Behavioral Economics What Comes After Consumerism

The national economy

For a long time, behavioral research in economics has been shaped by the image of man Homo oeconomicus - a central concept from standard economic theory. Homo oeconomicus is a rational decision-maker who exclusively pursues his own economic interests.

The traditional model undoubtedly has weighty strengths. On the one hand, it is based on a few, simple assumptions and is therefore broadly applicable. This generality is an advantage of economics over other social sciences such as psychology or sociology, in which theories are often highly contextual and difficult to generalize. On the other hand, the theory of rational self-interest can make surprisingly precise forecasts in certain contexts. For example, Vernon Smith, one of the pioneers of experimental economic research, demonstrated through experiments as early as the 1950s and 1960s that standard theory can successfully and accurately predict the trade equilibria of competitive markets.

The prerequisites for behavioral economics were laid when economists began to take an increasing interest in strategic interactions outside of traditional market structures. In the 1960s and 1970s, for example, game theory - a mathematical concept for analyzing strategic decisions - gained in importance. As a result, creative economists began to test game-theoretic predictions of social interaction by means of experiments in the early 1980s. This soon made it clear that the traditional assumptions of rationality and self-interest are inadequate to explain human behavior in strategic situations.

Motivated by this discrepancy between observed behavior and the predictions of standard theory, behavioral economists have tried since the late 1980s - initially against strong resistance in their own profession - to modify economic theory in such a way that it can better explain and predict actual human behavior. Often they based their work on existing knowledge from related disciplines such as psychology, biology, sociology and neurosciences.

Most behavioral economists never wanted to reject the traditional model entirely. For example, self-interest continues to be a major motive for human action, and most behavioral economists agree that people try to make decisions as rationally as possible. In contrast to followers of standard theory, however, they have realized that other motives are relevant in addition to self-interest and that the attempt to be rational sometimes fails.

Loss aversion as an economic factor

Behavioral economics has documented a multitude of human behaviors over the past three decades that the Standard Model cannot explain. Whether we are satisfied as humans or not does not depend so much on how much we have of something, but on how much the state of affairs has changed. People who get unexpectedly rich are temporarily happier than they were before. In contrast, people who have always been rich and are used to it are not, on average, much happier than others.

It seems that we are constantly comparing our achievements with so-called reference points. While positive surprises such as an unexpectedly high bonus make us happy, negative surprises such as a stock price slump dampen our well-being. Interestingly, in these comparisons we weight losses more than gains. In other words: a loss of 1,000 francs annoys most people much more than they do a profit of 1,000 francs. This so-called loss aversion was first documented by the psychologists Daniel Kahneman and Amos Tversky in the late 1970s and has since been confirmed again and again in numerous experiments in the laboratory and in the field.

The fact that people typically think in terms of comparisons and that losses severely impair our wellbeing have important implications for economic decisions. Thus, loss aversion leads people to avoid risk even if it comes at a high cost. A typical example is insurance for rental cars or electronic equipment. Because people want to avoid losses in any case, they are willing to pay enormously high prices for such insurance, even if the objective risk of high damage is low. In addition, there is a tendency to massively overestimate small probabilities.

Another implication of loss aversion is that consumers become vulnerable to certain sales techniques. Decoy offers, for example, work because people feel it is a loss if they do not receive the product. They are therefore happy to pay a high price for an alternative product if the original offer is no longer available. The same principle explains why car sellers often first show a model with all possible options: After that, the buyer perceives any missing extra as a loss.

Unfair wage cuts

Another central finding of behavioral economics is: When making strategic decisions, people often deviate from maximizing self-interest. Early experiments by behavioral researchers such as Werner Güth, Richard Thaler or Ernst Fehr have convincingly shown that many people are willing to reward other people for acting fairly or punish them for unfair actions - even if this is associated with considerable costs for themselves. However, fairness is not equally important to all people: while some people are willing to accept a lot to get a fair result, there are also a significant number of people who are more selfish. In addition, fairness decreases if you feel unobserved - or if you can disguise your egoism.

The inclusion of social motives in economic theory makes it possible to explain empirical phenomena that are not in accordance with the Standard Model. In recessions, for example, employers are more likely to lay off employees than cut their wages. The reason: wage cuts are often perceived as unfair. Therefore, there is a risk that employees will punish the employer by reducing their job performance. Motives for fairness can also explain why people are willing to enforce social norms and take action against violations. Examples are moral courage in the face of careless waste disposal in a park or in the case of harassment in public. Conversely, strangers who will never see each other again are often willing to help one another. Let's think of anonymous donations or help in the event of an accident.

Social motives can also influence the drafting of contracts and the management style of superiors. In joint work with Ernst Fehr and Oliver Hart, we show that - contrary to standard theory - it makes sense to make contracts very inflexible, because this can prevent conflicts in trade relationships. In a current work with John Antonakis, Giovanna d’Adda and Roberto Weber, we analyzed the effect of motivational approaches from superiors. It showed that the motivation boost that comes from a charismatic address to employees is comparable to the effect of financial incentives.

Living in the present

Intertemporal decisions are also important in behavioral economics: Many decisions that we make in everyday life not only have an immediate effect in the moment, but also consequences in the future. This applies to all types of investments (financial investments, training, security), but also to many consumer decisions (intoxicants, healthy food). Standard theory says: Rational actors carefully weigh the immediate and future consequences and then make the optimal decision. In contrast, the work of researchers such as David Laibson or Matthew Rabin suggests that most people underestimate the long-term effects over the immediate consequences.

The overweighting of the present versus the future explains many problematic economic behaviors. Examples are the inadequate pension provision in countries like the USA, the increase in obesity, drug addiction and over-indebtedness. By identifying the causes of such phenomena, behavioral economists made it possible to develop targeted solutions such as “nudges” or “defaults” (see box).

In conclusion, behavioral economics has expanded and modified the economic model by incorporating insights from neighboring disciplines in such a way that it can better explain and predict human behavior in many relevant decision-making processes. A realistic image of man is necessary because economists can only provide meaningful analyzes and suggest promising interventions if they understand the cause of economic developments at the behavioral level.