Behavioural Economics : A Challenge To Mainstream Economic Models
Introduction :
Behavioural economics is a relatively new field that combines insights from psychology, judgement, decision making and economics to generate a more accurate understanding of human behaviour. Economics has long differed from other disciplines in its belief that most if not all human behaviour can be easily explained by relying on the assumption that our preferences are well-defined and stable across time and are rational. Behavioural economics emerged against the backdrop of the traditional economic approach known as rational choice model. The basic message of behavioral economic is that humans are hard wired to make judgement errors and they need a nudge to make decisions that are in their own best interest. This approach complements and enhances the rational choice model.
The Rational Consumer :
Economists try to build efficient models by making simplified assumptions about consumer behaviour. One of the most common assumptions being that the consumer is rational, that is, a consumer that believes in maximising his/her utility. Such simplistic assumptions has allowed economists to come up with powerful models and analyse different markets and economic issues. However, deviations from this rational behaviour can be noted as humans might try to make rational decisions, but they also have limited willpower and cognitive abilities. Decisions can be guided by self interest but may also depend on fairness and equity. Such insights from psychology into economic analysis has sprouted the field of behavioural economics.Endowment Effect :
Thaler coined the term 'endowment effect' for the tendency of individuals to value items more just because they own them. Endowment effect can be understood by taking example from a study by Richard Thaler, Daniel Kahhneman & Jack Knetsch, in which participants were given a mug and then offered the chance to sell or trade it for equally valued alternative. It was found that the amount participants required as compensation for the mug once their ownership of the mug was established (willingness to accept) was twice as high as their willingness to pay to acquire the mug (willingness to pay).
When an individual is given good X, such that he moves from point A (quantity : X' , wealth : W') to point B (quantity : X'' , wealth : W'). Their willingness to pay is represented by the vertical distance BC, because after giving up that amount of wealth the individual is indifferent between points A and C. However, an individual who gives up good X and moves from point B to point A, their willingness to accept is represented by the vertical distance AD because after receiving that much wealth the individual is indifferent between point B and D. The willingness to accept (AD) is thus larger than the willingness to pay (BC).
Loss Aversion :
There are several explanations for the phenomenon of endowment effect, one of the most prominent basis lies in the idea of loss aversion. According to his idea, the prospect of selling or loosing an item has a stronger influence on the decision making than purchasing or gaining the item. In other words, it is more painful to loose something than to gain something. This idea is widely used in marketing techniques.
The prospect of selling or losing the mug has a stronger influence than purchasing or losing the mug. This discrepancy manifests itself in the different prices. The prospect of losing the mug for the seller is more significant than the prospect of gaining the mug for the buyer, thus the seller is willing to accept $6 while the consumer is willing to pay $3.
Prospect Theory is a behavioural model that shows how people decide between alternatives that involve risk and uncertainty. It demonstrates that people think in terms of expected utility rather than absolute outcomes. Prospect theory (Kahneman & Trvesky, 1979) was developed by framing risky choices, and it indicates that people are loss-averse, and since individuals dislike losses more than an equivalent gain, they are more willing to take risks, in order to avoid a loss.
I) A prospect of gain :
A) A certain win of $250, versus
B) A 25% chance to win $1000 and a 75% chance to win nothing?
II) A prospect of loss :
C) A certain loss of $750, versus
D) A 75% chance to lose $1000 and a 25% chance to lose nothing?
Tversky and Kahneman’s work shows that responses are different if choices are framed as a gain (I) or a loss (II). When faced with the first type of decision, a greater proportion of people will opt for the riskless alternative A), while for the second problem people are more likely to choose the riskier D). This happens because we dislike losses more than we like an equivalent gain
Mental Accounting & Consumer Choice :
This important concept of behavioural economics can be understood by looking at the work of Richard Thaler, Amos Tversky and Daniel Kahneman on the idea of mental accounting. The premise of mental accounting lies in the idea that consumers do not treat all of their money (or other resources) as if they have a huge pile of it. Consumers rather tend to have separate mental accounts, such accounts are based on people's goals. When the money ( or other resources) is spent, consumers keep track of it based on the mental account it came from.
If a person decides to watch a movie in a theatre which costs ₹10. After purchasing the ticket, the cashier gives the person ₹10 worth ticket. After reaching the theatre door, the person realises that he has lost the ticket. In this scenario, according to the survey carried out by Kahneman and Tversky
54% said they'd probably just head back home.
In another scenario, assuming that the person goes to purchases a ₹10 worth ticket from the cashier. But the person now realises that he has lost his ₹10 bill. In the same survey, when asked if people would like to purchase the ticket. 88% people said they'd probably go watch the movie.
[Source : The Framing of Decisions and the Psychology of Choice by Kahneman and Tversky, 1981]
In both cases there is a loss of ₹10. But the losing a ₹10 worth ticket enters into the mental account of say 'entertainment', perhaps the person does not want to spend too much on entertainment then the person chooses not to spend another ₹10 and have an total expenditure of ₹20. However, losing a ₹10 bill, it is not clear in which mental account the loss must be accounted to.
We use different mental accounts all the time, our minds just naturally keeps things separate. However, our intuition to keep things separate violates a classic economic principle : the idea that money should be fungible. Is a ₹10 worth ticket and ₹10 bill same things? For an economist, it should be. But for our minds, not so much.
Conclusion :
John Maynard Keynes famously wrote about how the economy is driven by animal spirit — or human psychology. Economics took an important turn some four decades ago when models of the macro-economy began to be built on assumptions about individual human behaviour — or micro- economic foundations. The first such models assumed the representative human being was perfectly rational. Rational expectations assumption in modern macroeconomics has led too many people to believe that all economists have a unidimensional view of human nature.
Behavioural economics poses a powerful challenge to that assumption at the level of individual decision-making and further enhances the understanding of economics. The challenge is to integrate its insights into mainstream models that look at the broader economy.Some of the recent Nobel Prize awards—including the most recent to Richard Thaler, shows the process has already begun.
References :
- Introduction to Behavioural Economics. https://www.behavioraleconomics.com/introduction-behavioral-economics/
- H. M. Shefrin and Richard Thaler (1978), An Economic Theory of Self-control. http://www.nber.org/papers/w0208.pdf
- Thaler, R.H (1985), Mental Accounting and Consumer Choice. http://bear.warrington.ufl.edu/brenner/mar7588/Papers/thaler-mktsci1985.pdf
- Amos Tversky and Daniel Kahneman (1981), The Framing of Decisions and the Psychology of Choice. https://www.uzh.ch/cmsssl/suz/dam/jcr:ffffffff-fad3-547b-ffff-ffffe54d58af/10.18_kahneman_tversky_81.pdf
- Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291. https://www.princeton.edu/~kahneman/docs/Publications/prospect_theory.pdf
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