Why in news?
Recently Richard.H.Thaler, an American received Nobel Prize for his behavioural Economic theory.
What are economic theories based on?
- Most economic theories are based on a certain set of assumptions without which it would be difficult to talk in a coherent fashion about any theory.
- These assumptions simplify the complex everyday reality.
- So an economic model could assume that economic agents have perfect information or that the transaction costs are zero.
- In a similar vein, one of the dominant assumptions has been about economic agents being rational.
- That is to say, they only act in self-interest, but often there are gaps between the behaviour as predicted by the model and as it is in reality.
What is the finding of Thaler?
- He has refined economic analysis by taking into account three psychological traits
- Limited rationality - It underlines that it isnot realistic to assume that individuals could be completely rational and think of all possible effects of their choices.
- Thaler built on this insight to come up with his theory of mental accounting, which describes how people organise, formulate and evaluate financial decisions.
- For instance, this tendency to create separate mental accounts for day-to-day expenses and holiday expenditure explains why individuals might not dip into their long-term savings and instead use a credit card to tide over some imbalances in daily expenses.
- Perceptions about fairness - Full rationality assumption of traditional theories cannot explain behaviour when it deviates to accommodate an individual’s sense of fairness.
- Through large experiments, Mr Thaler shown how people can set aside personal gain and concern themselves with questions of fairness.
- For instance, Consumers judge negatively a company which is seen to be unjustly raising prices in times of pressure.
- Lack of self-control -Actual human behaviour has shown that people may, contrary to notions of rationality, choose something that goes against their interest.
- For instance, a smoker who chooses to yield to an immediate temptation instead of favouring better health in the longer term.
Why is Thaler’s contribution significant?
- His contribution goes to the very heart of economic modelling and has a profound impact on many areas of economic research.
- Since field of economics concerns itself with how human behaviour explains the deviations from the established theoretical model, it has wide-ranging impact.
- Studying the so-called “irrationalities” has implications for
- Financial behaviour - Something like unjustified market volatility
- Marketing - The “buy two get one free” schemes providing a sense of having gained.
- Public policy making - Wherein politicians “nudge” individuals towards a societal improvement.
Source: Business Standard
