Rationalism is the concept of innate ideas, reason, and deduction. Rationalism is characterized by the philosophical term “a priori”, which uses logic and reason to come to a conclusion before experience. One common assumption that economists make when making models is that people are predictable and rational. However, in the real world, people can be impulsive and short-sighted when making decisions. The study field that analyses humans’ rationalism is called behavioral economics. More generally, the branch focuses on the philosophical, social and emotional factors when making decisions as discussed by Adam Smith in “The theory of moral sentiments” in 1759. Although rationalism (or the absence of it) makes it harder to predict human behavior for economists, behavioral economics has gained popularity over the past few decades and it has been applied in fields such as public policy, political science, marketing, and finance.
On the other hand, irrational human behavior does not negate classical economics but it adds an extra layer of complexity. In most cases, people are rational. For instance, when the price of a product falls, people tend to buy more of that product, holding the law of demand true. Yet, the bounded rationality which includes: limits on information, time and abilities, prevents people from seeking out the best possible outcome. When the price of a good is low, consumers might not necessarily buy more. In fact, they might buy less of the good if they think that the low price possibly suggests the poor quality of the product. In such a circumstance, the law of demand does not hold true anymore which raises questions in classical economics.
As mentioned before, one of the problems with classical economics is that it assumes that consumers have perfect information when making choices. This means that they can quickly access information about prices and quality, which is not often the case in reality. Prices play a crucial role in decision making as they can change consumers’ perception. In order to prove that, a study in California analyzed the neurological response of an audience when tasting a variety of red wines. The participants were given fake prices and their neurological response was examined to determine the level of enjoyment. Surprisingly, the results showed that the audience seemed to enjoy the wine more when they believed the price was higher. This observation remained valid even when the participants were given identical wines but told that one of the two wines is higher-priced. Therefore, the conclusion that can be drawn from this experiment is:
“Contrary to the basic assumption of economics, marketing actions can successfully affect experienced pleasantness by manipulating non-intrinsic attributes of goods.”
Therefore, behavioral economics seeks to understand when and why people behave differently than what economic models would suggest. This is proven by one of the most popular experiments in behavioral economics called Ultimatum game. Briefly explained, the two players of this game decide how to share a specific sum of money. The first player is given all the money and further asked to suggest a method of sharing the money to the second player. If the deal is accepted by the second player, the players share the money as decided. However, if the second player does not agree with the deal, nobody gets any money. Unsurprisingly, the less equal offers are often rejected by the second player which contradicts the classical economic theory. The most rational decision the second player can make is to accept any offer since any sum of money is better than no money. This contradiction can be explained by the fact that human behavior is not only motivated by gain, but also by other aspects such as fairness and justice. The “Ultimatum game” shows that:
“If people were entirely rational they would consistently make the same decision given identical options, but sometimes people’s preferences are dependent on how the options are presented. This type of cognitive bias is called the framing effect.”
Plus, T. G. (2018, February 21). Retrieved November 07, 2018, from https://www.youtube.com/watch?v=8bMztDEOMi8
Spaniel, W. (2009, October 03). Retrieved November 07, 2018, from https://www.youtube.com/watch?v=xpkxLKV_3d0