Behavioural Economics: The New Era - Essay Example

?Behavioural Economics: The New Era Introduction The Standard economic models are often questioned for the fairness of their assumptions. It seems like the assumptions for explaining the theories to be addressed are cyclical or in other words, they are assumed in such a manner that they are bound to produce the hypothesized outcomes. This approach has attracted various criticisms over time which had spurred wide debate among academicians. The recent global financial markets turmoil bears testimony to the fact that economic agents do not always behave in a way, which is predicted by the mathematical model of probability (Kahneman, Knetsch and Thaler, 1986). To have a better understanding of the standard model of economics, recently a relatively newer concept of economics has been seen to emerge. Behavioural economics is the one which infuses the elements of psychology and neuroscience in order to have a better understanding of economics (Wilkinson and Klaes, 2012). In fact owing to the aftermath of the recent global economic crisis, it is now believed that irrationality truly drives the decision making abilities (Ariely, 2009). This essay will explore two of the very basic ideas of standard economic behaviour, rational expectations and consistent preferences. This paper will also explain the possible shortcomings of these two assumptions, thereby considering the alternative approaches that can mitigate these shortcomings. Standard economic models and weaknesses In the model of consumer behaviour, which is one of the most fundamental economic models, it is assumed that all the consumers are rational and are guided by unbound willpower and complete knowledge for making decisions. This traditional approach of rational expectations has two sub-types, strong rational expectations and weak rational expectations. In the former theory, it is assumed that agents can always correctly frame their expectations based on available information. In the theory of weak rational expectations, it is assumed that without complete information, the agents make optimal use of available information (Tesfatsion, 2013). This shortcoming of this theory had manifested itself in the recent crisis in the financial market. This has raised questions on the age old beliefs of rational expectations which propagate that humans are driven by selfish interests. It has now been fully understood that it is irrationality, which often guides through the decision making process. Given that human beings are often driven by cognitive biases, it plays an important role in their true decision making process (Diamond and Vartiainen, 2007). Mainstream economics is characterized by a number of underlying assumptions like rational expectations, representative agents and consistent preferences. This school of thought draws from the views of neo-classical economics, neo-classical synthesis and also the Keynesian Economics. The approach based on this method is mostly based on the probabilistic theories and theories of mathematical expectations. The entire discipline is based on the deductive analysis of mathematical models. The broad purpose of economics as a whole is to understand the interaction among people among various sectors like business and commerce, in organization of production, in government operations and also the making of public decisions. It is the interaction of people in the daily lives that economics bases its assumption on. The approach of mathematical models for predicting the outcome of decisions made by economic agents is not necessarily wrong. However, this approach is not a strictly consistent one. One of the basic assumptions in standard models of economics is that people have a strict methodical approach of looking into the future. Models based on this concept assume that exponential discount function is consistent during their entire lifetime. However, there are both theoretical literature and empirical evidences to prove otherwise. Reality has shown that people do not always plan their lives in a mechanical way in line with the mathematical models. Psychological and more complex social actions play an integral part in the decision making process of the agents (Baddeley, 2013). The problem becomes more pronounced when the concepts of microeconomics are used as a fundamental base of macroeconomic issues. The concept of homogeneity as one of the basic assumptions, in classical and neo-classical models, is again flawed. A single individual is taken to be the representative of an entire group in its decision making process. This is almost practically a hypothetical assumption as every individual has their unique understanding of how to behave under given circumstances. This can be understood in a way where real people have only imperfect abilities to obtain process and regain and convey information. They often end up making decisions those are appropriate to them rather than what is considered to be “optimal”, as economists would describe. So, the theory of optimality is rather a reality in a utopian world, instead of being real in the practical world (Anon., n.d.). Thus, prediction of actions based on these assumptions, often leads to flawed interpretation of reality. Alternative approach Evaluation After a plethora of theoretical researches and experiments, researchers have come up with a relatively new discipline of behavioural economics that bears the ambitious responsibility of a better understanding of economic decision makers. Behavioural economics believes that psychology and neurobiology can be the more reliable factors in explaining the variances in the actions of individual agents (Grandori, 2013). This fact has gained dominance over time as it has been proved that even veteran statisticians make logical errors in their modelling of mathematical models that are built to predict reality. The creators of this new discipline were Daniel Kahneman, Amos Tversky and Richard Thaler. The works of these eminent economists led to the birth of behavioural economics. The idea was to explain the anomalies in the human decisions. Then again, given the experimental nature of the subject, there was no fundamental consistency in the approaches. The assumptions regarding the subject, the correct steps to be followed during the experiments and even the conclusions, had varied widely in their works (Wilkinson and Klaes, 2012). The major findings of behavioural economics can be illustrated in the following points: 1) Firstly, the concept of “new variable” has been introduced. This new variable is said to be an important one that has been ignored by standard economic models, but is believed to have significant explanatory power in the decision making power of the agents. However, this variable can only be viewed in an experimental situation and not in economic data. 2) Secondly, if there are any abnormalities in the behaviour of the agents, then behavioural economics tries to fit this observed abnormality into similar observed biases. 