By Shreya Deora

Edited by Nidhi Singh, Junior Editor, The Indian Economist

In the constant assumptions of ‘rationalization’ in Economics, experimental economics is developing with leaps and bounds. Experimental economics deals with using experimental methods to figure out why markets and other systems of exchange function the way they do. It aims to study behavior, social decision making, bargaining and market games, to name a few.

One of the most interesting aspects of such economic study deals with Behavioral Economics. Over my years of studying economics, every lecture and every model begins with the assumption that people are rational beings and that logic and self motive is the key factor behind every decision an agent takes in a market economy. And every time that is simply assumed, as so many other things in this field, I wonder at the logic behind this assumption itself.

Human beings are far from rational. Our decisions are affected by emotions, social cultures and has a lot to do with psychology and neuroscience. What these economic models are telling me then is that if I consider anything apart from pure logic and expected payoffs to make a decision, I am simply deemed ‘irrational’. And well, who are they to determine rationality anyway?

And such decisions refuting the rationality assumption can be seen in the everyday world. For example, bubbles in financial markets exist because of the herd behavior of investors, which depends on an unplanned method and movement. This eventually leads to crashes and market inefficiencies. But in spite of all this, over and under expectations in the financial market is a prominent feature.

The psychology of money is another example where rational perception fails human decisions. Representation of money into a certain product appeals to us more than just the money, and we place a higher value on specific items than the monetary value of those items. Even if rationally, the product has a less economic value than money.

Another interesting study in Behavioral Economics is based on the ‘Pain of Paying’. The concept revolves around the moral tax of guilt that gets added on consumption. For example , when we pay by cash than credit cards or when we receive constant notifications about payments from the card. The pain of paying gets magnified when our feelings about spending money get coupled with the actual transaction. In cognitive economics, the very consideration of your feelings of guilt when you spend money, may as well be enough to consider you to be an irrational human being.

Purchasing decisions should be based on pleasure against the price, but we have trouble identifying these tradeoffs. Judgment of a fair price depends on our perceived costs. But because determining value is so difficult, we take shortcuts and perceive costs to be dependent on other factors, like the level of visible effort required to produce something. This makes it very difficult for us to be willing to pay for some sort of expertise like the doctor’s fee, as the amount of effort there doesn’t seem to be a lot. Whereas we might be willing to pay the same amount for a product where the producer displays a lot of effort. In today’s era of higher fixed costs and lower marginal costs, the expression of such effort is becoming difficult and hence people tend to have a lower notion of fairness.

Behavioral Economics pushes you to think outside of just the market domain and consider other norms. We live in a world where both social and market norms affect our decisions. Sometimes, social norms take precedence over market norms and that may adversely affect behavior. A study conducted in day care centers introduced a fine on parents if they were late in picking up their children. This fine moved parent’s behaviors from a social to a market domain where being late did not come at the cost of guilt, but just at a financial cost. And once this system is in place, removing it and reverting back to the previous system fails even further, as then there is no perceived cost of being late at all. Hence social norms are also very important when it comes to understanding behavior of all human beings. And just purely thinking on logical monetary terms might actually backfire and make things worse.

Neuroeconomics is another field of experimental economics which aims to combine neuroscience, psychology and economics to determine decision making. It focuses more on the neurobiological mechanisms that affect decision making.

We have an awareness of action before we actually indulge in the action. But according to some studies in Neuro economics, it has been proved that the brain activity to do that particular action starts way before we even become aware of our decision to do so. Thus it seems like it is an illusion, that we have control over our decisions. Our consciousness simply acts to rationalize and explain the decision the brain has undertaken.

Thus genes, neurons, brain, cognition, society and the environment we live in all play an integral role in influencing our decisions, which might be deemed as irrational according to pure economic fundamentals, but is nevertheless very true. No economist in her right mind would state that such factors lead us to make illogical decisions. But still, we as economists continue to frame models with the inherent assumption that everyone will act rationally.

Even though the field of Behavioral economics and Neuro economics is fairly young, the world is finally catching up to the reality of such decisions. And more and more research is required to create concrete models and explain all economic activities from the far more realistic idea of decision making. And maybe this is why we face so many market inefficiencies that are hard to explain and far more difficult to clear. Once such other factors are taken in to explain the models and the way people behave in market norms, such inefficiencies can be tackled in a better way.

After all, economics is never just based on a cost benefit analysis of every move of every individual in the domain. Social, political and institutional factors do end up playing a very important role in the economic slowdowns and the booms of the world. And behind these factors, are billions of very irrational, emotional and illogical human beings who would rather make decisions which sound good to them, and not to satisfy the over simplistic nature of all economists.

Shreya is a graduate in B.A. Economic Honors from Kamala Nehru College, Delhi University. She is an avid debater and a passionate reader. She proclaims to be completely tune deaf, while being a jazz, blues and alternative music fan with equal conviction. She hopes to study Economics further and is particularly interested in Behavioral Economics, Micro Economics and International Economics. She plans to take a year off just to travel, hopefully without being constantly motion sick.


Posted by The Indian Economist | For the Curious Mind