Behavioural Economics

Economics is a study of human behaviour, but it is not the only field, that can make that claim. The social science of psychology also sheds light on the choices that people make in their lives. The fields of economies and psychology usually proceed independently, in part because they address a different range of questions. But recently, a field called behavioural economics has emerged in which economists are making use of basic psychological insights.

People are not always rational. Members sometimes called Homo economies are always rational. As firm managers, they maximize profits. As consumers they maximize utility. Given the constraints they face, they rationally weigh all the costs and benefits and always choose the best possible course of action.

Real people however are Homo sapiens. Although in many ways they resemble the rational, calculating people assumed in economic theory, they are far more complex. They can be forgetful, impulsive, confused, emotional and short sighted. These imperfections of human reasoning are the bread and butter of psychologists but until recently economists have neglected them.

Social scientists who work at the boundary of economics and psychology suggest that humans should be viewed not as rational maximizers but as satisficers. Rather than always choosing the best course of action, they make decisions that are merely good enough. Similarly other economists have suggested that humans are only “near rational” or that they exhibit “bounded rationality”.

Studies of human decision making have tried to detect systematic mistakes that people make. Here are a few of the findings:

People are over confident: Imagine that you were asked some numerical questions, such as the number of African countries in the United Nations, the height of the tallest mountain in North America and so on. Instead of being asked for a single estimate, however, you were asked to give a 90 per cent confidence interval – a range such that you were 90 per cent confident the true number falls within it. When psychologists run experiments like this, they find that most people give ranges that are too small: The true number falls within their intervals far less than 90 per cent of the time. That is most people are too sure of their own abilities.

People give too much weight to a small number of vivid observations: Imagine that you are thinking about buying a car of brand X. To learn about its reliability you read Consumer Reports, which was surveyed by 1,000 owners of car X. Then you run into a friend who owns car X, and she tells you that her car is a lemon. How do you treat your friend’s observation? If you think rationally, you will realize that she has only increased your sample size from 1,000 to 1,001 which does not provide much new information. But because your friend’s story is so vivid, you may be tempted to give it more weight in your decision making than you should.

People are reluctant to change their minds. People tend to look at internet evidence to confirm the beliefs they already hold. In one study, subjects were asked to read and evaluate a research report on whether capital punishment deters crime. After reading the report those who initially favoured the death penalty said they were surer in their view, and those who initially opposed the death penalty also said they were surer in their view. The two groups interpreted the same evidence in exactly opposite ways.

A hotly debated issue is whether deviation from rationality is important for understanding economic phenomena. An intriguing example arises in the study of 401 (k) plans that the tax advantaged retirement savings accounts that some firms offer to workers. In sometime, workers can choose to participate in the plan by filling out a simple form. In other firms, workers are automatically enrolled and can opt for the plan by filling out a simple form. It turns out many more workers participate in the second case than in the first. If workers were perfectly rational maximizers they would choose the optimal amount of retirement savings, regardless of the default offered by their employer. In fact, workers’ behaviour appears to exhibit substantial inertia. Understanding their behaviour seems easier once we abandon the model of rational man.

Why, you might ask, is economies built on the rationality assumption when psychology and common sense cast doubt on it? One answer is that the assumption even if not exactly true, is still good approximation. For example, when we studied the differences between competitive and monopoly firms, the assumptions that firms rationally maximize profit yielded many important and valid insights.