Behavioral Economics and Human Decision Making

                                      

In our day to day life, we make numerous decisions  about different things. These include our political decisions, personal decisions and financial decisions. Have you ever wondered what guides our decision making process and choices that we make? Well, “Behavioral Economics” is the discipline of study which tries to find out the answer to the above question. It also tries to explain what happens after the decision is made, as well as how present decisions impact future behavior and decision making.

The decision making process also depends upon the decision being made and there can be several factors which influence our decision making. To name a few, factors like past experience, cognitive biases, age and individual differences, belief in personal relevance, etc. influence the choices we make. To be able to understand what decisions are made, understanding of these factors is very important.

Human psychology and perception plays a dominant role in deciding how human beings make decisions. Perception can be defined as a process by which individuals organize and interpret their sensory impressions in order to give meaning to their environment. It becomes so important as people's behavior depends more on their perception of reality than the reality itself. Factors such as personal attitudes, motives, interests, experiences and expectations along with the time, work setting and social situation influence the perception of an individual. Why students strive so hard to clear the UPSC Civil Services Exams in India- maybe because of the perception that an IAS or IPS officer gets huge prestige besides having the vast powers of the public office.

Various types of errors and biases enter our decision making process when we try to take shortcuts while deciding. Let’s try to understand them. Among your friends, if you are considered to have a good sense of direction, you will hesitate to ask for help despite knowing the fact that you are lost while driving a car with your friends inside. This is known as Overconfidence Bias where we tend to be overly optimistic. If you are a dog lover and see a vicious dog attacking an innocent child, you tend to believe that the dog is defending itself against a menacing child. This is known as Confirmation bias which occurs when a person interprets a situation according to their own pre-existing beliefs. Few other errors/ biases in our decision making are Anchoring Bias, Availability Bias, Escalation of Commitment, etc. Hope we will discuss more about these concepts in the coming blogs.

In Behavioral Economics, we have something called the “rational choice theory” which assumes that human actors have stable preferences and engage in maximizing behavior. But this theory of rational choice has its own limitations.  It is here that we define a term called “Bounded Rationality” which states that our decisions are not always optimal. According to the works of Herbert Simon (1982) and Kahneman (2003), the term bounded rationality can be understood as restrictions to the human information processing, due to limits in knowledge (or information) and computational capacities. 

We prefer credit cards over cash transactions despite knowing the fact that it is going to cost more. Why?  The answer is quite simple and can be explained by the theory of mental accounting which says that people think of value in relative rather than absolute terms. In this situation the pain is thought to be reduced in credit card purchases, because plastic is less tangible than cash, the depletion of money is less visible and payment is deferred. We all must have experienced the moment of panic when the waiter comes to our table to take the order and we are still struggling to contemplate the appetizers on page 1 of a 10-page menu? This is referred to as Choice Overload which may lead to less satisfaction derived from our choice or reduced confidence in decision making or inhibition of any decision at all. The concept of choice overload explains well the bounded rationality of humans. Sometimes people refrain to obtain knowledge which is freely available. Research studies have shown that investors are less likely to check their portfolio online when the stock market is down than when it is up. We call this as Information avoidance in behavioral economics which goes hand in hand with our assumption of bounded rationality where people have limited ability to process the information. 

 

Now let’s see the relevance of Context in decision making which is nothing but any factor or situation which can shift the choice outcomes by altering the decision making process. It goes without saying that the situation in which the decision must be made influences the decision that is made. Here by context, we mean a combination of components like the decision need, financial aspects of the decision making, etc. Factors such as social, historic and cultural aspects of the situation also determines the context in which the decision must be made. 

Your Sunday plans might get affected when you have your exams the coming Monday, right?

Hope we have discussed some crucial aspects of the complex human decision making process. Thanks for reading. Cheers! 

Consumer Preferences and Microeconomics

We purchase various kinds of products or services. How we actually decide to buy those goods and services is an important question in microeconomics and the answer to that is known as theory of Consumer Preference. 

Consumer Choice Theory is the study of how people decide to spend their money based on their individual preferences and budget constraints. The consumer theory is not flawless as it takes into consideration a number of assumptions about human behaviour.

Economists give importance to "satisfaction" as a primary determinant of consumer preferences and a term called "utility" is defined. According to microeconomics, utility denotes the relationship between amount of goods consumed and the amount of happiness or satisfaction that a consumer gets. In other words "utility" describes the taste of consumers and it is the ability of the good to satisfy a want. 

   

To understand this concept more clearly, let's consider the case of three friends who have recently graduated their high school and are all set to go to the new cities and start their college life. And there is a laptop too in their shopping list. We know that the laptop market is mainly dominated by Windows laptops and Apple laptops called Macbooks. Armis enjoys photography and making videos and he plans to start a YouTube channel also in college. Therefore, he decided to go for Macbook over a windows os based laptop as he assigned more utility to the former than the latter. Suppose he assigned the MacBook a total utility of 10 utils and a total of 7 utils to the Windows Laptop. However, these numbers were opposite for Athos and Porthos who enjoyed playing games. They preferred windows over the Mac laptop. This approach is known as the Cardinal Utility method, where the satisfaction derived by the consumers can be quantitatively expressed. 

Now Athos ended up purchasing Dell XPS laptop while Porthos purchased Lenovo Legion laptop. They both ranked one brand over the other and there can be many reasons for it. However, this approach of not assigning any numerical units to the satisfaction derived and qualitatively measuring the utility is known as the Ordinal Utility method. This method is also known as Indifference Curve Approach.

Now let's ponder over the question- Are there any limitations to consumer preferences?  Well surely there are! Victor who used to play multiplayer games with Athos and Porthos ended up purchasing Acer Nitro 5 laptop as his finances did not allow him purchase any of those high end gaming laptops. Therefore, budget constraints, availability of the product, need of the commodity are the factors which cap consumer preferences. Thus, the consumer preferences are expected to be in accordance with few rules/ assumptions.

We can either prefer one consumption bundle over the other or be indifferent towards both the bundles. This is called the assumption of completeness. Next, we can say that consumers make consistent choices. If your girlfriend prefers Cappuccino to Espresso and Espresso to Mochaccino, you can surely order Cappuccino over Mochaccino on your date. This is the assumption of transitivity. Now we have the assumption of monotonicity i.e. consumers tend to prefer more to less. Isn't it too relatable? There are other assumptions to consumer choice theory such as the reflexivity and the convexity assumption as well.

Now let's throw some light on why the economists study Consumer Choice Theory and why is it important to to understand Consumer Preferences? The better understanding of consumer preferences has a major role to play in the relationship between the price of a good or service and the quantity demanded for a given period of time, and the shape of the overall economy because the company profits, labour market, investment, etc. depend on consumer purchases. Knowledge about Consumer Preferences also guides the firms to come up with the relevant marketing strategies to expand their reach. It is also the key to profit maximisation strategies of the firms.