3) Lastly, the approach is based on more of an economic psychology. This is however very difficult to quantify and apply in a different scenario. In behavioural economics, one of the most significant theories is the Prospect Theory. The concept of “reference point” is extremely useful in the prospect theory of behavioural economics. The reference point concept is flexible and can be understood with the help of the following example. If we take the example of utility maximization in gamble, then prospect theory would assume that a consumer would not make his decision in a wholesome manner. Rather, he would consider various subsets of risk separately instead of taking it as a whole (Pesendorfer, 2006). Basically, reference point is the one that can adjust itself in various economic scenarios. This means that it need not be fixed like, the parameters of standard economic theory, across various time periods and applications. Another example can be cited from the real estate industry. It has been observed that agents are willing to take higher risks when they are trying to maximize their profits. They may be unwilling to sell even if the asset incurs a loss. So, the reference point in this case is the price of the house at the time of purchase. It is perhaps the boldest aspect in behavioural economics that it can adapt itself to changing situations, rather than changing the situations to fit the prospect theory. In making these deductions, behavioural economics relies heavily on experiments from neuroscience. Another example was cited by Thaler in his paper to understand decision making on psychological lines. He had observed that there was a difference in the sale of theatre tickets if random discounts were given to the customers in season premiere. This had happened because the emotional aspect involved in watching the play on its first day is much higher than in the consequent shows. This is what that standard model of economics fails to accommodate. It is of paramount importance to understand that this alternative approach of behavioural economics does not have an independent point of origin. It rather supplements to the theory of standard economics to correct the shortcomings of the later. Policy implications It will be interesting to recognize the policy implications of this alternative view of economic study. The alternative approach is of growing importance to the policy makers (Civita, Macdonald and Downs, 2011). This new approach has already been used extensively in the fields like, pricing goods which cannot be marketed or environmental goods that have issues of sustainability. The alternative approach is also gaining importance in taxation theories (Agricultural and Applied Economics Association, 2013). Though concrete results are yet to be derived, research works are still going strong (Congdon, Kling and Mullainathan, 2009). However, as this alternative is based on a highly experimental approach, there have been anticipations about the methodologies which are to be used in policy making. Then again, the importance of alternative approaches to economic models through behavioural economics cannot be undermined. This has become even more relevant in the aftermath of the global financial crisis in the recent times. Behavioural finance is also gaining high importance in understanding the complexities in financial decision making, rather than depending on standard models. This manifests itself in the bold decision of the Obama government which has adopted behavioural economics in their administrative policies (Dorning, 2010). Even the British Prime Minister has set up a behavioural insights team (BIT) in his cabinet to implement the alternative discipline in the regular economic decisions (Engelhart, 2013). The growing national acceptance implies a deep significance of this discipline. Criticisms This alternative approach to standard economics is however not free from limitations. The main criticisms centre on the individualistic approach of decision making. In the view of Levine, behavioural economics does not succeed in overcoming the problems faced by standard economics. He argues that behavioural economics mostly impose the ideas of psychology instead of devising authentic ideas. The basic problem lies in the fact that psychological concepts are not entirely well developed and flawless for economics to freely draw ideas from it (Levine, 2012). In Microeconomics most of the derivations are based on the assumptions it makes. The model of optimum equilibrium in any theories like consumer behaviour or market structure comes under the radar in the light of the latest discoveries in the new era of Behavioural Economics. A debate arises as the main focus of psychology is to locate the abnormality in human behaviour, whereas the means to the end in economics is to predict the results on a whole, owing to which an individualistic approach seems like a tall order to establish the full picture. Conclusion In this essay, we have mainly tried to analyze the weakness of the assumptions of standard economic model and figure out the alternative approaches in order to deal with the economic problems. It has been observed that standard economics do face a lot of limitations in its assumptions to predict reality. It has also been observed in the previous three decades or so that the actions taken by humans are hardly unilateral or consistent. The actions that they take depend largely on the framework according to which it is done (Munro, 2009). To overcome the shortcomings inherent in these theories, behavioural economics have used the concepts of psychology and neurobiology to understand the wide variation in the behaviour of the agents (Brennan, 2012). Owing to its exploratory approach, the results obtained have not been whole heartedly accepted among the academicians and there still remains a wide debate. The surge in the importance of this alternative discipline is formidable as there are empirical evidences supporting the theories that it aims to establish. The key would be to codify the exceptions and build concrete theories based on the experiments. 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