A Change in Economic Perspective: The Behavioral Approach
By Melissa Navas
The idea was simple: give person X a sum of money and present them with the opportunity to (a) split the sum right down the middle with person Y; or (b) keep 90% of the sum and give the remainder to person Y. 75% of the people who participated chose to split the sum of money down the middle. There was no incentive or reward for doing so, simply a predisposition of altruism found inside humans. The results of this experiment, known as Dictator, were an astounding accomplishment for the field of behavioral economics. Prior to experiments like this, traditional economists wholeheartedly backed up the notion that all rational people would act in their own self-interest; therefore, they would have easily chosen to take the 90% and run with it. The notion that people are innately altruistic is now validated through experimentation and statistics, proving that the sector of behavioral economics has succeeded in areas where traditional economics has failed; as well as providing a glimmer of hope concerning the goodness of the human race.
Traditional economics has long supported the idea that people act in their own self-interest. The failure to realize that humans have a genuine sense of apathy and altruism, that runs deeper than their sense for selfishness, is a major fault in traditional economics. In the New York Times bestseller, SuperFreakonomics, Steven D. Levitt and Stephen J. Dubner set out to debunk the theories of traditional economics, and successfully provide insight into the world of behavioral economics through studies, statistics and anecdotes. Levitt and Dubner draw upon an experiment that began in the 1950s, and over time evolved into an “ingenious” game-theory problem known as Dictator; the experiment mentioned previously.
Another compelling study that supports the field of behavioral economics comes from Dan Ariely. In his New York Times bestseller, Predictably Irrational, he suggests that not only are we irrational beings, but as the title of the novel suggests, we are predictably irrational – meaning that more likely than not, we make the same irrational decisions over and over again. In a study conducted by Ariely, he asked 55 students to write down the last two digits of their social security numbers, and then had them bid on certain items such as vintage wines, fancy chocolates, cordless technology, and a textbook. Ariely states that traditional economists assume that prices for products are determined by two forces that are independent: production at each price, known as supply, and the desire of those with purchasing power at each price, known as demand. Where the prices of these two meet, at a point known as equilibrium, is what determines the price in the market.
A traditional economist would laugh at the idea that writing down the last two digits of ones social security number could influence them before bidding money on certain goods; however, the experiment Ariely conducted shows the myth of independence between supply and demand due to human irrationality. In the experiment, person X, who had a social security number ending somewhere between 80-99 bid significantly higher than person Y, who had a social security number ending somewhere between 1-20. This experiment shows that supply and demand are, in fact, dependent due to human irrationality. Behavioral economics takes the upper hand once again by showing that people are easily manipulated, therefore they are inconsistent, and in turn, irrational. Once people have a certain number in their heads, or a certain memory of a price, they will only want to pay a certain price for goods in the market; regardless of the laws of supply and demand.
If you have ever been in an economics class, you know that supply and demand are at the very foundation of the subject, as well as the name Adam Smith; with professors referring to him as the “father of economics”. In fact, many economists like to believe that they are all somehow, miraculously descendants of Smith. Although most famous for writing the groundbreaking novel, The Wealth of Nations, Smith wrote a lesser known novel by the title, The Theory of Moral Sentiments; a publication that focuses on fundamentals of psychology regarding human behavior. This novel is often referred back to as the studies of behavioral economics begin to increase. So yes, Adam Smith was not only a founder of economics, but also a founder of psychology and behavioral economics. Economists should be proud to believe that they are descendants of such an intellectual.
From the foundation of economics, until quite recently, economists have believed that rationality, or self-interest, is a core notion in the field. However, the field of behavioral economics is growing in popularity, and proving the notions of rationality and self-interest wrong. People are simply not rational creatures (or perhaps, not as rational as traditional economists would like to believe) and are often found to have bigger hearts than expected. Behavioral economics is the crossroad between economics and psychology; it bridges the gap, uniting the very structured conceptions of economics, and the immensely recondite ideas of psychology. As noted by Dan Ariely, it is important to understand the irrationality of the human race, so that in turn, we may understand how to make better decisions, actions and choices.
The focus of behavioral economics is not to take the spotlight away from the traditional foundation of the subject, but rather improve the way economists see and analyze economic situations and foundational aspects of the field. By studying the human condition, behavioral and traditional economists are able to see what people really want to gain out of situations, in a non-rational approach. Behavioral economists are looking at factors of irrationality in the way people make decisions and often using the outcomes of these studies to better understand the decision making process. The overall aim is to better understand the human condition. As proved by the studies discussed in this article, there are areas in which traditional economics has failed to provide the truth, whereas behavioral economics proves more efficient in terms of supplying a more conceivable outcome.
There are a limitless number of ways in which behavioral economics can be applied to better the field. As the studies continue to deepen, and more of the population begins to see the validity of behavioral economics, the sector will only strengthen, continuing to better the way economists see the factors of decision-making, irrationality and altruism. Next time the idea of rational people is brought up, remember that there is an intriguing argument that proves otherwise, and countless studies and statistics to back it all up.
About the Author: Melissa Navas
Melissa Navas is currently a Sophomore at Pace University and is majoring in economics. She is a member of the Alpha Lambda Sigma Honor Society and serves as an active member of the fundraising committee. In addition to writing for On the Margin, Melissa has participated in numerous school clubs, such as Hedge Fund Club and Rotaract Club.