Intro to Econ: Behavioral Economics
Economics is a social science concerned with the production, distribution, and consumption of goods and services. It studies how individuals, businesses, governments, and nations make choices on allocating resources to satisfy their wants and needs, trying to determine how these groups should organize and coordinate efforts to achieve maximum output.
Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the aggregate economy, and microeconomics, which focuses on individual consumers and businesses.
One of the earliest recorded economic thinkers was the 8th-century B.C. Greek farmer/poet Hesiod, who wrote that labor, materials, and time needed to be allocated efficiently to overcome scarcity. But the founding of modern Western economics occurred much later, generally credited to the publication of Scottish philosopher Adam Smith’s 1776 book, An Inquiry Into the Nature and Causes of the Wealth of Nations.
The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.
Despite this view, economics has been pejoratively known as the “dismal science,” a term coined by Scottish historian Thomas Carlyle in 1849. He used it to criticize the liberal views on race and social equality of contemporary economists like John Stuart Mill, though some sources suggest Carlyle was actually describing the gloomy predictions by Thomas Robert Malthus that population growth would always outstrip the food supply.
Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals and institutions and how those decisions vary from those implied by classical economic theory. Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory.
The study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice. The three prevalent themes in behavioral economics are:
- Heuristics: Humans make a significant proportion of their decisions using mental shortcuts or rules of thumb. However, when the decision made leads to error, heuristics can lead to cognitive bias.
- Framing: The collection of anecdotes and stereotypes that make up the mental filters individuals rely on to understand and respond to events.
- Market inefficiencies: These include mis-pricing and non-rational decision making.
The two most important questions in this field are:
- Are economists’ assumptions of utility or profit maximization good approximations of real people’s behavior?
- Do individuals maximize subjective expected utility?
In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction.
This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. Alas behavioral economics explains that humans are not rational and are incapable of making good decisions.
Behavioral economics draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models. Decisions such as how much to pay for a cup of coffee, whether to go to graduate school, whether to pursue a healthy lifestyle, how much to contribute towards retirement, etc. are the sorts of decisions that most people make at some point in their lives. Behavioral economics seeks to explain why an individual decided to go for choice A, instead of choice B.
Because humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if Charles wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories.
Behavioral economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall out of the weight loss bandwagon, showing his lack of self-control. Behavioral economics is often related with normative economics.
Normative economics (as opposed to positive economics) is a part of economics that studies objective fairness or what the outcome of the economy or goals of public policy ought to be. Economists commonly prefer to distinguish normative economics (“what ought to be” in economic matters) from positive economics (“what is”). Many normative (value) judgments, however, are held conditionally, to be given up if facts or knowledge of facts changes, so that a change of values may be purely scientific.
On the other hand, welfare economist Amartya Sen distinguishes basic (normative) judgements, which do not depend on such knowledge, from nonbasic judgments, which do. He finds it interesting to note that “no judgments are demonstrably basic” while some value judgments may be shown to be nonbasic. This leaves open the possibility of fruitful scientific discussion of value judgments.
Positive and normative economics are often synthesized in the style of practical idealism. In this discipline, sometimes called the “art of economics,” positive economics is utilized as a practical tool for achieving normative objectives.
An example of a normative economic statement is as follows:
The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save the family farm.
This is a normative statement, because it reflects value judgments. This specific statement makes the judgment that farmers deserve a higher living standard and that family farms ought to be saved. Subfields of normative economics include social choice theory, cooperative game theory, and mechanism design.
Positive economics (as opposed to normative economics) is the branch of economics that concerns the description and explanation of economic phenomena. It focuses on facts and cause-and-effect behavioral relationships and includes the development and testing of economic theories.
Positive economics as science, concerns analysis of economic behavior. Positive economics concerns what is. To illustrate, an example of a positive economic statement is as follows:
The unemployment rate in France is higher than that in the United States.
An increase in government spending would lower the unemployment rate.
Either of these is potentially falsifiable. In contrast, a normative statement is, for example, “Government spending should be increased.”
A standard theoretical statement of positive economics as operationally meaningful theorems is in Paul Samuelson’s Foundations of Economic Analysis (1947). Positive economics as such avoids economic value judgements.
For example, a positive economic theory might describe how money supply growth affects inflation, but it does not provide any instruction on what policy ought to be followed. Still, positive economics is commonly deemed necessary for the ranking of economic policies or outcomes as to acceptability which is normative economics. Positive economics is sometimes defined as the economics of “what is”, whereas normative economics discusses “what ought to be”.
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