Why is it important for economists to study psychology

danicon1_s.jpgIn conventional economics it is assumed that we are all rational — meaning that the decisions we make are the perfect decision for us. How do we achieve this feat? What standard economics assumes is that every time we face a choice we consider all the available options, compute the value of all the options, perform a cost benefit analysis, and then follow the best possible path of action. What if we make a mistake and do something irrational? Here, too, traditional economics has an answer: “market forces” will sweep down on us and swiftly set us back on the path of righteousness and rationality.

But, what if we are really far less rational than standard economic theory assumes. What if we can’t compute the discounted value of money, consider all the possible options, or figure out how much a new car is really worth to us? Shouldn’t our models of individual behavior, and more importantly our recommendations for new policies and practices, be based on what people actually do rather than what they are supposed to be doing?

More...The desire to base the models that guide policies and business practice on the way people actually behave seem to make intuitive sense, but nevertheless, behavior is largely ignored by standard economics. And what are the implications of this for economics? As the economist, John Maurice Clark noted many years ago:

“The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature… If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology.”

This is what behavioral economics is all about. The desire to modify standard economics to take behavior into account. To move it away from naive psychology (which often fails the tests of reason, introspection, and-most importantly-empirical scrutiny), and turn it into a study that encompasses the complexity of human behavior, and more importantly making it better suited to make recommendations that would help saving, education, healthcare etc.