Meet Consumer A. Consumer A needs a new computer so she can work from home. The computer must be reliable and have a large processor since Consumer A will be using it daily to do several complex tasks. However, Consumer A only has a limited amount of money to spend, so she must ensure that she gets the best computer possible for her money.
Before going to the store, Consumer A carefully researches her options, comparing prices and reading consumer reviews of different computers. Finally, being fully informed, she selects one that will best meet her needs. In this way, Consumer A is a textbook example of the “economic man” in neoclassical economic theory: the always rational and informed consumer who drives all economic activity.
Now, meet Consumer B. Consumer B just had a bad day at work. He’s depressed, bored and craving some excitement. He goes to the mall to do some browsing and sees a stylish new fishing pole on display. Consumer B hasn’t been fishing in six months and already owns two other fishing poles, but this particular fishing pole arrests his attention. Consumer B starts thinking about how much he would like to own this fishing pole and how exciting it would be to buy it.
Like Consumer A, Consumer B has a limited amount of money to spend, and the fishing pole is very expensive. However, Consumer B quickly rationalizes his purchase by arguing that it will make him happy. Without even knowing how well the fishing pole will work or when he will use it, Consumer B purchases it on the spot—with his credit card. This type of economic behavior is commonly referred to as “retail therapy”: shopping to improve one’s mood.
The concept of retail therapy, however, is surprisingly absent from neoclassical economics, despite being prevalent enough to warrant a phrase in the modern vernacular. For centuries, economists have assumed that people’s economic choices are always rational since they are motivated by need and limited by scarcity. But as retail therapy proves, that is not always the case. So where is the theory that takes into account irrational economic behavior like retail therapy?
That theory is called behavioral economics. Behavioral economics seeks to unite the basic principles of neoclassical economics with the realities posed by human psychology. The theory grew out of neoclassical economics in the early 20th century when neoclassical theory fell short of explaining the anomalies that occur within market economies.
Although behavioral economics arose from the writings of several notable economists, one of the theory’s leading principles came from economist Herbert Simon in the 1950s. Simon postulated that man could not always act logically because he possessed a “bounded rationality.” In other words, human minds are finite; they do not have unlimited information to solve problems, nor do they have all the time in the world to think about them. Humans also struggle to analyze problems objectively when the outcomes directly affect themselves, especially when viewing problems through a “frame” of personal experience warped by social or cultural bias.
To cope with these realities, humans apply their own rules of thumb, or “heuristics,” when making quick decisions. While it is inherently rational to do so, the rules themselves and the behavior they lead to may not be. In fact, heuristics, as described by leading behavioral economist Daniel Kahneman, are inherently irrational.
For example, in a common heuristic known as gambler’s fallacy, consumers take risks on what appears to be a future outcome in an instance of random chance, like a coin toss. Their logic is based on seeing the same outcome occur several times in a row and assuming a different outcome is due. The logic is, of course, faulty, since the odds for either outcome remain the same in every instance.
From Simon’s concept of bounded rationality sprang the idea that other aspects of humanity may be bounded as well, such as the self-interest that motivates the neoclassical “economic man.” Behavioral economists accept that other factors may drive consumers’ economic choices, like altruism or self-control.
Of course, an economic theory that allows for such variance in consumer logic and behavior poses a problem: how can economists rely on it to accurately predict economic outcomes? After all, pure neoclassical theory is much tidier by comparison, basing its mathematical models on a few basic, if convenient, assumptions.
Obviously, behavioral economists cannot rely as heavily on mathematical models to predict outcomes. Instead, they collect real world data on past consumer behavior and conduct experiments involving real transactions to gauge how consumers might behave in future situations. The goal in collecting such data is to eliminate unlikely outcomes so that likely ones come into focus. Although not as exact of a science compared to using mathematical equations, behavioral economists often manage to make startlingly accurate economic predictions. Economists have found that making realistic assumptions about human nature generally leads to a more precise result.
However, some economists still find reason to reject behavioral economics. Those who cling to pure neoclassical theory insist that the economic man is more rational than the natural man because market competition forces consumers to make rational choices. They claim that behavioral models based on data gleaned from experiments mostly illustrates one-time choices, not complex economic behavior exhibited over time. Also, economists who prefer the stark, impartial rigidity of neoclassical mathematical models view behavioral economics’ experimental approach with distrust. They say experiments and surveys can be skewed by participants’ biases. They see little application for behavioral models in real markets.
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Nevertheless, behavioral economics has succeeded in explaining market anomalies where neoclassical economics could not. For instance, it has been used to examine the roles played by human greed and fear in the 2008 financial crisis. The promise of windfall profits lead financial companies to create and sell highly complex credit default swaps without fully understanding their risk. When the stock market crashed, fear drove usually adventurous hedge fund investors to withdraw their money from the market, even when they could have bought good stocks at record-low prices. Behavioral economics can explain other phenomena as well, such as why some prices or wages refuse to change with market forces (price stickiness), why stock markets perform worse on Mondays (calendar effect) and why some investors choose to hold onto poorly performing stocks while selling high-performing ones (disposition effect).