Welcome to another episode of Apalla. In this section, we’re going to talk primarily about behavioral economics — a hot new trend in both psychology and economics that you’ve might have already heard about. But what separates behavioral economics from… you know… normal economics? Well, let’s dedicate our first episode to that exact question.
Traditional economics follows a rational model. The rational model states that people follow simple logical rules when making any resource-based decisions.
Now, we obviously know that there’s plenty of people out there who aren’t rational — the traditional economists knew that too. The problem for years, however, was what precisely was the difference between how the rational model worked versus how the actual model worked?
At some point, we came upon the model of behavioral economics. Behavioral economics has not yet solved all the differences between these models, but they have made some impressive headway in terms of getting closer to an ultimate solution. Here are three of the main differences that have been solved thus far:
The first is that actual humans have non-standard preferences. Rather than always preferring the highest long-term value option for them, people tend to also prefer based on social preferences and time preferences. For social preferences, we might use the example of reciprocity, where a person feels guilty after being given something by someone and feels a need to rectify that guilt. This guilt does not exist in the traditional model, where there is no real reason to give anything back. For time preferences, we notice that people tend to go for short term, present solutions over long term ones. This also conflicts with the rational model, as oftentimes longer term solutions grant more resources.
The second is that actual humans have non-standard beliefs. The rational model states that people only work within the scope of information that they have, and know to be true. This, of course, isn’t the reality. We have plenty of mental biases that we fall into — two particular examples are overconfidence, where people have an overestimation of their own abilities or information, and the law of small numbers, where people incorrectly extrapolate a small sample to the whole population.
Finally, it is such that actual humans follow non-standard decision making. As mentioned previously, the rational model has people following simple logical rules… but even that isn’t true! There are just as many decision making biases as there are belief biases. Some examples: framing, in which the understanding of evidence and results depend on how they’re presented, and heuristics, which are rules of thumb to reach answers more quickly. That last one in particular is going to become important next week, when we talk about the key ideas of behavioral economics. Stay tuned!