Tenets of Behavioural Economics - Example

BEHAVIOURAL ECONOMICS ESSAY The paper reviews the insights analysed by the study of behavioural economics and instrumental rationality theory to compare the two concepts and it reviews the theories of standard economic model regarding consumer choice and examines consumer behaviour to provide the comparison and contradiction in consumer choice. In the end, the examples of behavioural theories with more reasonable arguments to change many market outcomes designed through rational theories are given. TABLE OF CONTENTS Introduction……………………………………………………. ..4 Standard Economic Model………………………………………4 Overview of the Tenets of Behavioural Economics…………….5 Rationality Theory and Consumer Behaviour………………….7 Examples Favouring Rationality Theory………………………..7 Examples of Contradictions to Rationality Theory……………..8 Conclusion…………………………………………………………9 References………………………………………………………….10 Introduction Behavioural economics makes use of psychology and other disciplines to produce models of rationality, self interests and willpower. Additionally, behavioural economics explores the implications of economic aggregates. Rational choice theorists believe it is single unified model which can be used to predict human behaviour in a scientific manner and it claims that one cannot have two models of the same actor. Carbaugh (2005, p.1) states ‘In today’s world, no nation exists in economic isolation. All aspects of a nation’s economy—its industries, service sectors, levels of income and employment, and living standard—are linked to the economies of its trading partners. This linkage takes the form of international movements of goods and services, labor, business enterprise, investment funds, and technology. Indeed, national economic policies cannot be formulated without evaluating their probable impacts on the economies of other countries.’ Standard Economic Model and Analysis of Consumer Behaviour Economics studies individual economic behaviour of individual agents, firms, government agencies and consumers that make trade off choices, which allocates limited resources for competitive use. In the modern economics, mainly developed in 60s, the systematic study of individual economic behaviour and the economic phenomena was studied which included observation and theory using various analytical approaches. The microeconomic theory was the discipline to analyse the interaction with individual economic agent and their price interests. Standard economic model assumes individuals are rational, having self interests; they take any decisions of buying goods or services, using the price mechanism. The key assumptions of standard economic model about consumer behaviour are as follows: 1. Consumers are Rational Consumer decisions are based on factors - Income, price of goods, budget and to simplify the life. According to neoclassical economics “consumers are rational” this means: Consumers know the objectives and feasible alternatives of their decisions They establish criteria to evaluate the alternatives as compared to other objects The consumer choice is determined on several possibilities and preferences. 2. Consumers are Self Interested The individuals have self interested behaviour which are not only reasonable and realistic but have a minimum risk. 3. Consumers Follow Utility Maximization Principle Utility maximization is the foundation of consumer rational behaviour, where rational agents always select the preferred bundle from a set of affordable alternatives. 4. Consumer Optimal Choice and Demand Function The basic issue in consumer optimal choice is preference maximization, the set of affordable alternatives and set of hurdles which can satisfy the consumer budget constraint. In the standard economic model, the demand function is considered by varying prices and income to keep the consumer at a fixed level and the incomes changes are arranged to compensate for the price change. Overview of the Tenets of Behavioural Economics Behavioural economics make use of models of systematic imperfections in human reasoning to study the markets and policies. The imperfections include limitations of self interests and willpower (Rabin, 1998; Mullainathan and Thaler, 2000). There are two points of clarity which should make it clear that behavioural economics is not just a subfield of economics rather it is a style of modelling which can be applied to wide range of economic questions in consumer theory, labour economics and finance. The psychological data fuelled many developments in behavioural economics which are mostly experimental. Behavioural economics is an approach and experimental economics are methods. In modern behavioural economics, experiments proves to be useful way of establishing anomalies which are not produced through factors which are hard to rule out in field data such as transaction costs, confusion, risk aversion and self selection etc., but are easy to rule out with the experimental control. The main points in the experiments include ways to suggest the regularities which can be included in the models to make predictions which are naturally occurring field data. The empirically driven behavioural economics is based on two practices - explicitly modelling limits on rationality, self interests and will power, and using the established facts to provide assumptions about the limits. Behavioural economic theories have found the actions are incomplete and asymmetric to decisions, and other forms of the behavioural imperfections are raised by limited attentions. There has been a brief discussion which reminds of the behavioural economics which assumes human perception and cognition is highly influenced by a contrast, and the circle looks large when surrounded by smaller circles and also when it is surrounded by many large circles. The behavioural economics approach has clear departure from the method “as if” endorsed by Milton Freidman. The F- Twists Argument of Milton states: 1. Theories should be judged by accuracy and predictions 2. Theories must not be adjudicated by accuracy of assumptions The empirically driven approach of behavioural economics consents with the criteria (1) and rejects the criteria (2). Expected Utility - Many non-expected utility (EU) theories have been proposed and studied (Starmer, 2000) and the theory is found to be clearly rooted in psychology as compared to other theories which are based on ingenious ways of weakening the independence of axiom. Rational Choice Theory - The idea that people only are about self or monetary benefits is not the central tenet of rational choice theory. Economists are sceptical about how people express their concerns