concepts & Theory in psychology

PSYCHOLOGY MEETS ECONOMICS Sagar Pushp EMPD09 XLRI MEETS... • Assumes bounded rationality – meaning that people have limited time and capacity to weigh all the relevant benefits and cost

PSYCHOLOGY MEETS

ECONOMICS

Sagar Pushp EMPD09

XLRI

MEETS

How is Economy related to

Psychology?

BEHAVIORAL ECONOMICS

PSYCHOLOGY

+

ECONOMICS

• Some basic assumptions

– People are always rational and accordingly take

decisions

– They make choices to maximize some objective function mainly optimizing or maximizing profits.

Behavioral Economics

• It is using psychological insights to study economics

• Behavioral economics is concerned with the ways in which the actual decision-making processes are

influenced by our mind and emotions

• Assumes bounded rationality – meaning that people have limited time and capacity to weigh all the relevant benefits and costs of a decision

• Decision making is less than fully rational People are prone to make predictable and avoidable mistakes

• At the same time, decision making is systematic and amenable to scientific study

Some Interesting Examples

Example 1.

or a Sunday night It is a regular phenomenon now and the hotel authorities are pretty certain that there will be huge rush from all over the country and even outside All the available rooms will be booked.

and try to maximize their profits And moreover, it’s a regular phenomenon that happens every year

with what may perceive as unfair prices.

less likely to choose the same hotel because he will feel cheated.

stake For a short term benefit, one can not sustain long term losses.

Some Interesting Examples

Example 2.

whoever wins has gets 100$ to divide between himself and other player Other player has the option to accept the division or reject it If he rejects, both return with no money.

player.

70-30 or 65-35 distribution.

division, the other person is more likely to reject the offer

would think alike.

Why do People Gamble?

• Why have Las Vegas casinos become so

popular?

• Does rationality work here?

• No! Because here greed overrides rationality Although, The Theory of Economics would suggest otherwise!

• Why do Gamblers want more players to play the game?

• It is the short-term benefit that attracts him After losing some, he tries to play till the time he breaks-even.

• While the ‘rational man’ analysis yields a

powerful tool for analysis in Economics, it has some short-comings seen earlier.

• The following shall highlight seven broad

principles related to Psychology while

understanding human behavior when studying Economics.

Seven Principles of

Behavioral Economics

1 Other people’s behavior matters.

– People do many things by observing others and

copying; people are encouraged to continue to do things when they feel other people approve of

their behavior

1 Habits are important.

– People do many things without consciously

thinking about them These habits are hard to change even though people might want to change their behaviour, it is not easy for them

Seven Principles of

Behavioral Economics

3 People are motivated to do the ‘right thing’.

– There are cases where money is de-motivating as

it undermines people’s intrinsic motivation, for example, you would quickly stop inviting friends to dinner if they insisted on paying you

4 People’s self-expectations influence how

they behave.

– They want their actions to be in line with their

values and their commitments

Seven Principles of

Behavioral Economics

5 People are more afraid of incurring losses

than making profits.

– They hang on to what they consider ‘theirs’

6 People are bad at computation.

– when making decisions: they put undue weight on

recent events and too little on far-off ones; they cannot calculate probabilities well and worry too much about unlikely events; and they are strongly influenced by how the problem/information is

presented to them

Seven Principles of

Behavioral Economics

7 People need to feel involved and effective

to make a change.

– Just giving people the incentives and information

is not necessarily enough

• Economics is not wrong science and is also a study of human behavior but certain assumptions are

generalized and not seem empirical or practical which may bring ambiguity at times Behavioral Economics teaches us:

–To avoid making serious mistakes down the road

–Clarify what is rational and irrational decision

making

–Lead to a better understanding of opportunity costs, time discounting, and other economic concepts

–Provide a richer, more realistic understanding of

decision making in practice