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Economics and Psychology - Essay Example

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There exists a gap between the assumptions of psychology and economics. In 1970, Bruno Frey stated that "the agent of economic theory is rational, selfish and his tastes do not change." Kahneman (2003) throughout his paper commented on the development of these three assumptions.
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Economics and Psychology
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Download file to see previous pages Evidence also proved that offers rejected when they came from a person would be accepted if they were generated by a computer.
The assumption of rationality is not completely true as people do not always make rational decisions. In economics, rationality is understood to be an approximation with hope that departures from rationality are rare. Some economists have argued that some deviations from rational do not matter (Akerlof & Yellen 1985). Psychology have challenged the assumption of rationality which is the basis of economic subjective utility. The concepts of bounded rationality was introduced in an attempt to formulate a theory of rational choice (Simon 1955).
Economists predict the behavior of agents by assuming that they have stable, well-defined preferences and they make rational choices in consistence with preferences of the markets. Loewenstein & Thaler (1989) present a number of anomalies within empirical results which are difficult to rationalize.
Economic theory makes exact prediction of the discount rate of money people should apply utilizing the after-tax market value of interest. High discount rates are experienced in some contexts and by some groups which raises questions concerning the rationality of consumers. Economic theories of individual behavior are vague and un-testable. Intertemporal decisions are related to the spread of costs and benefits over time. The rationality of many intertemporal decisions especially individual and self-control choices are challenged.
Psychology of intertemporal choice complicated the question of selecting the proper social rate of discount. Standard computation of discount rate is determined by the standard rate of interest adjusted for tax distortions. Adjusting tax distortion is complicated by the internalization of capital markets. It is suggested to determine time preferences at the individual level to avoid these complications. The individual rate should be consistent across all individual belongings.
Economists do not agree with the psychology of decision making. Evidence from psychological research proved that individuals did not follow rational choices. However, psychologists did not provide means to incorporate these findings in economic models.
However, psychologists affect and benefits economic theories in a number of other cases. For example, in the case of wave profiling, psychology experimented and observed that people care about changes in wages in addition to absolute values of their wages. This could affect the profile of increasing wages in addition to the discount of the future. In this example, psychology suggested modification to the utility function of wage determination. Psychology provided testable assumptions which are supported by experimental evidence.
Smith, V. (1991). Rational Choice: The contrast between Economics and Psychology, Journal of Political Economy, vol. 99. No. 4., University of Chicago Press.
Smith (1991) examined the contest between economic theory and evidence from psychology with respect to experimental economics. He argued that rational choice is a combination of both rationalists from psychology and behavioralist from economics. Smith ...Download file to see next pagesRead More
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