for payoffs of others. Utilities - Utilities are numbers which are compared to the magnitude of certain processes in the brain and it searches for utilities, which are based on scientific methods. Such a research makes use of the economic variables to construct neutral constructs. Hope is a new construct which has been discovered and is the most graceful construct which accommodates the standard language of preference, constraint and beliefs. Complete Preferences - Completeness and transitory of preference is an important simplification. Power comes precisely by excluding the variables related to good’s utility which could depend upon the thinking of choice as a result of cognition, which suggests the ways in which completeness of preferences is violated ( Kahneman, 2003) . The way in which choices are framed can influence the choice by directing attention to various features. The psychophysics of adaptation found the changes from the point of reference as a carrier of utility. Rationality Theory and Consumer Behaviour - Complementing and Contradictory The theories of consumers and producer behaviour are used for studying individual’s perception and decisions choices. Modern economics provide the results which can be used for comparison of the two systems - the real world and the standard economic model. In the reference system, the standard economic model theory is assessed for analysing the efficiency; and the comparison of theoretical models and realistic economic mechanism is estimated. In the equilibrium theory, the reference system is studied and its outcome is compared to the various market structures; in the ideal case, in the competitive market. Carbaugh (2005, p.2) states ‘In short, economic interdependence has become a complex issue in recent times, often resulting in strong and uneven impacts among nations and among sectors within a given nation. Business, labor, investors, and consumers all feel the repercussions of changing economic conditions and trade policies in other nations. Today’s global economy requires cooperation on an international level to cope with the myriad issues and problems.’ Examples Favouring Rationality Theory Mehta et al. (2003) stated consumer rationality implies the consumers will engage in price search to reduce uncertainty. The Equilibrium Theory related to consumer behaviour and producer is used within the market institution. Rational consumers do what is best for them - be it manufacturer, consumers or retailers. Lipman (1991) defines rationality as taking the best way to decide. Acquisti, Alessandro and Varian (2005) define consumer awareness of firm’s incentives to lower future prices as one property of rationality. Zwick et al. (2003) define optimal search behaviour and the size of consumer consideration as the set the properties of rationality. Consumer learning is the property of rationality. Kalra et al. (1998) define consumers who are sceptical of manufacturer’s quality claims as one property of rationality. The examples of rational behaviour are - Organization’s decisions are driven by cost and the model used to develop a new product involves - competitive reaction, supply chain issues, feasibility and inventory requirements. Traditional economic theory designs consumer rationality in terms of expected utility maximization and a set of axioms which are sufficient for utility functions (Herstein and Milnor, 1953). Game theoretic applications define rationality as the best action giving well defined payoffs and rules of play. Examples of Contradictions to Rationality Theory The property of model of human rationality distinguishes itself from economic competition where the social science has cumulated many ideas and facts about human rationality. The approach uses careful analysis of the constructs and facts, and it is driven by psychology in making assumptions. Explicitly modelling limits on rationality, self interests and will power uses established facts to suggest the limitations. Lucas (1986) found the most rational expectation permits multiple equilibrium, which are theoretically based on limited rationality and it might actually be more precise as compared to the theories which are based on full rationality. This is also true in Game Theory where theories with rationality can be precise as compared to equilibrium theories (Camere, Ho, Chong, 2004). If the goal is precision, behavioural alternatives may process better as compared to rational theories. Slovic and Lichtenstein (1968) were first to find the reversals of expressed preferences which could result when people have to select between two gambles as compared to pricing the gambles separately, a violation of procedure in variance. This provides the base for pricing institution to have an impact on expression of preference. Loewenstein (1999) found despite blossoming of the utility, a concept and appreciation for diverse determinants of utility, the list of human motives which are codified in utility functions and incorporated in economic analysis remains incomplete. Weber’s concept found consumers are economically rational and yet economically non-rational actions are induced by ethics of absolute ends. According to Weber, there are certain rule governed behaviour, concepts of traditional action and emotional behaviour. Certain expressive behaviour has been explained by a group of researchers working on non-rational model of consumer behaviour. Contemporary rational choice theory, while starting from same rationality assumptions or the charity principle, has failed to reach its point of discovery despite some hints (Boudon, 1998; Elster, 1998). Conclusion Consumer rationality is an important property for researchers and it states that consumers follow self interested, rational and utility maximization approach for decision making. If the consumer is rational, the researcher will be better in a position to predict the behaviour in most situations. Perfect rationality is the condition when the consumer behaviour is highly predictable and important outcomes can be predicated from consumer behaviour. Certain researchers find completely opposite results when studying consumer behaviour and it has been found that consumers may have complete reversals of predicted expressed preferences, the decisions can be completely irrational as well. All in all, in order to explain the decision mechanisms employed by buyers in market analysis, the combination of both works of behavioural analysts and experimental economists, who used related choices rationally, should be implemented. References 1. Acquisti, Alessandro, Hal R. Varian. (2005). 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