In the realm of modern economics, there lives on a legendary hero. The Homo economicus, an alarmingly rational being, driven solely by his relentless quest for maximisation, unimpeded by personal ties. This famed ‘rational economic man’, is a cherished construct for economists everywhere. Still, he remains a disembodied caricature, one devoid of any shred of humanity.
The birth of the Homo economicus – the ‘economic man – can be traced back to John Stuart Mill in the mid-19th century. Mill did not deny that man possessed certain emotions and motivations, beyond one’s’ desire to pursue material wealth. Instead, he suggested that such properties of human beings should be entirely excluded from the study of economics. The idea of ‘stripping’ a human being down to a mere shadow of their full identity became central to the initial forays into the world of economics.
Mill’s ideas were further shaped by the influential works of Adam Smith. “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” The ‘interest’ that Adam Smith mentions in his opening chapters of ‘The Wealth of Nations’ (1776), subtly conveys the notion of ‘self-interest’. The Father of Economics himself, Smith further contributed to and popularised the cult of the ‘economic man’ even further.
What is Rational Choice?
Merriam-Webster defines the word ‘rational’ as “having reason or understanding”. If one is rational, they do things based on logic, as opposed to emotion, impulse or whimsy.
Homo economicus operates within the confines of Smith’s Rational Choice theory. Rational Choice theory uses axioms to interpret the intricacies of human behaviour. It posits that individuals are rational actors, making choices after due consideration of costs and rewards, attempting to minimise the former and maximise the latter. A decision will only be carried out when the benefit of an action outweighs its cost.
Regardless of how convenient such a being may be for our critical and analytical purposes; he remains alien to our universal humanity. Smith propounded the idea that humanity, when left to itself, invariably strays towards self-interest, which consequently results in greater prosperity than any state-controlled mechanism can ever bring forth. This prosperity was achieved through the control of the so-called “invisible hand” – perhaps Smith’s most influential idea to this date.
Adam Smith’s works are fundamental to our very understanding of economics, his contributions undeniable in their far-reaching magnitude. His influence has shaped economics, and beyond.
Shortcomings of Classical Economic Theory
The development and growth of classical economics as a school of thought can be largely attributed to Adam Smith in the late 18th century. Later, it was further advanced by David Ricardo and John Stuart Mills. Led by Smith, classical thinkers settled on the idea that the government should let the market chart its own course. A laissez-faire economy was the ideal, with Smith arguing that free markets were capable of regulating and readjusting themselves as long as third parties remained uninvolved – through a mechanism he called “the invisible hand”.
Classical and neoclassical perspectives of economics theorise that humans will consistently act with “rational self-interest” to gain benefits for themselves, irrespective of how it impacts others. According to this theory, if one just has the ample, accurate information needed, they will act predictably with perfect self-control and with their long-term interests in mind. If this were the case, challenges like being regular about a diet or planning financially for retirement would no longer even be challenges. No one would ever lose the down payment for their dream home in a poker game in Las Vegas.
A Bubble Burst: The 2008 Global Financial Crisis
In a 2008 paper “The State of Macro” Olivier Blanchard of MIT, later chief economist at IMF, declared that “the state of macro was good.” In his 2003 address to the American Economic Association, Robert Lucas of the University of Chicago claimed that the “central problem of depression-prevention has been solved”.
Housing prices down by 31.8%. Unemployment rates over 9%. The US Treasury Department spends $439.6 billion buying bank and car stocks. Markets plunge to all-time-lows. The economies of the United States and countries like Estonia, Ukraine, Argentina, Jamaica, Poland devastated – the quality of life for millions drastically altered, all due to the market’s so-called ‘self-regulation’.
In the wake of a global meltdown, the fault lines in economic thought seem wider than ever. A range of factors explain the 2008 stock market crash, some of them being:
- Excessive risk-taking in a favourable macroeconomic environment – The long period of global economic stability that immediately preceded the crisis, known as the “Great Moderation”, had convinced banking executives, government officials and economists that extreme economic volatility was a relic of the past. Risky borrowing in the housing market was done by investors seeking to make short-term profits and by ‘subprime’ borrowers (those with higher default risks).
- Increased borrowing by banks and investors – In the build-up to the crisis, banks and investors borrowed increasing amounts to expand their lending and purchase of MBS (mortgage-backed securities) products. Consequently, when house prices began to fall, banks and investors incurred heavy losses.
- Regulation and Policy errors – Control of subprime lending and MBS products was too lax. Deceptive practices like fraud were increasingly common, such as overstating a borrower’s income and over-promising investors on the safety of MBS products they were being sold.
The Wealth of Nations spurred nearly two centuries worth of economic theory, all of which carried the same central message: trust the market. Economists did admit that there were cases in which markets might fail, referred to as “externalities”, but the long-withstanding presumption was that we should maintain our faith in the market system, no matter what.
Unfortunately, this idealised vision of the economy led most economists to overlook every possibility of something going wrong. They turned a blind eye to the limits of human rationality, the problems of our institutions, the imperfections in the fabric of markets, and the dangers made possible when regulators stop believing in regulation.
Cognitive Biases & Human Irrationalities
Real-world consumers and investors – from the middle-class schoolteacher to the business mogul on the Forbes covers – have little in common with the ‘rational economic man’. All of us are subject to and bound by the whims of our personal irrationalities: herd behaviour, bouts of unwarranted exuberance as well as panic. Even during the heyday of perfect-market economics; on the periphery, there was born yet another school of thought – behavioural economics.
Behavioural economics perceives the economy through the lens of psychology – to understand how and why people make certain economic decisions the way they do in the real world. It differs from classical and neoclassical economics, which assumes that most people have well-defined preferences and always make well-informed, self-interested decisions based on those preferences.
