By Kashyap Arora

Edited by Namrata Caleb, Senior Editor, The Indian Economist

Behavioral Economics refers to a branch of economics, which takes into consideration the fact that humans are indeed emotional and irrational, and thus, will not always act in a rational manner. Boom and bust cycles in the financial markets are a  prime example of such behavior i.e. if investors always behaved rationally they would only buy assets that are undervalued to sell them whenever prices were above the fair value. As a result, over time, all assets would have been priced to perfection.

However, behavioral economics have been in the lime light for some time now, the main reason for its initial prominence has been due to the research initiatives taken by Herbert A. Simon analyzing the decision-making process within economic organizations, and Daniel Kahneman and Amos Tversky influential paper “Prospect Theory: An Analysis of Decision under Risk”. Furthermore, to add to the above tally are the recent publications of popular books such as Richard Thaler and Cass Sunstein’s “Nudge”, Dan Ariely’s “Predictably Irrational” etc.

The domain of behavioral economics has tried to incorporate various elements such as the risk averseness of individuals, social norms and has also attempted to take a cue from recent successful examples such as those involving usage of text repayment reminders to decrease the default of loans, discounting of fertilizers at the beginning of agriculture season then during the later part so as to incentivize individuals to purchase more agricultural fertilizers, and also the growth of companies such as StickK.com in developed economies, who primarily make use of the principles of behavioral economics.

Despite the above reasoning supporting the significance of behavioral economics, critics generally stress on the rationality of economic agents. Their claim is based on the learning effect i.e. learning and competition ensures at least a close approximation to rational behavior. They are also apprehensive about the experimental and survey-based techniques used in behavioral economics, as they believe them to be at the risk of systematic bias and lack of incentive compatibility.

However, behavioral economists constantly dismiss the above criticisms, as they claim to obtain consistent results in multiple situations and geographies. Behavioral economists also claim to respond to the above-mentioned criticism by focusing more on field studies than lab experiments. They also claim to have formulated revised neoclassical models to correctly predict some outcomes where traditional models have failed.

Thus, to sum it all I strongly believe that successful outcomes can be achieved by parting away from traditional methods of investigation and making actual behavior part of the data set. The single most important inference out of all the talks regarding behavioral economics points towards developing theories of behavior particularly in the arena of investment that are built on actual human behavior and not assumptions of rational behavior on part of all involved economic agents.

An economist from University of Warwick, Kashyap is an avid reader, writer, and tactician with a real zeal for economics and finance. He has also professionally represented and worked for some of the most prestigious organizations such as Standard and Poor, and HDFC. It is his passion which drew him towards “The Indian Economist”, where he aims to study aspects of Indian economic and polity scenario from a different perspective and derive more involvement from his readers, thus, laying down the  foundation for a highly aware future generation.

Posted by The Indian Economist | For the Curious Mind