Work for Fifi and why drug dealers love their mums

Freakonomics has been a runaway bestseller. Most readers of this review will already be aware of the book and, to judge by its sales, many will have read it. Steven Levitt, an outstanding economist at the University of Chicago, and Stephen Dubner, a New York journalist, undoubtedly deserve their success. They write clearly about a wide range of fascinating economic problems. Almost anyone with an interest in the social and economic everyday world can benefit from reading this book.

The strength of Freakonomics is that it uses the core insight of economics to illuminate real-life issues. It tackles questions such as why do drug dealers still live with their mothers; how much do parents really matter; why has crime fallen sharply in the past decade; does the choice of a child's name affect his or her prospects in later life in the job market? The attention of the media seriously distorts the true heart of economics.

The focus in news and current affairs discussions is on macro-economic factors such as retail sales growth, unemployment, interest rates and the effect of the decisions of the Monetary Policy Committee. But economics is, in essence, a description of the micro-level world, a theory of how individuals behave. The great insight of economics is that individuals react to incentives. It is this that distinguishes economics from all other social sciences. It is this that is the only really general law that we have in the social sciences. And it is this law Levitt and Dubner apply to understand the questions that they pose.

One example will suffice. Crime in the US has fallen sharply since the early 1990s. The fall is by no means understood completely, but several factors have clearly contributed. One, the reduction in the supply of poor young men - who commit almost all crime - through an increase in abortion has become rather notorious. But Levitt points out that stricter sentencing policies have also been important. The same point applies to Britain.

Michael Howard as Home Secretary increased both the number of people sent to prison and the length of sentencing, and his policies have been continued by new Labour. The effect has been to contribute to the reduction in crime. Many intelligent non-economists find it baffling that the prisons are full when crime has fallen. Surely if crime is lower, there should be fewer people in prison? But the causality goes the other way. A higher probability of being sent to jail if convicted and the prospect of a longer sentence has acted as a deterrent.

Economists of all persuasions should be pleased that their discipline can be shown to be so useful. But they should also reflect that much of what they teach about individual behaviour is not needed at all by Levitt.

Conventional economic theory relies on a very particular rule of behaviour for individuals - namely, that they examine the incentives that face them and then take the best possible decision, the "optimal" one, a word beloved by economists. This behavioural postulate lends itself very readily to formalisation in differential calculus and enables economists to fill their papers with pages of equations.

Levitt does not need any of this. He uses just the simple rule that individuals react to incentives. They may sometimes take decisions that are short-sighted, they may even take decisions that turn out to work against their own self-interest. The consequences may often be difficult to predict in advance, and only after the event are we able to understand why something happened as it did. But if the incentives that they face change, people will react.

This is entirely consistent with the rapidly growing body of evidence within economics itself that the general postulate on individual behaviour used in economic theory lacks empirical support. Except in very straightforward situations, individuals in general do not behave as if they are making optimal decisions. Instead, they rely on simple rules of thumb.

An example of the latter can be used to understand the spectacular success of Freakonomics itself. The book is very good, but its sales occupy a different dimension from other good and popular books on economics. In a complicated environment, a sensible behavioural rule of thumb to use in making decisions is to see what your social peer group is doing and to follow their example.

Our understanding of how ideas or recommendations percolate across such social networks has been enhanced enormously in the past decade, almost entirely from disciplines other than economics. We now know that there is a very strong random element to such processes. And once certain critical points are reached on a network, a recommendation can spread rapidly across the entire network. So part of the spectacular success of Freakonomics is due to simple good luck. But, no matter, anyone who has not read this book should do so.

Paul Ormerod is a director of Volterra Consulting and author of Why Most Things Fail .