It soon becomes evident that the “invisible hand” governing the economy is not just our ceaseless self-interest but the variety of human biases that govern us. Such systematic, universal errors in our decision-making don’t arise from logic or rationality, rather from our personal experiences, preconceptions, emotions and social influences.
To truly understand economics through an interdisciplinary lens, it’s essential to recognise some of the most common biases that shape our choices on a daily basis:
The Overconfidence Effect – Coined in 1999 by then-Cornell psychologists David Dunning and Justin Kruger, the eponymous Dunning-Kruger Effect is a cognitive bias whereby people who are incompetent at something are unable to recognise their own incompetence. Across 4 studies, Professor Dunning and his team administered tests of humour, grammar, and logic. Results indicated that the participants scoring in the bottom quartile often grossly overestimated their test performance and ability.
Temporal Discounting – The rational economic man relies on cost-benefit calculations to make the best decision. However, this leaves out an important variable – timing. In a variety of contexts, humans respond far more to immediate rewards than those that involve waiting. This “temporal discounting” stands as proof of our desire for immediate gratification in several forms.
Consider Amazon Prime. Many of us would reconsider our desire for a product if two-day shipping wasn’t an option. Partly owing to this promise of swift gratification, findings suggest that Prime members spend nearly double of what other Amazon customers do.
Loss Aversion – In one recent study, airline passengers were told they could sell their right to recline their seats. On average, those who usually reclined wanted $41 to give up their ability to do so. The experimenters then changed the default, telling passengers they could not recline unless they paid an additional fee. In this case, recliners said they’d pay only $12 for the privilege. Such a finding is anathema to classical economic thought. The passengers should’ve valued their ability to recline the same each time, regardless of how the question was framed. Nonetheless, in the minds of real passengers – the defeat associated with losing a privilege was far more significant than pleasure from a potential gain.
Anchoring and Framing – Anchoring refers to our habit of relying too heavily on the first piece of information we receive. Our initial impression defines our reaction to subsequent data we receive. Take Serendipity 3 as an example. A restaurant in New York City that did something no one had done before – charge $69 for a single hot dog. Serendipity 3 never intended to sell it. Once we see a sky-high price on the menu, suddenly $17.95 for a cheeseburger doesn’t seem unreasonable. After introducing the hot dog, their cheeseburger sales skyrocketed.
Framing describes how the presentation of a choice influences its outcome. There’s the classic example of food on a plate: the larger the dish, the more we eat. Traditional economics can’t explain this bias: s rational consumer should eat until full, regardless of how large their plate may be.
The Peak-End Rule – Nobel Laureate Daniel Kahneman observed that when forming impressions, humans unconsciously rely on the final and most emotionally intense moments of an experience. Kahneman’s classic demonstration of this effect involved ice water. Some participants placed their hands in 14-degree ice water for 30 seconds. Another cohort placed their hands in 14-degree ice water for 60 seconds, then slightly warmer water for another 30 seconds. The first group rated their experience as more painful despite being exposed to cold water for just half as long.
Behavioural economics emerged as a distinct field of study fairly recently in the 1980s – it is mostly understood to have originated from the heuristics and biases research program of Israeli psychologists Daniel Kahneman and Amos Tversky alongside Richard Thaler. By asking the right questions and identifying their answers through experiments, we’ve come to find that people rarely make the “rational” or “optimal” decision. Behavioural economics seeks to view people as “human”, subject to their own biases and irrationalities, influenced by their environments and circumstances.
The behavioural approach can revolutionise our understanding of economics. It can help us achieve consumer policy goals by nudging people to make healthy, sustainable and cost-conscious choices. School cafeterias can put fruit at eye level or near the cash register as a “nudge” to influence students to choose healthier options. Private companies, specifically their marketing teams, can hugely benefit from following this approach. For instance, they can utilise principles like loss aversion to highlight what consumers stand to lose if they don’t make a purchase. Principles of behavioural economics can be integrated into public policy as well, with better insight into people’s biases, ultimately shaping a better economic landscape.
Daniel Kahneman once famously said, “It seems that traditional economics and behavioural economics are describing two different species.” Whilst Homo economicus continues to occupy centre stage in mainstream economic thought, we must acknowledge the truth of his inhumanity. Our irrationality is not a flaw to be erased, rather a fact to be embraced – a fact that holds the key to a deeper understanding of human nature, and of ourselves.
References
Krugman, P. (2009, September 4). How did economists get it so wrong? The New York Times. https://www.nytimes.com/2009/09/06/magazine/06Economic-t.html
The evolution of economics and homo economicus. (n.d.). The University of Chicago Booth School of Business. https://www.chicagobooth.edu/review/the-evolution-of-economics-and-homo-economicus
Nickerson, C. (2023, October 10). Rational Choice Theory: what it is in economics, with examples. Simply Psychology. https://www.simplypsychology.org/rational-choice-theory.html
Britannica money. (n.d.) https://www.britannica.com/money/financial-crisis-of-2007-2008/Key-events-of-the-crisis
Australia, S. C. B. O. (2023, May 26). The Global Financial Crisis | Explainer | Education. Reserve Bank of Australia. https://www.rba.gov.au/education/resources/explainers/the-global-financial-crisis.html
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Mheslinga. (2022, June 1). Behavioral economics, explained. University of Chicago News. https://news.uchicago.edu/explainer/what-is-behavioral-economics
Goyens, M. (2018). Using Behavioural Economics For Rather than Against Consumers – A Practitioner’s Perspective. Intereconomics. https://www.intereconomics.eu/contents/year/2018/number/1/article/using-behavioural-economics-for-rather-than-against-consumers-a-practitioners-perspective.html