There are multiple factors which affect an economy and it’s growth. We can not have a ceteris paribus outlook when we are gauging the performance of an economy. Amongst many, some of the factors include a change in demand, market structure, policies, supply, (rise or fall in) prices, consumption/production rates. The real root cause behind the changes in all of these factors and eventually in (what happens in) an economy, is US! Well, I do not mean the country USA, who is no longer the big-brother for the world, but I am talking about you and me. If not entirely, at least for the majority of the time. There are other environmental factors as well but You and I play a crucial role in this game. I am sure you are wondering how? Let’s take a look.
Behavioural economics is a relatively new concept. It basically says that economics and psychology are complementary in nature. This field studies the various factors that affect the decision making of an individual. It is a combination of various economic theories, neuroscience and psychology. Decision making of a human brain can be influenced by emotional, social, cultural and various other environmental factors. A human brain develops various perceptions after gaining knowledge from various sources. Any new information can change the perception and hence the decisions taken by an individual.
Behavioural economics studies how we take market decisions or decisions which affect the consumption in a market. Humans make most of their decisions based on their experience and learning throughout their lives. Their decisions are also influenced by other people’s decisions and most often then not, the decision is made based on the information available. Heuristics is a very popular term that is used in behavioural economics. It explains how mental shortcuts and rules of thumb facilitate decision-making.
A very common concept used while analysing behavioural economics is rational choice theory. An individual will only make choices that suit his/her wants and fulfils the desire optimally. Now, another factor in this theory explains how the rationality of an individual is limited. It doesn’t take everything into consideration. The available information and the (very) limited time to make the decision is what determines the rationality. Here rationality is synonymous with optimization/making the decision which is the most desirable. They seek satisfaction and whichever seems to satisfy them the most is chosen. As per an analogy which explains this really well: It’s like a pair of scissors, where one blade represents ‘cognitive limitations’ of actual humans and the other the ‘structures of the environment’, illustrating how minds compensate for limited resources by looking for known elements in the environment. The human mind is mostly part rational and part irrational which explains why we, at times, opt for suboptimal decision making (decisions which may not be the best).
Behavioural economics studies how by using reasoning shortcuts, decision making is done. A completely rational person is not moved by emotions. Behavioural economics basically says that we can’t follow theories based on just rationality as they don’t consider the emotional factor. In a lot of cases, economists have said that for a lot of humans, empiricism (knowledge derived from experiences) is applicable. They believe this is what is an important factor which determines the decision.
Another important aspect of behavioural economics is the nudge theory. Slightest of changes can affect the desired outcome. With the same number of choices, in a very low-cost and effective manner, this theory is used practically. Nudge theory takes impulse, common perception, human reaction and other such factors into consideration. We all say never judge a book by its cover but yet, in reality, our first thought is a snap judgement based on its cover. Nudge theory deals with the snap judgement and decisions that we make.
Behavioural economics contrary to the classical economic theories, is more of an evolved concept as it takes psychology into account as well. Classical economics deals with more of markets and its behaviours whereas this focuses on human spending. One very important thing that we need to understand is that theories were made at a certain time keeping in mind the conditions at that time, so we have to analyse the past and forecast the future. Theories usually don’t evolve and change as humans do. A theory may not be completely relatable to the present conditions because of the era and other factors associated. It’s a paradigm shift which happens over time.
To understand the reason behind the irrationalities of markets, bubbles, the economic crashes, the recessions, and all the other major economic events, it is imperative to be familiar with this field of economics. More so in today’s time where the competition is high and the world is going through a pandemic.