Earlier this week, this year’s winner of the Nobel Economics Prize was announced. He is Richard Thaler of the University of Chicago. This award does great justice to a man who is known for efforts throughout his academic life to promote what is referred to as behavioural economics, which is the study of economics from a psychological perspective.
For many years there has been great opposition towards the idea that psychological research should be part of the study of economics. It was as if the human being, whether a producer or consumer, would always behave in a consistent and rational way and emotions have nothing to do with it.
The fundamental assumption for those classified as neo-classical economists is that the human person always behaves rationally. So they believe that human behaviour can be modelled on the basis of some mathematical calculation, which assumes that the human person always acts selfishly and independently of others, whose only constraint is one’s financial resources.
Therefore, no matter what, a business is always expected to take decisions that seek to maximise profit, and an individual is always expected to decide in a manner that seeks to maximise one’s financial well-being. These individual decisions are then reflected in what economists refer to as market forces.
The antagonism towards behavioural economics can probably be best exemplified by the fact that only around five per cent of all Nobel Economics Prizes have ever been awarded to behavioural economists. The citation that explains why Prof. Thaler was awarded this year’s Nobel Prize states that he has shown how three human traits affect individual decision-making, and consequently market forces.
We, as economic agents, cannot always act rationally because we are human
The first he describes as limited rationality. He developed the theory of mental accounting, explaining how people simplify financial decision-making by focusing on the narrow impact of each individual decision rather than its overall effect.
This would explain why we sometimes buy things because we consider them to be a bargain, irrespective of whether we really need them or not, or whether we have more important things to buy.
The second is referred to as social preferences. This relates to the human person’s concerns for fairness. So when a business is faced with excessive demand, contrary to traditional economic thinking, it would still not increase its prices out of a sense of fairness. It also explains our willingness to demonstrate solidarity with the more vulnerable segments of society, even though it would mean that we would have to forego material benefits.
The third human trait is the lack of self-control. Consistently rational behaviour would pre-suppose permanent self-control. However, we know that as human beings, we all pass through phases where that self-control is non-existent, and we succumb to our temptations.
This would explain why very often, people do not save enough for their retirement. If they get a financial windfall, they are more likely to spend it on goods they do not need rather than save it.
Putting all this in a nutshell, what Prof. Thaler and people like him say is that the human person is, after all, human, and at times tends towards rationality, and at times tends to allow one’s emotions to take over, in response to the context and the environment one is in. As a result, we make most of our decisions using a rule of thumb based on our life experiences, which frame situations in a particular way.
There was an advert of Apple that said that: “The people who are crazy enough to think that they can change the world are the ones who do”. If we believe that this statement is valid, then we, as economic agents, cannot always acts rationally because we are human.
This year’s Nobel Economics Prize is indeed a victory for those who believe that the human person adapts one’s behaviour to different economic environments, and that psychological, social and emotional factors affect our economic decision-making.