We know how often we use the ‘Assume a Can opener’ catchphrase to mock economists who base their theories on assumptions that might or might not have real-life applicability. The joke goes around about a physicist, a chemist, and an economist who were stranded on a desert island with no equipment and a can of food. The physicist and the chemist each suggested a technique for opening the can while the economist merely said, “Assume we have a can opener”!

Of these many economic assumptions, we also assume that people behave rationally! Behavioral Economics doesn’t choose this as its starting point. Rather than expecting people are rational and take the implications of that, Behavioral Economists have no prior belief and see how people behave, by putting them in fields and labs. And because people often don’t behave rationally in such situations, the implications are very different from that of standard Economics. It thus addresses the fundamental flaw of non-behavioral Economics, its highly constrained idea of rationality, and tries to bring together economists’ powerful analytical tools, traditionally applied in a restricted way to unravel the economic incentives and motivations driving us all. 

 

The intersection of classical economic theory and recent behavioral insights and social psychology is what we have in mind when we speak of “behavioral economics.” The sub-discipline being less than 50 years old is growing out largely. Now, why is that so? Because behavioral economics combines a unique collection of insights from social science. It brings together economists’ powerful analytical tools alongside plentiful evidence about real human behavior from other social sciences—especially psychology and sociology to unravel the economic incentives and motivations driving us all. 

“Governments are embedding behavioral insights into policy. Commercial businesses are using it to inform their marketing strategies. Lessons from behavioral economics are informing relationships between employers and employees. Even in the silos of academia, most applied research teams—most obviously other social scientists but also natural scientists, from neuroscientists through to behavioral ecologists, computer scientists and engineers—are keen to bring behavioral economists into the multidisciplinary teams so that they can connect their research with insights from behavioral economics.”- Michelle Baddeley from the University of South Australia says.

 

Now, even though the curiosity for this frontier of Economics has bubbled up in the past five years or so, the breakthrough took place about fifty years ago when Daniel Kahneman and Amos Tversky started to take on the neoclassical doctrine of rational, self-interested behavior. It turned out to be a destructive process when the two psychologists showed how humans systematically behave differently than homo economicus (an ideal decision-maker) would in a range of situations. Kahneman and Tversky demonstrated that humans are not perfect Bayesian agents, rather we fail to evaluate scenarios on a stand-alone basis and instead have in mind some reference point, have strong preferences to maintain the status quo, and consider sunk costs to be important in our decision making. Later in the early 2000s, young economists such as Richard Thaler and Ernst Fehr called into question the foundations of some of the most prominent theorems in economics. As Thaler described the sub-discipline as “economics done with strong injections of good psychology.”, he argued to make economic decisions more accurate simply with the help of cold-headed logic and realistic assumptions. Additionally, Ernst Fehr did a lot to show that humans care way more about their fellow man than homo economicus does. After providing enough pieces of evidence against the classical economic theory, the early Behavioral Economists started looking for patterns in the violations of the economic theory they had observed in order to develop alternatives to homo economicus. The most notable theory that emerged is Kahneman and Tversky’s Prospect Theory, which embraces some of the most distinct features of human decision-making, for example, humans are loss averse, i.e., losing 100 rupees will bring me more pain than gaining 100 rupees. Behavioral economics also strongly holds how some of the most prominent theorems of economic theory do have considerable explanatory power even though their assumptions are often violated. Consider, for instance, the First Welfare Theorem. It states that a free market will lead to a Pareto efficient allocation under some assumptions, such as no transaction costs, completeness of contracts, and perfect information. In reality, search costs can be high, contacts are usually far from complete, and asymmetry of information is instead a norm than an exception. Still, everyday economic activity goes ahead relatively smoothly, and this is not despite but due to the fact that humans are not selfish maximizers of utility. As Kenneth Arrow once put it, every economic transaction requires a modicum of trust — and countries, in which citizens do not have this minimum level of trust in each other, tend to do very poorly economically. This, of course, can only be understood by embracing Behavioral Theory.

So even though Behavioral Economics fails to provide a better understanding of how economies work as a whole, the most striking testimony of the acceptance of Behavioral Sciences into the mainstream is probably its growing influence on policy (through advising the policy-making teams of the then US President Barak Obama and the establishment of a “nudge” unit in Cameron’s Cabinet Office spawned the growth of similar units around the world—from Australia to Lebanon to Mexico, to name just a few), academia and numerous other fields which brings us back to our initial point about how fast it is growing. With so many nudge units in place across the world for understanding people’s behavior while making a decision and using these insights to establish policies, it becomes increasingly important for India to have one, especially in the education and public policy sector. But often and MBA or core Economics student is preferred by industry. Indians have more faith in numbers despite Behavioral Economics being more data and analysis-driven field. 

Whilst Behavioral economics can make a significant contribution to overcoming the limitations of Neo-classical economics, it is not necessarily a solution. In our complex world where uncertainty is the new normal, we cannot use a ‘one size fits all’ model for understanding the economy. Behavioral Economics is not a solution, but, as Paul Ormerod has argued, “An economist can no longer be said to have good training in economics if he or she is not familiar with the main themes of behavioral economics.”