If you open up the first few pages of an IB economics textbook, you will doubtless come across the word “rational”, in the context of explaining how economic agents (buyers and sellers, households and firms) interact. The assumption is, in the course of the two years of an IB economics student’s studies, that us humans make decisions based on reason, by calculating costs and benefits of each choice, as we are rational beings and want to achieve the most favorable outcome under any circumstance. In short, we want what we want, therefore we will act in our best interest. This assumption enables economists to predict people’s actions, and they have built numerous economic theories around this notion. Two main theories built on the belief that people make rational decisions include the rational choice theory, which assumes that people are “homo economicus” that act as economists to make rational utility-maximizing choices. Another, slightly different theory is the bounded rationality theory, which also sees people as rational but limited by the amount of information they have and can process.
There is one issue, as with most generalized assumptions: in practice, the economy simply does not work this way. While most would agree that bounded rationality shows a more realistic view of how humans behave, think, and make economic decisions, behavioral economists, who incorporate the field of psychology into the analysis of decision-making towards economic outcomes, would argue that often people do not act in their best interest, to achieve the most desirable outcome. This field of economics builds a framework around determining why people make such errors,considering a more limited cognitive ability than classical economics assumes, and modelling a more realistic view of the economy, in which people make decisions to maximize instantaneous benefits often at the cost of loss of potential long term utility, have trouble exercising self-control, act on impulse, “following their gut”, and are largely influenced by their surrounding and context.
Behavioral economics is considered a young area of the subject, as its first notable advancements are usually traced back to the end of the 20thcentury, to a pair of psychologists, Amos Tversky and Daniel Kahneman who published a number of papers challenging the traditional view that economics held about the rational nature of human beings as decision-makers. Prior to them, however, thinkers of the 18thand 19thcentury had already been interested in the psychology behind economics.Tversky’s and Kahneman’s work’s importance lies in their development of the prospect theory, which shows how people decide between alternatives that involve risk and uncertainty. The theory indicates that people prefer taking risks to avoiding losses (loss aversion), and that they think in terms of expected gains and current wealth, rather than long term, absolute outcomes.Other advancements in the field by Tversky and Kahneman were also considered crucial as they made important methodological contributions to the budding area of behavioral economics, by applying rigorous experimental approach to understanding decisions based on the measurement of actual choices made under various conditions.
The subject of behavioral economics was officially founded even more recently, by Richard Thaler, who, inspired by Tversky and Kahneman’s work, formulated the concept of mental accounting. The main point of his theory is connected to their work, as it states that people consider value in relative rather than absolute terms.The theory suggests that people do not only regard the benefits they gain from the end result of a decision, but also consider the transaction utility. For example, they tend to spend more money when paying by card rather than cash. It also discusses how people are susceptible to the sunk cost fallacy (people’s actions are biased by their prior commitment, such as time, money or effort invested, leading them to irrational choices) and often fail to consider opportunity costs.Thaler recently won the Nobel Prize for his advancement in incorporating psychology into economic interactions. He also suggested that theories of behavioral economics can be applied to explain decisions involved in Brexit and argued that they were influenced by gut choices over rational thinking.
On a larger scale, such theories are useful for companies looking to increase profits to encourage changes in behavior, and policy-makers, to suggest ways in which to restructure environments to facilitate better decision-making3. This is exemplified by David Cameron, who believes behavioral economics may help policies change behavior, such as “how to make it socially unacceptable for the young to carry knives; encouraging people to recycle; and tackling binge drinking and obesity”. He, along with many politicians today, believes that nudge theory, another concept originating from Richard Thaler, justifies the notion of policies to affect and change human behavior for people’s own greater benefit. Nudge theory, as shown by the examples explains how small interventions may be implemented to encourage individuals to make changes in their behavior, or different decisions. A successful way this has been used was with the implementation of e-cigarettes as a less harmful but similar substitute for smoking, which resulted in over 2 million people choosing this “lesser evil” option and has been a more successful way of decreasing the amount of people smoking than by any other means.
In conclusion, the development of the area of behavioral economics has provided us with a new view on decision-making and rational thinking. Through the reconsideration of the classical economic assumption that people behave as rational beings to maximize utility, the field has opened us up to a new perspective on the interactions between economic agents, interlaced with the subject of psychology, and has shown to be increasingly relevant in the context of firms and producers, as well as on a higher scale, among policy-makers.
Economy,What is ‘rationality’?
The Guardian, What is Behavioral Economics?Posted Oct 9 2017 by Richard Partington
Psychology Today, What is Behavioral Economics?Posted May 3 2017 by Shahram Heshmat Ph.D.
Behavioral Economics, An Introduction to Behavioral Economics
Behavioral Economics, Prospect theory
Behavioral Economics, Mental accounting
The Guardian, From Obama to Cameron, why do so many politicians want a piece of Richard Thaler?
Economy, What is ‘rationality’?Accessed Oct 15th2018, at https://www.ecnmy.org/learn/you/choices-behavior/what-is-rationality/
The Guardian, What is Behavioral Economics?Posted Oct 9 2017 by Richard Partington, Accessed Oct 15th2018, at https://www.theguardian.com/world/2017/oct/09/what-is-behavioural-economics-richard-thaler-nobel-prize
Psychology Today, What is Behavioral Economics?Posted May 3 2017 by Shahram Heshmat Ph.D., Accessed Oct 15th2018, at https://www.psychologytoday.com/gb/blog/science-choice/201705/what-is-behavioral-economics
Behavioral Economics, An Introduction to Behavioral Economics,Accessed 15thOct 2018 at https://www.behavioraleconomics.com/resources/introduction-behavioral-economics/
Behavioral Economics, Prospect theory, Accessed 15thOct 2018 at https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/prospect-theory/
Behavioral Economics, Mental accounting, Accessed 15th Oct 2018 at https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/mental-accounting/
The Guardian, From Obama to Cameron, why do so many politicians want a piece of Richard Thaler?,Posted on 12th July 2008 by Aditya Chakrabortty, Accessed 15th Oct 2018 at https://amp.theguardian.com/politics/2008/jul/12/economy.conservatives
TAGS: economics, behavioral economics, psychology