concepts & Theory in psychology

MEETS

PSYCHOLOGY MEETS
ECONOMICS
Sagar Pushp
EMPD09
XLRI


How is Economy related to
Psychology?

PSYCHOLOGY

+
ECONOMICS

BEHAVIORAL
ECONOMICS


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
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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.
(a)
Consider an Indian Premier League match in Mumbai on a Saturday
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.
(b)
Owing to above, hoteliers should hike the prices of their hotel rooms
and try to maximize their profits. And moreover, it’s a regular phenomenon that
happens every year.
(c)
But they don’t do it as they are reluctant to antagonize their customers

with what may perceive as unfair prices.
(d)
Tomorrow, when the same person visits Mumbai for a business trip is
less likely to choose the same hotel because he will feel cheated.
(c)

Do popular restaurants jack their prices on weekends, No, they don’t.

(d)
More than mere maximizing profits, it is the reputation which is at
stake. For a short term benefit, one can not sustain long term losses.


Some Interesting Examples
Example 2.
(a)
There is game with two volunteers, A and B. It begins with a toss and
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.
(b)

So if a staunch economist wins the toss, how should he go about it?

(c)

How would someone else (irrational non-economist) divide it?

(d)
The Economist would divide with 99$ for himself and 1$ for the other

player.
(e)
Someone else who doesn’t think like an economist would go for a 7030 or 65-35 distribution.
(f)
A normal person would know that even if he does a 90$ and 10$
division, the other person is more likely to reject the offer.
(g)
Because, an economist may think otherwise, but two non-economist
would think alike.


Why do People Gamble?

• Why have Las Vegas casinos become so
popular?
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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.


Summary

• 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