Economics: Psychology vs. Rational Self-Interest

The main premise behind classical economics is that people are driven in their consumption decisions by what Adam Smith called rational self-interest. That premise is not correct. Most consumption decisions are not driven by rational self-interest; they are driven by psychology.

I do not mean only the person who overeats or the person who wastes his money on gambling. I also mean the person who spends huge amounts of money on fashionable clothing when he could get good-enough clothes for one tenth the price. I also mean the person who buys a Hummer when he could have a Jeep for one-fifth the money expended. I also mean the person who procures a huge house that he has to work relentlessly for many years in order to pay off. I don't just mean decisions of people who are obviously sick. I also mean the decisions of many normal people.

Another obvious influence of psychology on economics is in marketing. Most marketing is based on psychology. There are very few ads that simply and rationally state the benefits of a product. They use all sorts of psychological manipulative techniques. We see the obvious outcomes of that in inferior products dominating the market for reason of superior marketing. Beta had the better product; VHS got the market. Borland had the better product; Microsoft got the market. Mom-and-pop shops had the better product; instead the market is dominated by fast food chains.

Does this make Keynes right in claiming market to be based on "animal spirits?" While that term is too judgmental, a more reasonable claim to be made is that the market is dominated by psychology. Is that good or bad? Could be good, bad, both or neither. But what this definitely demonstrates is that it's not people's rational self-interest that comprises capitalism and drives the "invisible hand."

I knew a poet in Tucson who proposed this as a metaphor for the civilization: A mechanism that extracts eros and powers the economy. As he explained, "Man sees on the TV a naked woman, man feels 'want to breed with the naked woman,' man goes out and buys stuff, and that powers the civilization." Here is a claim not frequently considered: That behind people's economic decisions is erotic striving. That of course is an outgrowth of psychoanalytic theory, which is at the root of psychology.

In any respects, what actually drives people's economic decisions is only rational interest in some cases. Most economic decisions are based on psychology. This is the case with both economic decisions that work and economic decisions that don't work. Certainly there is very little to recommend the economic decisions of someone who overeats or gambles; but we see psychological role in all sorts of decisions, including not as overtly disastrous ones.

It is of the essence to understand the role of psychology in economics, because its role is vast. I don't just mean psycho-pathological choices; I mean regular choices. I mean buying super-expensive clothes just because they are fashionable. I mean buying VHS instead of Beta and Microsoft instead of Borland. I mean having McDonalds instead of going to a mom-and-pop shop. I mean driving up housing prices in irresponsible speculation when there is no real-world reasons to justify this craze.

Is capitalism bad? No; but it's not based on what its basis is claimed to be. Psychology, not reason, forms the basis of a vast chunk of economic choices. Many choices come from manipulation by marketers. And any number of others come from reasons that are psychological rather than rational (achievement of self-esteem, atoning for insecurity, desire to prove oneself or feel glamorous, and any number of other factors).

Perhaps the most important issue here is the definition of rational. Which interests are rational, and which ones are not? Clearly gambling away one's savings is not a rational choice. But there are many other irrational choices that are not as obviously irrational. And any number of them are committed by your average person.

 

The problem with your theory is that you think there is an objective ideal of what people should buy and do. Value is subjective. People act on what they believe to be their best interest, and you as an outside party cannot judge whether their decision was actually in their best interest because you don't know what their values are. Is diet and exercise good for your health in the long run? Of course, but pizza, donuts, ice cream and soda taste really good, and it's a lot of fun to sit on the couch and watch TV. For some people the prestige they feel when buying designer clothing is worth the higher cost. For others this seems silly. But, since value is subjective, each person values ends in their own unique way.

You say gambling away your savings is not a rational choice, but for some people gambling is a lot of fun, and they don't value their future lives that much. That doesn't mean they won't regret their choices in the future, but at that moment in time, based on their subjective values, that is a rational choice for that individual.

 

The perceived self interest of the consumer is affected greatly by advertising, "keeping up with the Jones' " , being like a monkey and copying the behavior of others, and being conditioned that a particular brand makes you better, higher, more desirable as a person. Self worth is even, with some people, determined by what you buy and own, and of course show off to others.

We are hardly rational beings, but there are a few of course. But when it comes to consumption, few are rational at all. Advertising appeals to this irrationality. And obviously advertising works. We are easily manipulated by others, who are clever.

 

If you think it's so easy to get people to buy stuff, I'm sure you're a millionaire ad executive, right?

