Behavioral Economics

Traditional economics focused on the results of economic behavior (supply, quantity demanded, prices and the like) rather than the actual behavior of consumers themselves. Behavioral influences on consumers were viewed as complicating factors which could be assumed to cancel each other out. George Katona found this approach lacking and argued that an appreciation of how psychological variables influence consumers could lead to a deeper understanding of the behavior of economic agents. Katona’s viewpoint now known as behavioral economics, was fostered by important changes which occurred in our economy. Economics was fostered by important changes which occurred in our economy, especially after World War II. Rising income levels had given a large number of consumers significant discretionary income – spending power available after necessities had been purchased. In short our economy had changed from one characterized as much for a few to one described as more for many.

What made discretionary income so interesting to Katona and others is that it has become a very important component of our economic system since a healthy portion of it is devoted to the purchase of durable goods such as cars, stereos, washing machines and CD players. Because the cost of these items is usually high, consumer will tend to purchase them when they perceive the general economic climate and their personal situation as being favorable. Therefore, this important influence on our economy is somewhat volatile and is affected by consumers perceptions and economic expectations.

A very simplified representation of Katona’s viewpoint appears in the figure below

A simplified representation of Kotona’s behavioral economics perspective

Actual economic conditions  Psychological process Consumer sentiment  Economic behavior  Actual economic conditions.

As in traditional economic models actual economic conditions are shown as influencing consumers. These economic conditions include the rates of interest inflation and unemployment, the level of the GNP as well as more personal economic situation such as the household’s current status regarding axes, income and debt. However, as the diagram shows with a modulating arrow, rather than directly influencing the consumers these actual economic conditions are modified by psychological factors which include consumer’s motivations knowledge, perceptions and attitudes.

The diagram shows that consumers sentiment results from psychological processes modifying the effect of actual economic conditions on the consumer. Consumer sentiment may be thought of as the consumer’s level of confidence about current economic conditions he faces and his expectations about the status of economic conditions in the future. This consumer sentiment in turn is a deciding factor in the amount of discretionary spending that the consumers will engage in at any given point of time. For example even when current economic conditions are quite acceptable the consumer expects that an economic downturn with possibilities of unemployment will occur in the near future, her purchase of a new car might be postponed until she is confident of her liability to handle future monthly payments. Katona argued that when many people in the economy share a similar view, a large number of consumers will hold back on discretionary spending and this is likely to lead to an economic downturn.

In order to test his arguments in the early 1950s Katona began conducting surveys of consumers and used their responses to a series of economic and personal finance questions to develop the Index of Consumer Sentiment (ICS) , which is published on a regular basis . This index is claimed to represent the confidence consumers have in the economy.

Was Katona justified in proposing that psychological variables are needed to better understand the spending behavior of consumers and their effect on the economy? Has the ICS been a good predictor of changes in our economy? Figure shows a graph of the ICS from 1960 through 1992. Also shown in the graph are times which have been officially identified by the US government as recessionary periods. The graph rather clearly shows that the ICS has declined prior to recessionary periods and therefore seems to be a predictor of their occurrence.

Source: Consumer Behavior