Homo Non Economicus: An Essay on Behavioral Economics

by Kristin Knepper

“Economists aren't rational, because they assume people are” -Michael Fitzgerald

When I first heard that one of the pillars of modern economics is that “humans are rational”, I doubted that I could ever grasp economics. I know from my bar experience that there’s no such thing as a free drink, and I know that without ceteris paribus (all else held constant), economists would run in circles with “what ifs”. But humans, being rational? No way. Just watch some reality television.

This notion of rationality began when economists Adam Smith and David Ricardo wrote that people act in their own self interest and will pursue the option that leaves them "better off"; the optimal solution. This evolved into John Stuart Mill writing of an "economic man" or homo economicus, the theory that humans will maximize utility and businesses will maximize profit. While we would like to think we always make the best decisions for ourselves and our families, behavioral economics proves we do not.

Behavioral economics assumes that people have cognitive biases that prevent them from making rational decisions. Cognitive biases can be influence by the power of words. A “free” product has proven to be chosen much more than an item that is one cent. Biases can also be influenced by the necessity to make a decision quickly or with little thought.  By having knowledge of these cognitive biases, sellers can manipulate the behavior of consumers. For example, Apple started selling their latest iPhone at $600, and then reduced the price to $400. This made consumers think they were saving money. However, they probably would not have thought the same if the price started and stayed at $400 (Ariely, 2009). To be “rational” is to maximize utility. But are consumers’ really maximizing utility when they buy a $400 iPhone and think they are getting a bargain?

It is crucial that economists do not underestimate the power of cognitive bias and perception. People act in their own interest. When I buy that new Kate Spade purse, I’m not rationalizing that the money would be better spent on college tuition or 100 Starbucks cappuccinos. I’m thinking about how cute that purse would look on my arm. My interest, in this situation, is not to maximize utility and not to maximize my dollars towards necessities. My interest is to look good, as best explained by economist Frank Taussig:

“An article can have no value unless it has utility. No one will give anything for an article unless it yield him satisfaction. Doubtless people are sometimes foolish, and buy things, as children do, to please a moment’s fancy; but at least they think at the moment that there is a wish to be gratified. Doubtless, too, people often buy things which, though yielding pleasure for the moment, or postponing pain, are in the end harmful. But here ... we must accept the consumer as the final judge. The fact that he is willing to give up something in order to procure an article proves once for all that for him it has utility – it fills a want” (1912).

This is the same concept that explains why a majority of people do not save enough for retirement. If they were perfectly rational, people would save more than enough. But consumers misspend. They are on the fast track for the pursuit of happiness. They would much rather spend now than later (hyperbolic discounting). These decisions must be accounted for in the study of economics.

By being more realistic about the human condition, economists can better predict and analyze economic scenarios. “We are finally beginning to understand that irrationality is the real invisible hand that drives human decision making… companies now see how important it is to safeguard against bad assumptions. Armed with the knowledge that human beings are motivated by cognitive biases of which they are largely unaware (a true invisible hand if there ever was one), businesses can start to better defend against foolishness and waste” (Ariely, 2009).

Works Cited:

Ariely, Dan. "The End of Rational Economics." Harvard Business Review. 01 July 2009. Web. 25 Jan. 2016. <https://hbr.org/2009/07/the-end-of-rational-economics/ar/1>.

Fitzgerald, Michael. “Irrational Economics.” CBS News. 20 March 2008. Web. 25 Jan 2016. < http://www.cbsnews.com/news/irrational-economics/>.

McFadden, Daniel. "The New Science of Pleasure." National Bureau of Economic Research. Jan. 2013. Web. 25 Jan. 2016. <http://www.nber.org/papers/w18687.pdf?new_window=1.

Picture source: http://mu-peter.blogspot.com/2012/03/evolutionary-economics.html