In the second of our series Etai, sets up the backdrop to Behavioural Economics.  Later this week I shall be meeting Professor Paul Dolan of the London School of Economics at a session on Behavioural Science.

By Etai Biran

In this post I will describe what behavioral economics is and how it differs from standard economics theory. I know this sounds threatening for people who are like me (and most people of legal background), afraid of numbers. However, bear with me because describing this difference will help understanding what behavioral economics is all about. Whereas standard economic theory assumes absolute human rationality, behavioral economics claims that human beings have bounded rationality. This is a key understanding that will later help explain why we make poor decisions.

Behavioral economics is a relatively new sub-field of standard economics. It asks to shed some light on some of the fundamental assumptions that standard economics relies on. Behavioral economics incorporates insights from human psychology and investigates what happens in markets where agents operating within these markets display human limitations and complications.

Standard economics assumes that humans are rational in an obsolete way. According to standard economics, a rational human being is expected to know all the relevant information regarding his decisions and is therefore able to calculate the value of the different options he faces. Furthermore, rational human beings are not cognitively constraint in any way while they weigh the ramifications of each potential choice they face. The result is that we are presumed to be making logical and sensible decisions at all times. If we somehow do come to make a wrong decision, we are still able to quickly adapt and improve, either on our own or with the help of market forces.

Accordingly, while facing a decision, we humans are fully capable of assessing the worth of all goods and services and the amount of utility all decisions are likely to produce. This is a fundamental belief in the classical theory, which defines the market as “a market where there are large numbers of rational profit maximizers actively competing… where important current information is almost freely available to all participants”. Under these assumptions, every individual in the market place is trying to maximize profit and is striving to optimize his experiences.

Behavioral economics asks to question these assumptions by applying scientific research (some of which will be presented in this series of posts) on human and social cognitive and emotional patterns. The scientific research conducted in this field has demonstrated that humans are subjected to be influenced by irrelevant emotions and shortsightedness from their immediate environment, which lead them to making irrational decisions.

In my view, behavioral economics picks up where classical economic theory falls short. It focuses on how people actually behave rather than assuming how they should behave. This key difference paves the road to understanding why people behave the way they do. This is a question standard economics fails to answer because it relies on the assumption that human decisions are unquestionable (human beings are rational creatures that are expected to make the best decision because they are “programed” to maximize utility). The understanding that human beings do not always behave rationally and that we make mistakes in our decisions implies that there are ways to improve our decisions.

Is there such thing as “Free Lunches”?

Milton Friedman claimed that “there’s no such thing as a free lunch”. From an economical point of view, it is impossible to get something for nothing. This simple idea has been a core assumption of standard economics theory for a long time. Standard economics theory assumes that all agents within the marketplace are rational agents working effectively to maximize their own welfare. Since all the agents are seemed to be in a state where they are all maximizing returns, it follows that there are no “free lunches”. Even if there were any free lunches, someone would have already found them and extracted all their value.

Behavioral economics, on the other hand, assumes that the marketplace suffers from various inefficiencies and that the agents within the marketplace do not always maximize their own welfare. Instead, agents follow suboptimal decision strategies and fall prey to different decision traps. This depressing view of human irrationality has a silver lining though. The human mistakes that we make provide opportunities for improvement. Moreover, if these mistakes are systematic, we can surely develop tools and methods that will help us make better decisions and improve our overall well-being. This, according to behavioral economics, suggests that there is such thing as “free lunches”.

With this understanding of the concept of “free lunches” we can point out another important difference between standard and behavioral economics. While standard economics does offer a rather optimistic view about human nature, behavioral economics offers, in my opinion, a more realistic one. Rather than appealing to the tempting and compelling idea that our human reasoning is limitless and that we are capable of making optimal decisions, I suggest we acknowledge that we humans are imperfect. It is only with this understanding that we can take advantage of the free lunches offered to us and thus improve our overall well-being. Otherwise we would just be clinging to an appealing belief that we maximize utility in the best possible way because we are naturally programed to do so. It is this naive presumption that would paradoxically lead to a decrease in utility maximization and eventually to market inefficiencies as well.

For suggested readings related to this post please contact me at: etbiran@gmail.com