Most economic models and theories rely on the assumption that people (consumers, producers, etc.) are rational. The idea of homo economicus, or the “economic human”, represents the perfectly rational and perfectly imaginary individual represented in most of economics. The assumption of rationality keeps models straightforward and results consistent. Rational people buy low and sell high, they always purchase a perfectly balanced bundle of goods that satisfies them completely, and they definitely consider consumer/producer surplus when buying Christmas presents and/or the opportunity costs when buying a house or a car. The economic human is psychologically rational and fundamentally self-interested. However, we do not live in a rational world. It’s obvious that most people are not inherently rational. Behavioral economics helps to explain anomalies and explore the deviations from rationality that normal human beings commit everyday, while focusing on the neurological, psychological and social aspects of our decision-making.
Behavioral economics can be separated into three main themes: heuristics, framing and market inefficiencies. Heuristics are the “rules of thumb” we use to make decisions. They are cognitive biases that help us make quicker and more consistent decisions. These biases act as mental shortcuts and cause us to focus more on one aspect of a problem than another. These rules usually lead us to the right decision, but sometimes facilitate irrational or illogical choices.
Framing occurs when collections of stereotypes and anecdotes put problems or events into our own personal perspectives. Media exposure, political ideology and even daily interactions all help us to frame problems in a way we understand, and ultimately make a decision. Framing a concept in different ways can elicit completely different reactions in a person, and prompt them to make irrational decisions.
Lastly, market inefficiencies fall into behavioral finance, which uses behavioral economics to explain market anomalies such as arbitrage, unfair competition and loss aversion in firms.
The use of behavioral economics in scholarly papers and policy research has grown in the past few years. It is proving to be a very exciting field with new and interesting discoveries being made regularly. Unfortunately, it is not often covered in the mainstream media despite its direct relevance to our everyday lives. Decision-making is a deceptively simple process, almost every conscious decision we make comes down to heuristics (biases) and framing (perspective).
This is the introduction to a short three-week series on behavioral economics. Next week I’ll focus on heuristics and discuss how these rules bias your judgment but ultimately help you make the right decision.