Economics has traditionally assumed rational human behavior, but psychological research shows that people often make irrational choices in economic decisions. This research is changing the methodology of economics and deepening our understanding of human behavior.
Every day, the media talks about investor psychology to explain movements in the stock market or real estate market. People buy when they expect the stock price to rise, and sell when they expect it to fall. This shows that economic activity is not just driven by numbers and statistics, but human emotions and psychology play an important role. However, economics doesn’t teach us much about psychology. This is why many people were puzzled when the Nobel Prize in Economics was awarded to a psychologist named Daniel Kahneman in 2002. What do economics and psychology have to do with each other?
Of course, it is well known that the economics of John Maynard Keynes, who emerged in the 1930s during the Great Depression and modified the laissez-faire philosophy, was based on reflections on human psychology. He argued that economic activity is not just driven by rational calculations, but also by human psychology, which is sometimes irrational. Keynes specifically used the term “animal instinct” to explain that economic decisions are heavily influenced by emotions, intuition, and fear of uncertainty. However, John Maynard Keynes did not delve into the science of human psychology per se; he emphasized that our decisions are always made in the context of uncertainty about the future, and that the uncertainties we face are often difficult to identify even probabilistically. He believed that it is human nature to make choices even when we don’t know what will happen in the future, and that is why human behavior is sometimes intuitive and sometimes impulsive, rather than rational as economics assumes. Business investments, he thought, were influenced more by the entrepreneur’s animal instincts than by interest rates. However, while his ideas may have gained traction among economics students, emphasizing the importance of human psychology, they did not go far enough to change the rationality-based approach to economics.
However, the work of probability cognitive psychologists such as Daniel Kahneman changed the methodology of economics. They found that people are very prone to rely on subjective reasoning when making judgments about probabilities. For example, when judging the probability that A belongs to B, we are more influenced by how much A resembles B than by information that affects the actual probability. Or, the easier it is to recall a specific example of A, the more likely we think it is that A will occur. These findings suggest that humans rely heavily on experience and memory when making judgments, rather than simply following a rational, logical process. It also suggests that while we adjust our assessments as new information is added, our final estimates tend to lean toward our initial assessment. This subjective reasoning is a convenient way of cognition, but it is also prone to systematic biases and serious errors.
Building on these findings, the researchers moved on to critique existing perceptions of rational human behavior, one of which is the inconsistency between decisions about gains and decisions about losses. Through a wide variety of experiments, they found that people are risk-averse when faced with gains, but risk-preferring when faced with losses. While this behavior is understandable, it contradicts the most central assumption of rational behavior under uncertainty: consistency in attitudes toward risk. Daniel Kahneman and others have interpreted these experimental results as showing that people are not risk averse, but rather loss averse. This is because losses always seem bigger than gains.
These findings suggest that economics cannot fully explain human behavior with simple mathematical models and assumptions of rationality. Humans are not mechanical beings trying to maximize profit, but rather make emotional and sometimes irrational choices. These studies have had a profound impact on economics, which has long dealt with social phenomena based on certain assumptions about rationality. These studies call for starting from observations of human behavior rather than assumptions about it. It will be interesting to see how and if psychology will change economics.
