We're all citizens of Muddleton

Pete Lunn is well placed to write about behavioural economics, having originally trained as a behavioural scientist and then retrained as an economist. His argument is that mainstream economics mistakenly emphasises rationality, selfishness and independence and so operates only in a fantastical world that he calls "Marketopia".

In reality, he contends, we live in "Muddleton" - an uncertain place in which people are easily "MISLED" by mistakes, information gaps, surprises, luck, subsequent events and dishonesty. Lunn argues that behavioural economics has the empirical tools - for example, surveys and experiments to illuminate our basic economic instincts - and he provides plenty of experimental evidence to show that we are not Marketopians.

"Ultimatum game" evidence illustrates his point: in this behavioural game, a proposer offers a responder some share of a fixed sum - say £100 - but if the responder rejects the proposer's offer then both get nothing.

Mainstream economics predicts that proposers should maximise by offering the minimum - say £1 - and responders should maximise by accepting it, as £1 is better than nothing. But the experimental (and real world) evidence shows that proposers make relatively generous offers of around 50 per cent, while responders tend to reject unfair offers below about 30 per cent.

Other behavioural experimental evidence shows that people avoid immeasurable uncertainty, shift preferences over time, trust others, reciprocate generosity and forgo monetary rewards in punishing uncooperative behaviour.

Lunn argues that these findings are explained by preferences for the familiar, interpersonal relationships and social signals (although he neglects the burgeoning literature on social capital and social networks). He contends that mainstream economics ignores our basic instincts: the "Witt" ("we're in this together") instinct to cooperate, the "Yucki" ("you can keep it") instinct to reject unfair bargains and the "Endian" instinct to favour our own group ("Endian" coming from the allegory in Gulliver's Travels about Lilliputian battles between "Big Endians" and "Little Endians" who differ only because they eat different ends of boiled eggs first).

A major shortcoming of Lunn's analysis is his straw-man version of orthodox economics; it is, at its worst, confusing and misleading (particularly his presentation of theories of the firm and imperfect competition). Lunn's commentary is harsh: "if our children go on to study economics, they appear to lose maturity ... when economics students are used as experimental subjects, they are more inclined to behave selfishly ... (this) association between economic orthodoxy and childishness is fairly amusing to those of us struggling to open the profession's mind - patiently enduring the toddler tantrums of the traditionalists as the evidence piles up".

Lunn also claims that mainstream texts largely ignore behavioural economics: "The profession has for years been teaching its practitioners and students to recite doctrine." But the latest edition of Hal Varian's Intermediate Economics has a chapter devoted to behavioural economics, and N. Gregory Mankiw's Macroeconomics addresses behavioural issues of time inconsistency and preference shifts.

The pity is that Lunn's critique is essentially correct: the mainstream reliance on assumptions of axioms of rationality, selfishness and independence and on market solutions to complex problems is misguided.

But the persuasiveness of a potentially powerful and legitimate critique is undermined by Lunn's cartoon-like depictions of rival theories.

His portrayal also ignores the "dark side" of our economic instincts: "Endian" instincts explain discrimination, but Lunn spends little time on this point, even though it is essential to fundamental socio-economic problems of social alienation, gang violence, racism and so on.

Some interesting themes explored here include comparisons of the differences in evolutionary approaches: in contrast to the mainstream emphasis on market selection, behavioural economics explains the natural selection of economic instincts as highly evolved responses to environmental constraints, particularly uncertainty.

Lunn offers interesting methodological insights in underscoring the importance of the inductive method. His policy lessons are also profound: market-based solutions - for instance, labour market deregulation and inflation targeting - will be undermined by our basic economic instincts.

Surprising features in Basic Instincts are the cursory references to Keynes (arguably the first behavioural economist). Also, given Lunn's background in neuroscience, it is surprising that he claims little for neuroeconomics: "For the revolution in progress, neuroeconomics is probably no more than an entertaining sideshow."

Basic Instincts is a good starting point for investigating behavioural economics (and it includes a useful annotated reading list). It is engaging, colourful, accessible and contains many interesting anecdotes and stories.

Expert economists will accuse Lunn of dumbing down with his Marketopia versus Muddleton fairy-tale style, childish language (the Yucki and Witt instincts) and misleading acronyms (MISLED), but economics is perhaps too full of esoteric jargon, and Lunn's simple rhetorical style will suit the general audience. That aside, this is a provocative, comprehensive account of behavioural economics' most interesting insights.

And, essentially, Lunn is right: behavioural economics will revolutionise economics.