Updated: Nov 21, 2019
By Ibarra Jonel Mari Gabertan
Standard Economic Principle – Is there room for improvement?
Traditional microeconomic theory considers humans as “perfectly rational”. This stems from the standpoint that we make logical, unbiased, and perfectly informed decisions based on all the other alternatives that we have in order to optimize their utility by deriving the best option (Begg, Vernasca, Fischer, & Dornbusch, 2014). Simply put, this means that we would seek to weigh out all their choices and make the most out of their decisions when spending or saving money or time.
Figure 1: Would you know what to choose?
Doesn’t there seem to be some variable lacking in this equation? Consider the decisions that the general public make in their daily life, and how far we are from such idealistic ways of thinking. Our personal choices are always subject to some extent of “human error”, an innate tendency to misjudge a situation due to a variety of external and internal factors (Rabin, 1998).
Analysing and executing every economic decision with perfect comprehension and precision makes the person seem more like a calculative robot than a human. It is certainly uncommon, if ever that we are able to account for every single tangible variable in our daily decision making. This is where the study of Psychology provides a new dimension of theories to help explain our irrational tendencies.
Introducing Behavioural Economics
2017 Nobel Prize winner and Economist Richard H. Thaler is known as the pioneer of Behavioural Economics, collaborating with Psychologists Daniel Kahnemann and Amos Tversky between the years 1977 and 1978. He describes the theoretical robots who make such mechanical optimisations as the imaginary manifestation called the “Econ”. These Econs set themselves apart from human beings as “cold-blooded optimizers”, out of touch with the characteristics that make us human (Thaler, 2015).
This does not mean to imply that we are totally irrational. Personally, I believe that everyone tries to make their most logical choice when tasked to. However, in a world full of options, it is a near impossible challenge to keep up.
How do we filter information? – Heuristics and Satisficing
Thaler found that people tend to rely on heuristics, rather than logic when they are overwhelmed by the amount of choices they make in their everyday life. Heuristics are defined as mental cues, or innate rules that a person has which help them make decisions on the spot without handling the mental overload of the overwhelming amount of choices that they have with limited time (Gradinaru, 2014). They can also be viewed as “mental shortcuts” to a complex situation.
An example of heuristics in play would be simple choices in life such as “What should I eat for lunch?” Picture yourself walking into a large kopitiam at lunch hour, with over 30 different stalls and large varieties of food in each stall.
Figure 2: The Interior of the Old Airport Food Centre
With the time constraint, chances are you’re most probably going to go for the food option that you’re most comfortable with, the “safe option” rather than trying to explore new options.
Alternative heuristics that could come into play would be “select the cheapest option”, “select the option that has the least queue”, “select the healthiest food option”, or even a mix of all these variables given the person’s preference. For all the options that life throws at us, we use heuristics to quickly assess the situation and make a decision, whether we are aware of them or not.
The topic of choosing food at a kopitiam is a rather open question. The first step to finding your optimal solution would be to go around asking all the patrons about which stall had the best-tasting food, then determine the affinity of each dish’s taste profile to your preference. After which, proceed to calculate the calorific and nutritional content of each dish and add those variables to the aforementioned consideration. Does this comprehensive thought process sound familiar? That’s the thought process of an Econ, or a die-hard foodie in this context.
My point here is that people are not as focused on optimization with “perfect information” as microeconomic theories assume them to be. The limited amount of information that we have, the cognitive limitation of our brains, and the lack of time to process our options can be summarized as bounded rationality (Thaler, 2015).
This leads people to focus on ‘satisficing’, which refers to the people’s innate tendency to choose solutions that satisfy the minimum requirements to achieve a particular goal, rather than the “optimal solution” that maximizes one’s utility of time and money. As dictated by the illustrious examples of choosing food in a kopitiam, we tend to narrow down our decision-making process to one or two key factors and make a less optimal, but satisfactory choice for convenience’s sake.
Patterns of human nature – Mental Accounting
One of the most important aspects of money that people tend to forget is that it is fungible; regardless of whether we intend to spend or save a proportion of our money, it is transferable and all the same (Hastings & Shapiro, 2013). This brings up the topic of Mental Accounting.
In our attempts to organize our resources, we tend to have a rough division of the money we have in our head. For example, given a pay check of $1,000 from working part-time for the month, the normal tendency would be to split up the numbers evenly into rough figures in prediction for future costs such as travel, food, bills, and savings, to name a few. The question is, why do people still overspend beyond their boundaries?
Credit cards are a good example for the application of mental accounting and the tendency to overspend. The idea of directly handing over $50 on a purchase is much more daunting than that of adding $50 to an accumulated total of money to be paid at the end of the month, all the more so if that amount was in three or four figures. However, you still lose $50 for your purchase of the product whether you pay for it now or later, though people would generally be more willing to pay on a credit card.
Figure 3: An echo of my exact sentiments
Another example draws parallels to a study in Princeton University (Thaler, 2015). The given situation is that you intended to watch a movie at the price of $10 and one of two possible scenarios took place:
You arrived at the counter to purchase your ticket and you realised the $10 bill you placed in your pocket intended to purchase the ticket is missing – presumably you’d happened to drop it en-route, would you still fork out another $10 for a ticket?
You bought your ticket, and whilst walking to the theatre you dropped you ticket by accident, only realising so when you reached the counter, with no way of retrieving your lost ticket. Would you still purchase another ticket?
It is obvious that a sunk cost of $10 is in play for both scenarios without coming to a conclusion. Surprisingly, 88% of participants in scenario 1 said they would purchase another ticket. This is nearly double the 46% of participants in scenario 2 who said they would purchase another ticket.
This inconsistency in behaviour is explained by mental accounting. In both scenarios, you have already incurred a net loss of $10 either by losing your money or the ticket. However, as the results show and Thaler theorised, people already have a mental account of spending $10 on the ticket that they have lost, hence they are averse to spending $10 on another ticket. On the other hand, having lost a $10 bill registers a loss of money in a separate mental account. Hence, people would not mind handing over another $10 to watch the movie.
Patterns of human nature – Endowment Effect and Loss Aversion
The concept of lack of fungibility is not exclusive to money. It also has an application to material objects, or assets. Let us refer to the unfortunate example of losing a movie ticket. Another factor that affects the decision to not buy another ticket is the Endowment Effect.
On top of the bias regarding the “ticket” mental account, is an additional psychological factor associated with the sense of ownership of the ticket. The pain of the ticket loss is felt twice as badly as compared to the joy of obtaining a ticket for free. This inconsistency of feeling for an equal gain/loss is also known as loss aversion (Gal & Rucker, 2017).
Another example of the endowment effect in action relates to investor behaviour. If a share was bought at the price of $200 and expected to rise to $500, the investor would be reluctant to sell the share at any less price than $500, even if the stock stabilizes under that value at say, $350. Though the investor is much better off liquidating his asset and finding a new stock to buy, his ownership of the stock and aversion to the loss of expected value causes him to hold.
Figure 4: Not just yet
Is the standard model flawed?
There is nothing wrong with being irrational. The fact that it happens so naturally is what makes us “homo sapien”, more so than “homo economicus” (Thaler, 2014). Behavioral economic theories do not serve to call for an overhaul of the standard economic theory, but rather provide an additional perspective to what we already know, and improve our understanding of what truly motivates our decision-making thought processes. I would say that being aware of such patterns of human nature will allow us to learn how to be more efficient with our life choices.
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