Economics, please behave!

What is it that converts ordinary humans into champions and winners in the various fields that they operate in? What is it that changes a hopeless situation into an opportunity to excel? What is the one thing that an employer looks in an employee? What is it that drives a stock price of an organisation beyond its wildest common sense?

The answer to the above questions is ‘attitude’ or ‘behaviour’ which can arguably be interlinked. Studying behaviour patterns helps in anticipating future behaviour in a similar situation. There is an increased emphasis on identifying behaviour that can derive value in day-to-day interactions by reinforcing specific behaviour. Globally, organisations are trying to explore the use of customer behaviour and even influence certain behaviour that can maximise profits. This has led to a subject called Behavioural Economics. Adam Smith, who is best known for the concept of the ‘invisible hand’ and The Wealth of Nations, wrote a less well-known book The Theory of Moral Sentiments, which laid out psychological principles of individual behaviour that are arguably as profound as his economic observations.

Need for Behavioural Economics

In the last few decades, there has been an increased criticism on the traditional economic models that are largely based on expected utility maximisation. There is a growing belief that traditional economic theories have too much weight for the role of reason in economic decision making and too little for the role of irrational emotional and psychological factors.

There are two main motivations for Behavioural Economics concerning noticeable weaknesses in traditional economic theories:
– People make choices that are not easily explained with traditional economic theories.
– Traditional economic theories do not explain consumer welfare or their motivations, resulting in inconclusive results.

Behavioural Economics is the study of influence of psychology on the behaviour of market participants and their subsequent effect on markets. Behavioural Economics tries to explore the reasons why behaviour does not follow any specific economic models when people make irrational decisions. It assumes bounded rationality, i.e. market participants or consumers have limited time and capacity to weigh all relevant costs and benefits for a decision taken. Traditionally, this subject was revolved around resource allocation and organisational behaviour. The 2009 global financial crisis has aggravated the need for study of interlinking market participant behaviour with economics, and there are multiple studies currently underway to investigate the use of behavioural economics in the area of capital markets. Behavioural Economics does not replace the standard rational choice and equilibrium models, but adds value to it. Behavioural Finance is a relatively new concept that proposes psychology theories to explain capital market anomalies, where it is assumed that the information present and the characteristics of market participants systematically influence an investor’s buy-sell decisions and inadvertently influencing market outcomes.

Economics linked to animal spirits

The book called ‘Animal Spirits’ authored by George A. Akerlof and Robert J. Shiller explains that the traditional economic models fails to take into account the extent to which people are guided by non-economic motivations, essentially called the animal spirits. The book explains in detail the sub-prime issue. Real estate’s unwarranted reputation as a brilliant investment was dependent on ‘money illusions’ and stories that fuelled overconfidence during the recent real estate boom. Money illusion is one of the animal spirits described in the book where market participants are confused by inflation or deflation and do not reason through its effects. The self proclaimed astute investors made money illusions of real estate when the stock market crumbled in the 90s. Multiple orchestrated stories began to circulate about making money through buying and churning real estate. In the interim, the political class was preaching to the minority population, the significance of home ownership and linked it to the progress of the nation, thus resulting in a subprime lending boom. The rest is history, and the economic crisis was quite widespread and the world is still feeling it’s after effects. Consumers are not buying nor are they able to get loans and the credit is restricted. This credit crunch was ascribed to engineered securitisations and derivatives. Until recently, world’s leading analysts loved to tell stories of inspiring innovation about these instruments which have now changed to stories of corruption and greed. Conventional economic models do not address confidence. To rebuild trust, policy makers need a credit target aside from the conventional monetary and fiscal targets. This is being considered through various mechanisms such as stress tests, scenario analysis, game theories and simulation.

Many sociologists and anthropologists have argued that social factors such as culture, customs and religion play a very important role in explaining consumer choices, though economists have traditionally ignored such factors as being relatively unimportant. For e.g.: the concept of a fairness cream is still lucrative even though it is proved that it actually does not change your skin colour. The sales numbers drastically increase when the consumers see or believe that movie stars or sports professionals use the product.

Behaviour and social motives

Studies have been conducted through various games that explain the significance of social motives. The trial results have been used to offer evidence for or against the rational behavior of customers and have been controversial. The following games are a part of experimental economics which validates economic theories.
– Dictator games: In this game, the proposer determines the allocation of winning money to the responder, who is passive and receives only a limited amount of the money, thus resulting in no game at all. This experiment was conducted to prove that the proposer even though is a dictator would still allocate minimal amount to the responder and not keep the entire amount to himself.
– Ultimatum games: In this game, the proposer makes an offer which the responder accepts or rejects. If the responder accepts, then both the sides receive the agreed split of the winning money. Otherwise, they both win nothing. This game describes the bargaining power of both the participants. Research and studies show that many responders reject very low offers, and this threat of rejection results in larger offers.
– Trust games: This game is an extension of the dictator game. The proposer first decides whether the engage / invest or exit. If the proposer decides to engage / invest, the trustee then has the decision to make in terms of division of the winning money. Many people do feel obligated to justify the trust shown by others, and extend the trust themselves. This game helps us to understand how business conducted on handshakes and verbal agreements work.

Use of Behavioural Economics in decision making has a lot of advantages. It can explain the difference between rational and irrational thinking, helps in gaining a superior understanding of opportunity costs and time constraints and generally enhance the judgement process. The subject is a continuous learning process and there is no perfect answer to the market dynamics – but the deviations from perfect rationality could be predicted at a certain level. Finding such predictable patterns can significantly improve the existing economic theories.