Tag: Classsical Economics

Human beings are the epitome of what evolution has done with the earth. Starting from the stone age to the age of AI, we had a long journey of continuous adaptation. The development of various tools like weapons for hunting to the machinery for industrial development to the ginormous simulation engines to simulate space missions are to name the few. The common thing between all these tools is that these tools are made from the resources available around us. From developing the hunting spear from the stone and a stick of a tree to making the computer chips from the silicon from sand and stones, we have mastered the use of resources around us. This became possible only because of the development in our abilities to manage our resources, our techniques of handling the available materials which we can closely connect to economics. Barter system used for trading things, development of metal currency, then paper currency and now the cryptocurrency – the journey is phenomenal. Economics deals with how we manage the resources and we all are clear that these resources have one agreed medium of transaction called currency, money.

Most of the people perceive economics as a boring subject, where you develop some theories and mathematical models to predict money trends. The models may agree with some datasets, may break down at some points implying that the field is full of biases and assumptions which are far away from reality and understanding of common public. There is this joke about economists:

– Why did God create economists?
– In order to make weather forecasters look good.

Though the joke is really good, many great economists have really shaped our perception of money thereby resources and prediction of the interactions on personal, social and global levels. Today we will be discussing one such stream of idea which revolutionized the perception of new economics though the idea was already present deep down in the older and starting ideas of economics and psychology. Before that we will need some foundation to start with.

Classical Economics

Adam Smith also known as father of Economics has this book called “the wealth of nations” responsible for the development of Classical economics. Classical economics has following ideas:

Competitive advantage – success of any industry depends on how efficiently it uses its resources

Free market – defining the prices of goods by negotiation between buyers and sellers in an open platform without any intervention of government and without any monopolies leading to equilibrium between supply and demand thereby establishing fair price

Division of labor– Defining and separation of tasks will lead to specialization thereby leading to the efficient use of resources to optimize people to enhance their skills and economic interdependence.    

Then came the Neoclassical economics in 1900s which brought new school of thought which aligns with “the rational behavior theory” stating that people think rationally while making economic decisions. Hence, they are ready to pay the price of a thing/ resource based on the value it brings to them.

In simple words, the classical economics believes that the price of any product is dependent its cost of production. Whereas, neoclassical economics believes that the price of product is dependent upon the utility to the customers not its cost of production.   

The conventional nature of economics – the problem

For many years the main idea behind the theories in the economics is that the people are rational while making any decision related to money. Every person exposed to a product/service has well defined preferences and unbiased ideas and expectations. These unbiased ideas make people to choose whatever is the best for them.

These ideas in the conventional economics lead the economists to formulate and study economics mathematically as inspired from the physicists. Physicists theorized an idea and based on the mathematical principles developed models which can predict the nature and behavior of objects- from a ball to the motion of planets around the sun. Hence, in economics you will find many complicated mathematical equations and wild correlations (a correlation is degree of dependence of two datasets). One funny representation is as follows, somebody found out that the there is strong positive correlation between the pool drowning deaths and movie releases of Nicolas cage. So does that mean that people were so fed up with nick’s movies so that they preferred drowning over his films. Definitely No! I am a fan here.

Here is one more:

There was this funny correlation that the skirt length was related to the stock market movement called ‘the Hemline theory’. A theory saying that stocks prices move in the same direction as the hemlines of women’s dresses. For example, short skirts (1920s and 1960s) indicating bullish and long skirts (1930s and 1940s) indicating bearish markets.(!)

These are some of the reasons why the economists and their models remained part of funny discussions. This was one of the reasons why many economical models were applicable to limited datasets. The problem is not about the flaws in these ideas, the problem is that many big financial, political, life altering decisions were made based on such theories and models.

I mean these models were not completely wrong; nothing is perfect, there is always room for improvement.

Quest for establishing the correlation between human behavior and economic theories-

When economists were in the establishment of mathematical foundations of the subject causing their economics to reflect the equations and theorems, the psychologist directed their studies more towards experimental approach for the development of psychology. Their theories were more of verbal and theme based, that is also the reason why you can find psychology as a set of vocabulary itself.

Psychologists in some sense developed the ideas about how we interact with others and materials, resources around us. What affects out decision making when we interact with each other and things in our surroundings.

Some of the famous Psychologist had already tried to establish the connection between the ‘machine-like’ economic theories which strictly followed some equations and the real emotions, sentiments that make these economic models unfit with the reality. Their ideas helped us to find the reason why money does not strictly follow the strict optimized and high output giving trends. The reason does not lie in the money, it lies in the nature/ sentiments of the people who drive the money, the people who sometimes choose other things over money.

Richard Thaler, Daniel Kahneman, Amos Tversky, George Katona, Herbert A. Simon these are some of the notable names which have strongly influenced the ideas of behavioral economics.

The dawn (rather awakening) of the behavioral economics  

The basic idea of behavioral economics establishes that we humans make mistakes and most of our decisions are emotion and influence driven. People are not always rational. After are we are humans. Humans are flawed (!) hence don’t follow machine-like strategies. People love to mis-behave; they love breaking the rules.

Expected utility and Prospect theory-

According to expected utility theory in conventional economics, people will choose gambles which give highest outputs whatever may be at stakes. It says that, people take money related decisions based on the maximum future value it will bring to them, whatever will be the conditions. It’s like a person buying a lottery ticket.

