Are humans rational?
A brief journey into the concepts of behavioural economics
Magda Wasilewska, Warsaw School of Economics
‘Economics done with strong injections of good psychology,’ says Richard Thaler, the Nobel Prize winner, when describing a field he co-founded - behavioural economics. Around 40 years ago, economists went on a journey into psychology and brought substantial souvenirs into their primary domain. These new ideas and concepts led to massive development of sciences such as finance, marketing, or advertising and contributed to the modern understanding of human behaviour in the economic context. Let’s have a look then on three adventures in the field of behavioural economics, concerning how people choose, perceive, and lie.
According to the ‘rational choice theory,’ humans make decisions based on the profit and loss account of the choice. Being a condition of most microeconomics models, the theory spread across other fields such as sociology or political science, receiving much criticism. American economist Duncan Foley argued that ‘the rationality has increasingly become the touchstone by which mainstream economists identify themselves and recognise each other.’ The inconvenience is ‘not so much a question of adherence to any particular conception of rationality, but of taking rationality of individual behaviour as the unquestioned starting point of economic analysis.’ Then, in 1979, Kahneman and Tversky created the ‘Prospect Theory’ - ‘the first rational theory of irrational behaviour.’ It provided a mathematical framework to model behaviour that was not rational.
The primary outcome was the observation that people are loss-averse-they dislike losses more than equal gains, and they are more willing to take risks, to avoid a loss. Another base concept of behavioural economics is the idea of ‘bounded rationality,’ according to which humans are rational. Still, their rationality is limited by their knowledge, computational capacity, lack of time, or other factors. The fact that our behaviour and decisions are not entirely rational, but influenced by various psychological factors found multiple applications in economics.
As much as we would like to think of ourselves as rational choosers, our decisions are highly influenced by external and internal factors. ‘Choice architecture’ is the influence of how options are presented on one’s choice. For instance, packages of cigarettes containing images of effects of nicotine addiction are meant to have a discouraging influence on some of the buyers. Another example is the ‘decoy effect,’ according to which people tend to change their choice based on whether they are presented with two or three options. National Geographic ran an experiment in which firstly customers were presented with small popcorn for 3$ and a large popcorn for 7$. Their choice was based on their appetite. More or less half of them went for a small portion and half for a big one. In the second stage, the third option was introduced – a medium popcorn for 6.5$. In this case, the majority of customers chose the big one, as the attractiveness of the small price difference between a big and medium one exceeded the lack of a large appetite.
Another intriguing effect connected to choices consumers make is the ‘choice overload,’ a situation when we are faced with so many options that make it hard to decide. A wide range of products available may seem like a good thing; however, it has several drawbacks. For instance, a choice overload makes customers buy less, as proven in an experiment by Iyengar and Lepper. The behaviour of customers was tested in a situation of limited (6) and extensive (24) selection of jams. The researchers concluded - ‘Though consumers shop at this particular store in part because of the large number of selections available, having ‘too much’ choice seems to have hampered their motivation to buy.’ Secondly, the bigger set of products available, the complexity of the decision is more significant, which discourages customers from making any decision at all. That was proved in the research of Chernev, who concluded that consumers avoid choices from large assortments and opt for the ones from smaller ones.
Not only the choices we make, but how we perceive things is subject to behavioural economist considerations. One of those is the ‘hot-cold empathy gap,’ the difficulty of predicting one’s behaviour in the future, based on current or future emotional and psychical state. When in a ‘cold’ state we find it hard to imagine our feelings and behaviour if we were in a ‘hot’ state, which is a state of increased emotions or feelings (being angry, hungry, tired). Consequently, when we are ‘hot,’ we can hardly predict our behaviour in a ‘cold’ state when emotions wear off. An excellent example of the latter is shopping while hungry and buying unnecessary items.
Moreover, our emotional involvement in products affects how valuable we think they are. The so-called ‘IKEA effect’ is an increase in the valuation of things we put effort into. We generally value our work, which explains an increasing range of partly-DIY products, from furniture to food. Another effect connected to how we value things is the ‘endowment effect,’ an increase in the valuation of products that we own. The phenomena may be explained by loss aversion or mere ownership effect-people value a product they own more than something similar they do not possess. Business Insider ran an experiment in which journalists asked to buy people’s lottery tickets for much more than they paid. Most interviewees did not want to sell their ticket, although, from an economic point of view that would be reasonable-for the money they would receive, they could buy many more of them. They overvalued the lottery ticket just because they owned it.
Did you ever wonder why people steal things like pens or paper from work? In one of the experiments, participants were asked to perform a task and divided into two groups - one was paid in tokens, easily exchangeable for money, the other one was paid in cash. The researchers found out that the group paid in tokens were much more likely to cheat, having that one step of separation from real money. Turns out, it is much easier to steal a product than to steal the money equivalent to it. Another example of how cheating is being rationalised by our brain is the ‘licensing effect,’ according to which doing something good or positive makes us feel (often non-consciously) like we earned the right to do something morally dubious. The licensing effect is useful in the study of customer behaviour as it turns out that ‘Individuals whose prior choices establish them as ethical and reasonable spenders (or people in a general sense) should be more likely to indulge in frivolous purchases later on.’
We do not always act rationally and according to our common sense. The impact of psychological factors on human economic behaviour should not be underestimated, as it does affect our decisions-as individuals, as consumers, as economic actors. The behavioural economy is among the most vibrant branches of economics nowadays. Its rapid development and various practical applications will surely provide it with a permanent place on the horizon of economic sciences.