 

Recently young people think things to joy can be taken for free of charge.

 

Humans are irrational by our nature. As a whole, we make decisions based off emotion far more than we realize.

With that said, basing decisions off of psychology desires isn't irrational in and of itself.

You can't look at it like that. A person can derive value from those purchases in excess of the materials, in which case the decision to do that can be rational.

Ads are generally based off three things. Comedy, sex, and death (mainly the lack of fear of it). These are also good for enhancing one's chances for procreation, and thus the potential for genetic immortality.

Functionality is just one part that goes into a purchase. Branding yourself in order to project a certain image to others plays a bigger role in my opinion, which in itself is not irrational.

I don't interpret Keynes' description of "animal spirits" to be rational or irrational. It merely urges one to take action.

I absolutely believe the market to be dominated by psychology, but then again so is all human decision-making, so I would say it's neither good or bad.

I would say "perceived" rational self-interest is what drives capitalism and guides the "Invisible Hand." Since humans are inherently irrational, all economic systems will be irrational since they're controlled by humans themselves.

Men and women alike want to attract the best mate they can for reproductive purposes. It increases the likelihood of genetic immortality, which on the face of things is a purely rational decision. And if purchasing certain products can lead one to finding a higher quality mate, would it then be irrational not to purchase those products?

What decisions aren't based on psychology? But yes, a large amount of our decisions are based off emotion and therefore irrational. Especially those that are rushed. Daniel Kahneman refers to those as System 1 decisions.

McDonald's and locally owned restaurants offer different options. McDonald's is generally quicker and you know what the food is going to taste like from any of the locations, so if you're in a hurry it offers additional benefits you won't get from a sit down restaurant; whereas with a locally owned restaurant the food will (hopefully) be of a higher quality, but will also be more expensive and require more time.

Agreed about the housing prices. Even though many different events led to the severity of the housing bubble, ultimately "irrational exuberance" was the cause of it.

How so?

What would your solution be? Should people not be able to make purchases they believe will maximize their "utility?" After all, shouldn't people make purchases they feel will increase their happiness?

Agreed that humans make many choices that aren't obviously irrational, but are. And it's not just the average person, but all of them.

 

Behavioral economics is characterized by three prevalent themes:

Heuristics enable people to make decisions based on approximate rules of thumb instead of strict logic.

Framing refers to the collection of anecdotes and stereotypes making up the mental emotional filters individuals rely on to make sense of their world.

Market inefficiencies include mis-pricings and non-rational decision making.
https://en.wikipedia.org/wiki/Behavioral_economics

"Behavioral economics and the related field, behavioral finance, study the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation.[1]

"Behavioral economics is primarily concerned with the bounds of rationality of economic agents.

"Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models cover a range of concepts, methods, and fields.[2][3]

"Behavioral economics is sometimes discussed as an alternative to neoclassical economics."

 

When you consider that a large political constituency subscribes to the completely irrational rational actor theory of economics and that this informs many of their basic prescriptions concerning economic and social policy, policy that is often put into action, the deeply psychotic state of our present society is revealed.

 

Wanting or preferring to buy a Ferrari is an emotional event, however, analyzing the monthly payment, insurance, maintenance, etc. is calculated. Does emotional buying trump calculated buying...sometimes yes but most of the time no. Most people spend what they earn, with some spending more by using credit purchases, and again most people have calculated how to handle monthly payments on credit cards and loans. For the 5%-10%, recklessly buying beyond their income potential, they emotionally decide to buy an item, spend a few nanoseconds analyzing the cost, then ignore their analysis and buy anyway...this is not psychology...this is idiot spending...

 

Economic studies indicate that all markets act irrationally. That is proof that even in aggregate, at the largest possible scale, the rational actor is a mythical figure.

 

Your premise is flawed. You use rational as it if were subjective to your view, rather than an objective and unbiased. Economically speaking, human beings make rational decisions when they act with purpose. The purpose may seem silly or unimportant to you, and that is your own subjective bias. That does not make the economic decision objectively irrational.

Again, economically speaking, there may not be any real cases where people make irrational economic decisions. Everyone acts with purpose, even if that purpose is far outside your own.

Are you saying that the gambler acts without purpose, or are you applying moral values to an amoral science?

