Behavioral Economics

Economics was developed in the late 18^th century as a scientific subject seeking to fill our gaps in our understanding of human behaviour. It deals with production and consumption of products to satisfy human wants. Economics seeks to explain how humans behave by quantifying utility and satisfaction. The father of economics Adam Smith in his path-breaking book “Wealth of Nations” in 1776 put forth two assumptions on which whole of our present-day economic research is based. Firstly, he argued that people seek economic incentives and these incentives keep the market running smoothly. Secondly, he also pitched that a human being would ideally take all decisions rationally and empirically, where he would not ignore opportunity costs, i.e. the benefit he could have gained by opting for some other choice. Today, we realize that these assumptions are false.

Let me start with a thought experiment. The college decides to give a grant to you and your friend. Now, the college has left the prerogative with your friend to split the money in any ratio he/she decides. The grant gives you an option. If you approve of the split, your friend and you will get money according to the decided ratio. However, if you reject the split, no one gets the grant. This grant is a one-off chance. Obviously, your friend has an upper hand in the whole ‘game’ and may offer you as lopsided ratios as 80:20 or maybe even 90:10, against your favour. If the first assumption of Adam Smith is applied, you would be happy with whatever economic gain you get from the grant afterall, “something is better than nothing”. However in practice, I doubt you would agree for such a blasphemous offer. This is where economics fails.

Another thought experiment. Suppose you have Rs. 200 in your wallet and a ticket to theatre which also costs Rs. 200. Now in scenario 1, you lost your money worth Rs.200. You would definitely be unhappy but still go to the theatre. Scenario 2, you lost your ticket for the theatre and need to spend Rs. 200 to buy a new one. Experiments have proven that people are less willing to buy the ticket and attend theatre in the second scenario, than the first case. Why is this so? The opportunity cost that is money lost is same, i.e. the money lost by the person is same in both the scenarios. Economics has no answer for this?

Economist blame humans for all these ‘errors’, claiming they are not rational enough. Perhaps we are not rational and Economics needs to take this fact into account. Infact very few of the acts involve rational thinking. If man though rationally, I can guarantee that Apple would not have sold a single iPhone or iPad.

The basic questions still haunt us. We are nowhere near understanding human response to economic incentives. There are enormous gaps in our understanding of human behaviour towards materialistic assets. Unless we cannot answer these questions, we cannot understand how humans live and hope to gain an insight into the very working of our human psyche.

There is some development on this front. Behavioral Economics is a new branch seeking to grasp an understanding of humans behave when subjected to economic incentive in different circumstances. It is an exceedingly exciting field, where the prerequisites are orthodox economics, psychology and loads of common sense. This is one field where I would love to research on.