It is well known today that economics consists of many aspects of human behaviour and rational decision-making. Economics is compared to a social science which deals with; Human Rationality, Self-Interest and Utility Maximisation. It is about how we, as rational decision-makers, meet with our everyday needs, develop our happiness and well-being. In the past, it was said that all economic behaviour was human behaviour, however, in more recent times, this tends not the case. Not all people act rationally when it comes to decision-making.
The neo-classical view of human behaviour has been more recently controverted by a different view called; behavioural economics. Behavioural economics determines how individuals make economic decisions. Studies now suggest that a better devised model of human motivations is needed to explain behaviours such as; the way that people react to choices, and the ways in which people generally seem to act against their own self-interest. Instead of generating assumptions regarding human behaviour, behavioural economics relies more so on scientific experiments, such as; surveys, questionnaires etc…, to determine how people behave in different situations.
In this report, I will provide information on raw data collected from a random sample of twenty people. This questionnaire was carried out to test how two different economic concepts, in this case; Expected Utility Theory and Incentives , supported or contradicted the standard economic framework, and this will include a summary of the results gathered.
Concept 1: Expected Utility Theory:
As stated by Philippe Mongin; “Expected Utility Theory states that the decision maker chooses between risky or uncertain prospects by comparing their expected utility values, i.e., the weighted sums obtained by adding the utility values of outcomes multiplied by their respective probabilities”, (Mongin, 1988). This theory can be observed in the questionnaire, for example; Problem number two asks people to choose between two different options having already had €3,000. Option A; a sure loss of €750, and Option B; a 50% chance to loss €1,500 and a 50% chance to lose nothing. In this particular experiment, the majority of people chose option B. From this result, it can be noted that the neo-classical view of an individual’s behaviour is being controverted. This finding was surprising to me as it contradicted with the view that most people are rational and risk adverse, when in fact, people are more likely to compare and consider different choices due to favouring their preferences of satisfaction over the risks involved. Additionally, the graph below indicates a risk-taking individual.
The concept of risk and uncertainity was first brought forward by Frank Knight in 1921. Knight observed the world as constantly evolving and changing, but he also discovered that we as individuals have an imperfect knowledge of what the future holds. According to him, risk applied to situations where individuals were unsure of the outcome of certain situations but could accurately measure the odds. Whereas, uncertainty applied to situations where individuals didn’t know all the necessary information. Knight stated; “There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known”, Knight (1921).
This ties in with the concept of expected utility theory where an individual makes a choice which therefore maximizes their expected utility rather than their expected wealth. This concept was once again demonstrated in the questionnaire. For example; in problem number three, individuals were asked to choose between two different options, either A; a 95% chance of winning €500 or B; a 25% chance of winning €1,000. In this experiment, most individuals chose option A. Even though expected wealth was greater in Option B, individuals did not take the risk and instead, favoured maximising their utility by choosing option A. This result did not surprise me as it is most commonly assumed that individuals are risk adverse, as highlighted in the graph below.
Concept 2: Incentives:
The concept of incentives is hugely important in economics. “People respond to incentives”, Landsburg, (1995). Incentives are usually divided into three elements; Economic, Social and Moral. The most famous observation demonstrating the main concept of incentives is the idea of the demand curve. For example, when a certain product or service increases in price, the quantity demanded will therefore decrease. Similarly, when a certain product or service decreases in price, the quantity demanded will increase.
Relating back to the information gathered in the questionnaire, I observed that this law of demand seemed to be firmly believed by the majority of individuals ways of thinking. The power of incentives seemely took over. This can be noted in problem number four of the questionnaire. Here, individuals were asked if, in general, a certain product or service was to increase in price, would they buy more or less of it? More then half of the results suggested that individuals would buy less. This result was expected as most products and services obey the law of demand.
Howver, this is not always the case. Certain products and services disobey the law of demand, meaning, as the price of a product or service increases, its quantity demanded may also increase and vice versa. The reason for this may be due to the presence of designer, high-quality, expensive goods and services which are precived by most individuals as being of high exclusivity. Another reason may be that certain individuals act out of self-interest and become brand loyal to certain products and services. For example; problem number five in the questionnaire asked individuals to think; what if their favourite brand of cereal was to suddenly increase in price, would they then still pay more for their preffered brand, or instead, opt for a cheaper alternative? The results suggested that the majority of individuals would still buy their preffered brand even if the price increased.
Economic, social and moral incentives such as those demonstrated in the questionnaire, give us a greater understanding of an individuals way of thinking. Both incentives and utility maximisation are linked to peoples behavioural economic patterns. It is typical that individuals will try to maximise their incentives and minimise their dis-incentives at the least cost to themselves. When there are little social and moral dis-incentives however, individuals may try and cheat incentives to get free rewards. Getting incentives right is therefore crucial.
Overall, to summerise my findings, the majority of the results supported the standard economic framework. However, some of the results did, in fact, surprise me. For example; back in problem number two of the questionnaire. In this particular case, the results contradicted to the view of human rationality and therefore, challenged the Neo-Classical view of individual decision-making. In addition to this, I noticied that the responses from more educated and older individuals tended to contradict more from the standard economic framework with regard to the concept of Expected utility theory.
For the most part, however, I discovered that individuals seek to maximuse utility with regards to the concept of incentives and act out of self-interest. Most importantly, human rationality is not always guaranteed. As determined by the results in the questionnaire, individuals may not always be rational when it comes to decision-making. Bounded rationality, as discovered by Kahneman and Tversky, can also be observed within the findings of this report, due to the reason that individuals are flawed because people have biases, such as; patterns of deviation, and heuristics, for example; short-cuts in thinking.