PSYCHOLOGY MEETS ECONOMICS Sagar Pushp EMPD09XLRI MEETS

How is Economy related to Psychology? BEHAVIORAL ECONOMICS PSYCHOLOGY +ECONOMICS

Economics Some basic assumptions –People are always rational and accordingly take decisions. –They make choices to maximize some objective function mainly optimizing or maximizing profits.

Behavioral Economics It is using psychological insights to study economics. Behavioral economics is concerned with the ways in which the actual decision-making processes are influenced by our mind and emotions. Assumes bounded rationality – meaning that people have limited time and capacity to weigh all the relevant benefits and costs of a decision. Decision making is less than fully rational. People are prone to make predictable and avoidable mistakes. At the same time, decision making is systematic and amenable to scientific study.

Some Interesting Examples Example 1. (a)Consider an Indian Premier League match in Mumbai on a Saturday or a Sunday night. It is a regular phenomenon now and the hotel authorities are pretty certain that there will be huge rush from all over the country and even outside. All the available rooms will be booked. (b)Owing to above, hoteliers should hike the prices of their hotel rooms and try to maximize their profits. And moreover, it’s a regular phenomenon that happensevery year. (c)But they don’t do it as they are reluctant to antagonize their customers with what may perceive as unfair prices. (d)Tomorrow, when the same person visits Mumbai for a business trip is less likely to choose the same hotel because he will feel cheated. (c)Do popular restaurants jack their prices on weekends, No, they don’t. (d)More than mere maximizing profits, it is the reputation which is at stake. For a short term benefit, one can not sustain long term losses.

Some Interesting Examples Example 2. (a) There is game with two volunteers, A and B. It begins with a toss and whoever wins has gets 100$ to divide between himself and other player. Other player has the option to accept the division or reject it. If he rejects, both return with no money. (b)So if a staunch economist wins the toss, how should he go about it? (c)How would someone else (irrational non-economist) divide it? (d)The Economist would divide with 99$ for himself and 1$ for the other player. (e)Someone else who doesn’t think like an economist would go for a or distribution. (f)A normal person would know that even if he does a 90$ and 10$ division, the other person is more likely to reject the offer. (g)Because, an economist may think otherwise, but two non-economist would think alike.

Why do People Gamble? Why have Las Vegas casinos become so popular? Does rationality work here? No! Because here greed overrides rationality. Although, The Theory of Economics would suggest otherwise! Why do Gamblers want more players to play the game? It is the short-term benefit that attracts him. After losing some, he tries to play till the time he breaks-even.

While the ‘rational man’ analysis yields a powerful tool for analysis in Economics, it has some short-comings seen earlier. The following shall highlight seven broad principles related to Psychology while understanding human behavior when studying Economics.

Seven Principles of Behavioral Economics 1.Other people’s behavior matters. –People do many things by observing others and copying; people are encouraged to continue to do things when they feel other people approve of their behavior. 2.Habits are important. –People do many things without consciously thinking about them. These habits are hard to change even though people might want to change their behaviour, it is not easy for them.

Seven Principles of Behavioral Economics 3.People are motivated to do the ‘right thing’. –There are cases where money is de-motivating as it undermines people’s intrinsic motivation, for example, you would quickly stop inviting friends to dinner if they insisted on paying you. 4.People’s self-expectations influence how they behave. –They want their actions to be in line with their values and their commitments.

Seven Principles of Behavioral Economics 5.People are more afraid of incurring losses than making profits. –They hang on to what they consider ‘theirs’. 6.People are bad at computation. –when making decisions: they put undue weight on recent events and too little on far-off ones; they cannot calculate probabilities well and worry too much about unlikely events; and they are strongly influenced by how the problem/information is presented to them.

Seven Principles of Behavioral Economics 7.People need to feel involved and effective to make a change. –Just giving people the incentives and information is not necessarily enough.

Summary Economics is not wrong science and is also a study of human behavior but certain assumptions are generalized and not seem empirical or practical which may bring ambiguity at times. Behavioral Economics teaches us: –T–To avoid making serious mistakes down the road. –C–Clarify what is rational and irrational decision making. –L–Lead to a better understanding of opportunity costs, time discounting, and other economic concepts. –P–Provide a richer, more realistic understanding of decision making in practice.