Behavioural Economics

An introduction to Behavioural Economics

Traditional economics conventionally conceptualizes a world populated by calculating, maximizers emotionally unbound, commonly referred to as Homo economicus. The standard economic framework that prevailed for decades now, virtually rules out cognitive and social psychologists' work regarding people's behavior. This “unbehavioral” economic concept was more than once defended on several justifications; some people argued that the traditional model was easier to put in use as well as realistically relevant whereas others had just accepted the fact that the model has been working for years now, thus making it right. Behavioral economics flourished from the apprehension that neither point of view was correct. Behavioural economics advocates that human judgment regarding economic decisions is emotionally biased, and that by taking psychological concepts into consideration when projecting economic outcomes, results can be more realistic.

The standard economic model of human behavior includes three unrealistic traits; unbounded rationality, unbounded willpower, and unbounded selfishness.[1] All three traits have been widely accepted/recognized as a result of recent studies and are said to be flaws of the standard economic model, putting forward firm foundations for behavioral economic theories. Behavioral economics modify and take all three traits into consideration, differentiating the specified field from traditional economic theories.

Herbert Simon (1955) Nobel Prize winner, was one of the first people to oppose the idea that people have unlimited information-processing capabilities. He introduced the concept of bounded rationalism to describe a more pragmatic idea of people's ability to process and solve problems that arise. Daniel Kahneman, along with Vernon Smith was influenced by Herbert Simon's theories and in 2002, received the Nobel Prize in economics, for a research entitled Maps of Bounded Rationalities. Kahneman was awarded the prize “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” The research explores the psychology of intuitive

beliefs and choices and examining/illustrating their bounded rationality by exploring the systematic biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models.

The rational agent is an agent which has incorporates logic in his/her decision making, models uncertainty via expected values and always chooses the action that results in the optimal outcome for itself.[2]The rational-agent model was Tversky's and Kahneman's starting point. Rationality is prejudiced against in choices as well as judgment. There exists an extensive list of ways in which judgment and choice deviate from rationality, examples of which could be overconfidence as well as optimism. (see Kahneman et al. 1982).

Behavioural economists support that failure to embrace rationality boundaries into economic models is bad economics and equivalent to the presumption of the existence of a free lunch. Since ordinary people have limited brainpower and usually time, they cannot be expected to always solve difficult problems whichever way is most favorable; to a certain extent, people would be expected to adopt rationality as a way to economize on cognitive abilities. Nevertheless, the standard model disregards these bounds.

One important hypothesis involved with traditional economics is the principle of self control. The above hypothesis is a very misleading one; Every single one of us has at least once lost self control in their life even when we know it's for the worst. A simple example of the principle's misleading hypothesis could be the fact that everyone has at least once drunk or eaten more than they could handle; same goes for spending and savings. Although it is in everyone's understanding that these things happen, very few people can consistently exercise self control; another flaw for traditional economics.

[1] http://www.econlib.org/library/Enc/BehavioralEconomics.html

[2] http://books.google.com/books?id=kWxN3Mn5ZIgC&pg=PA133&dq=rational+agent&cd=1#v=onepage&q=rational%20agent&f=false

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