Updated: Jun 7, 2019
When Adam Smith published his most famous book, "The Wealth of Nations in the 18th Century," it was revolutionary. The wealth of a nation is the combination of the economic activities of its citizens. He described the evolution of human commercial enterprises from a hunter society to modern society. He also explained what concepts enabled humans to participate in profitable pursuits such as property rights (the right to own tangible and fixed things), contracts (rules that outline the obligations to be met) and law (to protect those rights, and enforce contracts). Perhaps, the concept he is most famous for is the idea of the market or “the invisible hand.” He posited that for the society to be rich, the market should be set free.
In his theory, an individual, to enrich himself, will seek to be more productive and put more capital in order to create future wealth. To Smith’s mind, this process shall be automatic, thus the term “invisible hand.” For this to happen, regulations from the government shall be limited to enable the market to maximise its productivity. The government’s function shall be the enforcement of the law. There must also be competition to achieve the market’s maximum capacity. This paved the way for the development of rational choice theory in economics.
Economics, for a long time, was anchored on the theory that an individual, the decision-agent, will make rational choices given that he has complete information along with clear and measurable goals. A corporation, a decision-agent, has an objective of creating value for the shareholders more like a basketball team that has a goal of scoring the basket. Just like Adam Smith’s theory, any decision-agent, especially humans, will be guided by the invisible hand to make rational decisions. This is not wrong, but there are only certain scenarios that humans are capable of rational decision.
Then, enter the studies of Daniel Kahneman, a Nobel prize winner in Economics despite not being trained as an economist. In his book, "Thinking Fast and Slow," he described that humans have two systems of thinking: System 1 and 2. System 1 is the automatic thinker that makes decisions quickly and easily. System 2 allocates attention to a human’s mental activities before making a decision. System 1 is usually favoured by humans due to its lack of effort and energy required. This system enabled humans to make quick decisions and therefore, survive. This theory of two systems was revolutionary in the field of Economics that long held the rational choice theory.
Kahneman, together with Amos Tversky, studied heuristics and biases, and how it affects human choices. One of their famous findings is what they call “anchoring effect,” and this is a phenomenon where a person’s estimate stay close to the number that person considered. For instance, in price negotiations, humans will always stay close to the asking price of the counter party. The first offer will be the anchor and the buyer or seller will be influenced by this amount, thus, preventing him to make a rational choice. Another famous finding of Kahneman is the psychological application of regression to the mean. Getting back to the basketball reference earlier, a common misconception is the hot hand fallacy. The basketball coach almost always gives the ball to the hottest player on the court in clutch moments. This choice is not optimal because it was proven that earlier successes do not translate to future successes. Future performance will always regress to the mean.
Another Economist that studied human behaviour is Richard Thaler. He also became a Nobel Prize winner in 2017 for his contribution in behavioural economics. His most famous finding is the endowment effect which states that people are more likely to retain an object they own than acquire the same object they do not own. This is due to human’s loss aversion--the pain of giving up an item is more than the pleasure of obtaining the same item. A good example is in the negotiation of housing prices; an owner of a property who bought it at a higher price is less likely to sell at the price lower than the fair market value than the owner who bought the same property at the price lower than the fair market value. This may seem common sense, but according to rational choice theory, the historical buying price is already a sunk cost, thus, irrelevant to the current market value. This behaviour, especially if taken collectively, affects the supply of housing and the whole housing market.
Economists often simplify what humans ought to do in an economic transaction or any transaction for that matter, and policies are often designed around these assumptions. Study after study shows how humans actually behave in a modern economy. And, this fueled the rise of “behavioural economics.” What policy-makers should do is to understand the quirks of humans and how to enable them to maximise their potential. Governments have to understand how to “nudge” their citizens into doing what is right, or enable the market to be efficient and inclusive. A simple change in default options in pension enrolment could make a massive change in saving-behaviour of the society. A plain alteration in the framing of a reminder of income tax payment could increase compliance dramatically.
I am not saying we use psychology to manipulate people. But, humans often need a guide, like the sunlight, to point out the right path. Governments should not spend millions of dollars to implement a policy to address a matter that can be solved by using our collective knowledge in behavioural economics and only a few thousands of expenses. Academics, policy-makers, and pretty much everyone, must understand that Homo economicus only exists in certain scenarios and Homo sapiens are vulnerable to cognitive biases and irrationalities that need understanding and further guidance.