 

These things don't appeal to you, so the people who do them appear to be irrational. Their purpose is not in alignment with yours, so you subjectively apply "irrational" to their purposeful economic decisions. The fact is, they are quite rational, in the economic sense, just as are all of your decisions. You, like so many others, are trying to apply subjective morality to an amoral science. "Rational self-interest" simply means that people are making purposeful economic decisions, and they do so with their interests in mind. Whether or not those interests and those purposes are beneficial only in the short term or beneficial in the long term is irrelevant.

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Markets don't act.

 

This assumes that a person who is not perfect is not making purposeful economic decisions. Humans act on the knowledge that they have. While they may be misinformed, that does not mean their decision making is not rational (purposeful.)

 

Irrational or rational...spending is a personal decision, personal behavior and we know it can be controlled within reasonable limits. Sure, a person can rationalize they must buy something, but if the purchase gets them in trouble, they still have options to deal with the trouble. Or they can continue to ignore the options and remain in their rationalized spending rut...

 

https://www.google.com/#q=rational
"ra·tion·al
ˈraSH(&#601n(&#601l/
adjective
"1.
based on or in accordance with reason or logic.
"'I'm sure there's a perfectly rational explanation'
synonyms: logical, reasoned, sensible, reasonable, cogent, intelligent, judicious, shrewd, common-sense, commonsensical, sound, prudent..."
I'm not clear on why you believe a "purposeful" decision is also a "rational" decision? In general, rationality implies the conformity of one's beliefs with one's reasons to believe based on facts or reason. There are many examples of actions which are done with a purpose in mind, yet they are highly irrational acts. With regard to economic acts, I would suggest any purposeful decision I make in the market place is irrational if I lack any piece of information or knowledge necessary to making a fully informed choice.

https://en.wikipedia.org/wiki/Rationality

 

If I want the general use of the word, I go to the general dictionary. If I want a definition for a word that has a more specialized meaning in a field of study, I go to the dictionary for that field. For instance, "enjoyment" is generally used to mean to have a good time or some other positive interaction. In the legal field, as it applies to property, "enjoyment" means the ability to utilize that property, regardless of whether it's good or bad.

Here are some economic dictionary definitions of rational:


"Rational Behavior:
The notion that people make decisions based on the desire to obtain the greatest amount of satisfaction. Rational behavior essential means that people prefer more to less. The presumption of rational behavior underlies most economic analyses, especially those applied to consumer demand theory."
http://glossary.econguru.com/economic-term/rational+behavior


"Rational agent Most economic models assume that agents are rational, meaning that they do the best they can, given the constraints they face, to maximize their own well being. "
http://www-personal.umich.edu/~alandear/glossary/r.html

BREAKING DOWN 'Rational Behavior'

"Rational behavior does not necessarily always involve receiving the most monetary or material benefit, because the satisfaction received could be purely emotional. For example, while it would be more financially lucrative for an executive to stay on at a company rather than retire early, it would still be considered rational behavior for her to seek an early retirement if she feels that the benefits of retired life outweigh the utility from the paycheck that she receives."
Read more: Rational Behavior Definition | Investopedia http://www.investopedia.com/terms/r/rational-behavior.asp#ixzz3kitjnPzk

"Economists, while developing any theory of economics, make the fundamental assumption that entities, which are part of the theory, exercise rational behaviour while making decisions. For example, if a person chooses a job with a profile of his liking instead of a high paying job, then it would be also termed as rational behaviour." http://economictimes.indiatimes.com/definition/rational-behaviour

Then you are using the word in a way that economists do not. You think as a layman, not as an economist. I am also a layman, and I understand that what a word means to me in layman's term may be different in technical usage, and I had best be aware of it before trying to have an intelligent discussion about it.

Regardless of what you do, other people act with different purposes, and with different amounts of information. Not everyone is wired to make decisions by accessing all pertinent information ahead of time and then carefully choose what they believe is right.

 

What rational purpose would economic agents serve by making observational errors like the difference between a measured value of a quantity and its true value? Errors like these create market inefficiencies affecting prices and returns.
"DEFINITION of 'Rational Behavior'
A decision-making process that is based on making choices that result in the most optimal level of benefit or utility for the individual. Most conventional economic theories are created and used under the assumption that all individuals taking part in an action/activity are behaving rationally."
Behavioral economics argues most consumers rely on heuristics instead of strict logic, and their collection of anecdotes and stereotypes to make sense of the world when deciding what to buy; this sort of reasoning, according to Behavioral economists, leads to market inefficiencies like mis-pricings and non-rational decision making
https://en.wikipedia.org/wiki/Behavioral_economics
"Behavioral economics and the related field, behavioral finance, study the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation.[1] Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory; in so doing, these behavioral models cover a range of concepts, methods, and fields.[2][3] Behavioral economics is sometimes discussed as an alternative to neoclassical economics."

