for the field of economics to incorporate Adam Smith's insights, and why are so many of the ideas Smith developed yet to be pursued for academic research?

A: Economics has had success as a field of scientific inquiry because it's been able to develop tractable models with strong predictive capacity; in other words, it simplifies the complex phenomena of human decision-making, interaction, and exchange into its barest form and makes predictions based on those. Of course, this has meant that economists have often had to sacrifice realism for tractability. Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith and others had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls, etc.

One of the most unexplored areas, which we are only now beginning to be able to measure, is the degree to which people are motivated by the "aerial coin of praise" and social status, something Smith thought was a crucial motivation for economic activity.

Q: What do you think Adam Smith's advice to business leaders would be concerning corporate ethics given what he writes about trust?

A: This is a great question. Smith believed that there were certain virtues, such as trust and a concern for fairness, that were vital for the functioning of a market economy. He wrote about trust and reciprocity as critical foundations of the early beginnings of the market, allowing reciprocal gift exchange to emerge, and leading to trade. One might think that the need for trust and trustworthiness diminishes as a market develops, but if anything the opposite is true.

For example, we trust managers to carry out the interests of shareholders: We can build contracts to align manager incentives with those of shareholders, but we are never able to completely contract on all the things we care about and want to enforce. Implicitly, then, we hold a belief that managers have internalized the values we care about, and trust them to act on those, particularly when they might come in conflict with their own interests.

There are similarly other professions where individuals are entrusted to serve, like doctors, teachers, auditors, but cannot be monitored fully. We thus rely on these individuals' professionalism and honor (or "enlightened self interest") to carry out their occupations.

Across organizations, in the marketplace, factors like brand reputation and warranties help facilitate transactions without requiring complete trust. Within organizations, the issue of trust and trustworthiness—of employees to their bosses, of managers to each other and to shareholders—becomes even more important, and even more difficult to replace by market forces or better incentives and contracts.

Thus, Smith's advice to business leaders would likely be that they should weigh carefully the costs of breaking trust and of risking reputation. The costs of sacrificing ethical standards of conduct are much larger than any individual might imagine, precisely because they decrease trust and can strongly affect organizational and market functioning as a whole.

About the author

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.