Here is why Psychologists should be involved in Economics.

Economists assume that humans make only rational decisions and consistently try to maximise well-being. However, psychologists in the field behavioural economics have shown that human decision-making deviates from those assumed by classical economic theory.

Modern economic theories play a crucial role in our lives, from a single grocery shopping trip to global financial crises, basically anything that involves money. Much of economic research focuses on a crucial feature called utility (i.e. the total satisfaction one receives from consuming a good or a service) which roughly corresponds to one’s subjective value or well-being. Economists, in turn, have a deep interest in utility because it directly influences the demand and price of a product and enables them to formalise complex mathematical models indicating a company’s profit, for example. Moreover, traditional economic theories indicate that individuals try to maximise utility, and they do so based on the assumptions that people are rational, have full access to all the information about a product and have unlimited time and cognitive power to process information. These individuals are called ‘Homo economicus’.

However, behavioural scientists have suggested that individuals deviate from standard models of economic decision-making [1]. That said, there has been a rise in behavioural economics, a research field investigating the effects of psychological, emotional, cognitive, social and cultural factors on the decisions of individuals and institutions, as well as how those decisions vary from those implied by classical economic theory [2]. Therefore, economic psychologists and behavioural economists seek to understand in which ways human decision-making deviates from those of the Homo economicus. For example, psychologists and Nobel laureates, Daniel Kahneman and Amos Tversky demonstrated how human decision-making violates formal economic views of utility built on rational choices [3]. They presented university students with two decision tasks: 

Task 1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between: 

A. A 50% chance to gain $1,000.

B. Gaining $500 for sure. 

Task 2: In addition to whatever you own, you have been given $2,000. You are now asked to choose between: 

C. A 50% chance to lose $1,000.

D. Losing $500 for sure. 

For Task 1, 84% of participants chose option B, i.e. the certainty of gaining $500, which indicates that students preferred some certainty. In other words, students demonstrated a risk-averse behaviour for gains. However, for Task 2, 69% chose option C, the riskier choice. 

Taking a closer look, one notices that both options A and C present the same problem, meaning a 50-50 chance of going home with more money than you had before the task (earning $1,000 and $2,000). Likewise, both options B and D would guarantee a net profit of $1,500 (Task 1: $1,000+$500=$500 and Task 2: $2,000-$500=$1,500). So, if humans are fully rational, then when choosing A, C would be the next logical choice, and equally, when choosing B, D would be the logical choice. 

Furthermore, research involving non-monetary scenarios have reported similar results, where participants had to decide how many lives to save [4].

“Imagine that the United States is preparing for an outbreak of an unusual Asian disease, which is expected to kill 600 people. Here are two alternative programs to combat the disease: 

If program A is adopted, 200 people will be saved.

If program B is adopted, there is 1/3 probability that 600 people will be saved and 2/3 probability that no one will be saved. 

Their results showed that 72% of participants chose program A, the ‘safe’ program. Then, in a separate version, psychologists re-framed the questions in terms of the number of lives lost rather than saved: 

If program A is adopted, 400 people will die. 

If program B is adopted, there is 1/3 probability that nobody will die and 2/3 probability that 600 people will die.

Unsurprisingly, in this case, 78% chose the ‘risky’ option B, which indicated that in both examples framing identical outcomes as gains or losses lead to a preference reversal. Therefore, these results support the claim that human decision-making is not rational and violates the expected utility.

Furthermore, these findings create valuable insights to policymakers and businesses stakeholders when planning scenarios that involve human decision-making and expected utility. First, the reference point is essential, meaning that individuals evaluate outcomes based on a reference point, which usually is their status quo. Second people are risk-aversei.e. the idea that a given loss ‘looms larger’ than a gain of the same absolute value. 

Conclusion

Here is why psychologists should be involved in economics. Human decision-making is complicated, especially so when involving economic decisions. Moreover, no model has managed to replicate with mathematical precision 100% of human behaviour. In the last decades, behavioural economics has provided insights influencing the field of economics, especially those from Kahneman and Tversky. Although there is some criticism [5] to the examples above, there is evidence that economic models, as well as political decisions based on the Homo economicus, do not represent human judgement and decision-making process on expected utility. Future policymakers and economists should attempt to merge both economic and psychological insights to promote a healthier, wealthier and happier society.

References:

[1] DellaVigna, S. (2009). Psychology and economics: Evidence from the field. Journal of Economic literature, 47(2), 315-72.

[2] Wikipedia: Behavioural Economics.

[3] Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrics, 47, 263-292.

[4] Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 453-458.

[5] Birnbaum, M.H. (1992). Violation of monotonicity and contextual effects in choice-based certainty equivalents. Psychological Science, 3, 310-314.

Photo by Alec Favale on Unsplash

You May Also Like