Read more: Rational Behavior Definition | Investopedia http://www.investopedia.com/terms/r/rational-behavior.asp#ixzz3kmUo4FuN
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People act on whatever subjective preferences they have, and that is rational for them. To say it's irrational is to insist that your subjective preferences are the only valid preferences. While that may play well in politics, where such preferences can be enforced in policy, it is far too moralistic for economic science. That is why classical economics doesn't make assumptions about what is rational. If a human being decides it, they are making a decision that is rational for themselves. No one else can decide for them that it is irrational. I would be tempted call your view of economics as "Puritanical" as only what you deem to be appropriate behavior is rational, and everything else evil and to be prevented.

 

It seems your position is that as long as there is some rationalization for a behaviour, no matter how subjective, it cannot be characterized as irrational. Psychopaths make the exact same argument.

Classical economics is nothing but a bad joke, a teetering edifice resting on some basic assumptions about human behaviour, both individual and in aggregate, which have yet to be indicated in any of the many many studies undertaken into how individuals and markets actually behave in the real world. Behavioural economics comes a lot closer to describing markets and their participants. You might want to look into it.

 

I have been inundated with ads to make my peter bigger and stand taller longer, but I have never made such as purchase. There are limits to what advertising can do. Even with keeping up with the Jonses, there will still be somewhat rational choices being made by most consumers within the scope of what is largely discretionary spending.

 

If those psychopaths are talking about economics, they'd be correct.

Just because you *want* something to be considered by economically irrational, does not make it so.

Behavioral economics is not settled on the issue of rationality, though from my readings (and in spite of your patronizing digs), it appears that the models still assume that humans are rational (as you'll see in the definitions I gave above, had you paid attention), and are more interested in "bounded rationality." In other words, unlike older economic models, humans aren't assumed to have perfect knowledge nor are assumed to act optimally (ie. they miscalculate.) However, that doesn't mean that they are acting irrationally. The economic definitions of "rational" above account for that. Perhaps you should read them.

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Why would it be irrational to make that choice? To you or I, it would be silly. It is not silly to the people making those purchases. They choose to trade something value for something they value more, which is the promise of having a larger penis. To say they are not rational for not expressing your preference is a completely subjective value judgment, rather than a scientific assessment.

 

Nothing in my post said or implied that it was not a rational choice. Exactly the opposite actually.

 

In order to establish common ground, do you agree/disagree with any of the following?

"What do modern day economists do? What procedures and methods do they employ? The standard textbook response is that economists formulate economic principles that are useful in establishing policies designed to solve economic problems. To discover these principles, also known as generalizations, economists engage in positive economics, that is, they hypothesize and theorize about empirical observations, strictly limiting themselves to describing reality, and they avoid issues or questions of what ought to be. The latter is called normative economics.

"In this positivist approach there is an impassable line of distinction between morality and economic science. Morality is a 'non-fact' for positive theory and analysis. To suggest that moral principles could be relevant 'empirical data' within the positivistic episteme clearly would be a serious breach of scientific analysis and purity."

http://jpatton.bellevue.edu/biblical_economics/morality-economics.html

 

People rationalize most everything they do; Hitler rationalized his 'grand idea', those who voted for GW twice rationalized their voting position, Japan rationalized that bombing Pearl Harbor was a good thing, McVey rationalized bombing a building, a handful of people rationalized crashing some planes into the WTC buildings, etc. These rationale could have been based subjectively or objectively. Dems and Reps, although diametrically opposed, rationalize their positions. Those who judge these and other actions to be irrational or insane or inferior or whatever are being 100% subjective. Each of us has some level of capability to think about our actions, and no matter how we choose our actions, they are our actions! Who knows what Japan was thinking when they bombed Pearl Harbor, but obviously Japan didn't do enough thinking! The guy who gambles away his mortgage payment thought he could achieve something good but like Japan he didn't do enough thinking. IMO US consumers for decades have been spending like they're on steroids, cash and credit, and my judgment and/or opinion, a huge percentage of the stuff we acquire in our lifetimes is non-essential crap!

 

Markets do not act. Individuals do. The market is merely an environment in which the actors exist. The question is: What is the precondition for rational action. The answer will tell what kind of social system is proper to man's nature.