If a person buys a $1,000 lottery ticket with $10 and the probability of winning is 10% then he thinks that the utility or value it will bring to him will be $1000 x 10/100=$100.

But you know how lotteries work. If the same ticket has winning probability of 0.5% the expected value becomes $1,000 x 0.5/100=$1,000 x 5/1000= $5, which is already less than the money it takes to buy that ticket. Here the expected utility is far less so the person won’t buy the ticket.     

The value of the lottery ticket became high due to the higher winning probabilities as the expected utility of that ticket is $200 over ticket price of $10.

In simple words, expected utility theory says that people take the chances and decide the value based on the its probability. More the probability of winning more it will be favored.

Kahneman and Tversky created ‘Prospect theory‘ which challenges the Expected utility theory. According to prospect theory it is not just about more probability and less probability of winning, it is also about the situation in which decision maker is; this called as a reference point. Other than winning or losing, a new condition is created which we can call as a reference condition. If the same lottery buying person is given the choice of

A. Getting $100 immediately

OR

B. Having 10% chance of winning the same $1000 thereby 90% chance of gaining nothing      

The same person will choose to get $100 immediately and walk off. Here the person did not choose the expected value of $100 rather, the person chose the instant benefit that he got, the person saw less risk in option A although the person may have won $1000 from the lottery, but chose to avoid the risk.

This is also famously known as ‘Loss Aversion’.

In simple words, losing $100 hurts more than winning $100. We as a human always try to avoid higher risks options and make ourselves safer. We always try to make the decisions closer to the reference points created by out experiences, assumptions. We try to “break even”.

Exponential discounting and hyperbolic discounting

According to exponential discounting (in classical economics), the value of any gain declines equally with time period it is delayed.

Here are two cases:

P. Getting $100 today over getting $110 after a week

Q. Getting $100 in 10 weeks or getting $110 in 11 weeks

A rational person will behave like an adult and will chose to wait for 7 days to get $10 more- just like a sincere (!) person. Whatever is the case- either P or Q the wait is same (waiting for 7 days) and gain is same (gain of extra $10) both the Case P and Case Q have same discounting rates, same rate of losing the value. This is exponential discounting

But what would you have done when provided with case P and case Q?

Behavioral studies show that people always go for instant benefit and chose $100 today in case Q whereas they are also ready to wait for one extra week if they are provided with only second case (Q) where the time-frame of gain is expanded. Means, people are selfish! They want this and that too. We always seek immediate rewards, instant gratification. No doubt social media is the living proof of this.  

Social Preferences

The behavioral economics says that people not only just care about what they are getting, they also care about what they are getting compared to others. (That might be the reason, your HR department instructs you not to ask for the salary details of your subordinates, colleagues, seniors!)

Consider a game where one person out of two people is said to divide $100 between them and they both will get those $100 if and only if the second person agrees to whatever share she/he receives otherwise, they both won’t receive anything. The rational choice for the second person is to accept whatever she/he would receive. Whether she/he gets $1 that too is acceptable because she/he had nothing ($0) before. Having something should be better than having nothing.

But in reality, and discovered from real life observations- people always try to reason with overall situations. People compare their gains with the gains of others, thus the above said second person in reality will only agree only if they both break even otherwise, she/he won’t accept the offer knowing that they both won’t get the money. This is really observed in studies and is funny.

Conventional economics considers people as a rational choice making machine. They always know what they are doing. It’s like for every human being is an economic optimization machine what economists call ‘Homo economicus’. Here people always make rational decisions, thus follow specific mathematical models based on a set of variables. Also, there is one idea called Becker conjecture which says that the people in the top management (politicians, leaders, chief directors, executives) always know what they are doing, they are always accurate on the probabilities of the outcomes. They always behave optimally.

In contrast, Behavioral economics established that humans are humans, they have emotions. They make mistakes and misbehave. They are not ‘Homo economicus’ implied as always thriving for optimizations. They are humans – ‘Homo sapiens’ implied as imperfect and prone to mistakes. There is no such human behavior where everything will cause to balance leading to establish equilibrium. There is always evolution when it comes to being human. They learn from their mistakes change themselves, adapt and evolve instead of being stagnant as in equilibrium.

(There are many interesting concepts in Behavioral economics like impact of Game theory, Supposedly Irrelevant Factors (SIFs), Difference between Equilibrium and Evolution, Roots of Behavioral economics in Classical economics, the endowment effect, social utility and those will be the topics for another day!)

References and further reading:

1. Misbehaving: the making of behavioral economics by John F Chaves (Psychiatry)    
2. Behavioral Economics: Past, Present and Future by Richard Thaler (American Economic Reveiw)
3. Behavioral economics: Reunifying psychology and economics by Colin Camerer (Proceedings of the National Academy of Sciences (PNAS))
4. Behavioral Economics Comes of Age: A Review Essay on “Advances in Behavioral Economics” by Wolfgang Pesendorfer (Journal of Economic Literature)
5. Adam Smith– Wikipedia
6. Richard Thaler– Wikipedia
7. Daniel Kahneman– Wikipedia
8. Amos Tversky– Wikipedia
9. George Katona– Wikipedia
10. Herbert A. Simon– Wikipedia

PS: One should really try to compare the concepts discussed here with the characters Walter White (As Classical economics) and Jesse Pinkman (As Behavioral economics) from Breaking Bad. You will get the idea, plus it will be fun!