Lessons in behavioral economics

In economic theory, behavioral definitions assume that people are mostly economical in their decisions, making rational judgments towards obtaining the highest possible utility with the least possible input. The term used to describe this behavioral assumption is maximizing utility, epitomized in the concept of Homo economicus. However, as other scientific disciplines have shown, the concept of people acting rationally in pursuit of their self-interests can hardly be an accurate representation of reality. Alternative assumptions propose remarkably irrational behavior that contradicts the Homo economicus model in many ways.

One of these assumptions is that people base their decisions on their perceptions of loss and gain, whereas they feel worse about the pain of a loss than they feel better about the pleasure of a gain. This concept, known as “loss aversion”, was introduced by Daniel Kahneman and Amos Tversky, two psychologists considered to be the founders of behavioral economics. Countless psychological experiments have substantiated the concept of loss aversion ever since. In a review of neuropsychological findings that show evidence of loss aversion in brain scans, the American Scientist concludes: “Homo economicus is extinct, felled by the new sciences of behavioral economics and neuoeconomics which have demonstrated that we are irrational creatures.”

An example of loss aversion is the endowment effect, proposed in the late 1970s by economist Richard Thaler to explain our irrational tendency to overvalue something just because we own it. In experiments involving coffee cups randomly assigned to a group of students, mug owners asked for significantly more money to part with their possession than randomly assigned buyers were willing to pay for them. In a later experiment, a team of psychologists found that buyers were willing to pay sellers’ price when the buyers already owned an identical mug. This finding led the scientists to suggest that ownership and not loss aversion must cause the endowment effect. In terms of consumer behavior, researchers have concluded that ownership creates a link between an item and the consumer’s self-concept and that this association enhances the value of a product.

Probably the most influential contribution to the psychology of decision-making is Kahneman and Tversky’s identification of heuristics. Heuristics are cognitive rules of thumb or mental shortcuts we routinely use to make judgments and decisions, for example to evaluate losses and gains. Heuristics are normally helpful. Much of this behavior is basically an effort to cope with the complexity of the world by approximating. However, they can often be irrational and cause stereotypic thinking.

Evidence from psychological research has only begun to find its way into economic models of consumer choice. In an article advocating the necessity of overhauling of the theory of consumer behavior, The Economist argues that economics should draw much more from other disciplines such as psychology, neuroscience and anthropology in order to truly to understand how people make decisions.