Classical economics has always been predicated on the assumption that humans are perfectly rational, but countless examples in our day-to-day lives have shown this to be wrong. However, this falsehood has been ignored for centuries, until the creation of the field of behavioural economics sought to challenge this.
Behavioural economics studies the psychology associated with the economic decision-making processes of individuals to organisations. This branch of economics entwined with social psychology started fairly recently in relation to economics as a whole but has already come to influence a range of decisions from systemic changes in firms that increase sales to significant government policies that could determine a person’s retirement savings. The field questions the base model for humans based on assumptions that normative economists use in their research and theories. This model has come to be known as rational economic man, or homo economicus, as it is assumed to be perfectly rational, self-interested, calculating and use all information and time available to them before coming to a decision.
The image below is a visual depiction of this idea of homo economicus, created by Kate Raworth to try to illustrate the ‘human character at the heart of mainstream economic theory’[1]. It embodies all of the assumptions that normative economists have made – it stands alone, thinking only for itself with money in hand and a calculator in the head.
However, as many may have realised instantly, humans are nothing like this. We don’t always make the best choice for ourselves; we’re not always selfish. Many of us fail at basic arithmetic and often rush into deciding without researching the options. Yet economists chose to ignore these misconceptions despite having recognised them, as they preferred to use homo economicus as it was simply easier to work with inside their models.
Behavioural economics changed this by highlighting the misgivings of current economic policy due to these assumptions and posits two main questions[2]:
- Are economists’ assumptions that consumers look to maximise utility and firms look to maximise profit genuinely representative of natural human behaviour?
In the subject of economics, there are three key economic agents: the consumers, who consume goods and services to raise and maximise their overall utility or satisfaction; firms, who produce these goods and services to generate profit; and the government, who strive to maximise welfare. Together, these economic agents form and interact within an economy, with their three main goals of maximising utility, profit and welfare. However, economists take these goals as the only objectives of these agents, but consumers may also want to help protect the environment and purchase a more expensive but eco-friendly alternative despite it reducing their potential utility. In addition, a firm may wish to provide additional benefits and services for their workers despite it cutting out of their profits. Still, the current models in economics fail to take this into account. Therefore, behavioural economics asks this question, trying to identify any other targets consumers and firms may have aside from maximising utility and profit.
- Do individuals maximise subjective expected utility?
Economists base their assumptions about consumers on this idea of utility. A consumer considers how much satisfaction they expect to gain from purchasing a particular good over another and the opportunity cost of doing so. Opportunity cost refers to the potential additional utility from the next best alternative not chosen. However, it is hard to quantify and measure utility, and so when two goods are very different, consumers are not able to effectively compare which one would bring them more marginal utility. Furthermore, if the consumer does not have complete information on a good or has never consumed it before, they would not be able to consider the expected utility gain and may not make the rational choice.
[1] ‘Doughnut Economics’, Page 96 – Kate Raworth, 2011
[2] Investopedia – Behavioural Economics, 2020
https://www.investopedia.com/terms/b/behavioraleconomics.asp
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