Welcome to Behavioural Economics!

Welcome to the world of Behavioural Economics: where Economics meets Psychology and stays for nice little chat, taking a comfy seat by the warming fireside of experimental evidence, holding a hot mug of pure rationality. Hmmm... rationality. The oil that makes the world go round.

Or does it?

Behavioural Economics is the area of study devoted to the exploration of how economic agents (that you and me folks) think, act and react. Put simply: are we rational? Rationality is where people have consistent preferences, and that from any given range of options, people always chose the one they most prefer.

In 1971 two psychologists named Sarah Litchenstein and Paul Slovic stumbled upon a phenomenon that was to rock the economics world: preference reversal. Preference reversal challenges an assumption economists make every day: that economic agents (still talking about you and me) are consistent. If we are not then the cornerstone of microeconomics is compromised.

This is because the accuracy of economic models hinges on whether they are able to predict human behaviour. If we are systemically inconsistent, and thus irrational, economists need to be able to ‘model’ this behaviour. Traditionally, however, economists have circumvented this problem by, well, ignoring it.

Enter stage left, Litchenstein and Slovic. The subject of preference reversal will be my next blog, where we will discover that we are not as logical as we like to think. So for now all we shall note is that it got the attention of economists who, since then, have being trying to define our irrationality and incorporate it into their models.

But why does any of this actually matter?

Because economic models are highly influential. Interest rates, Government spending and taxation are all set according to economic models that are built on the assumption of rationality.

So it’s important, but why should you bother with it?

Because it affects the decisions you make every day: what you say you prefer, what you buy and how much effort you put in at work. Furthermore, companies are starting to wake up to Behavioural Economics and are attempting to use it to manipulate economic agents (still us) to buy their stuff.

You still may not be concerned by that. Which is fine. But then, are you sure you’re rational?

Recommended listening:

What A Wonderful World by Louis Armstrong