Updated: Mar 11, 2020
by Sherin James
Economics traditionally conceptualizes a world populated by unemotional, selfish optimizers that have, lovingly, been dubbed as Homo Economicus. The economics we are taught today is replete with assumptions – just as any other science – such as assumptions of a being called Homo Economicus. There are three basic assumptions that we work with right from the beginning – rational consumers, profit maximizing firms and competitive markets. Although the idea of perfectly competitive markets is usually weaned out right in the earliest stages of ‘taught’ economics, the first two assumptions continue on unquestioned and hence, unchallenged. Economics is for Homo Economicus – a being with unbounded rationality, will-power and self-interest.
But that isn’t always true. The simplest example is the first economics class where the concept of sunk costs was introduced – a concept taken to be true by economists almost for granted. Basically, sunk costs are costs which are irrevocable and no matter what you do you can’t get back the price you paid for it – be it time, health or just simply money. The concept goes on to tell you that you shouldn’t consider these costs while making decisions and as a consequence everyone who does just falls out of the economic framework because the rationality carpet just gets pulled from beneath their feet. This leads to skewed market results and failing economic models lead to catastrophic results. So, just as mainstream economics is taken on broad, general implications of market failures arising from externalities, imperfect competition and information asymmetry suggest that our analysis should include potential failures because the agents operating it aren’t perfectly rational.
The realization of human weaknesses isn’t just dawning. The possible effects of assuming unbounded rationality, selfishness and immaculate information processing capabilities have long come under scrutiny. One of the earliest critics of the latter was Herbert Simon (1955). He suggested the term “bounded rationality” to describe a more realistic conception of human problem-solving capabilities. As stressed by Conlisk (1996), the failure to incorporate bounded rationality into economic models is just bad economics. Since we have only limited brainpower and limited time, we cannot be expected to solve difficult problems optimally. It is eminently “rational” for people to adopt rules of thumb, commonly called heuristics, as a way to economize on cognitive faculties. Yet the standard model ignores these bounds and hence the heuristics are commonly used. As shown by Kahneman and Tversky (1974), this oversight can be important since sensible heuristics can lead to systematic errors.
Departures from rationality emerge both in judgments and in choice. The ways in which judgment diverges from rationality is long and extensive (Kahneman, Slovic and Tversky, 1982). Some illustrative examples include overconfidence, optimism, anchoring, extrapolation, and making judgments of frequency or likelihood based on salience (the availability heuristic) or similarity (the representativeness heuristic).
This departure from economic assumption can very easily be demonstrated by hundreds of examples but for the sake of common understanding, take overconfidence. If investors are overconfident about their abilities, they will be willing to engage in trade even when true information isn’t available. This helps explain a major anomaly of financial markets. In a market where rationality is present, there would virtually be no trading. Trade would happen in light of substantial, hard evidence of a company’s strengths and weakness which could go in one direction only for the shares of the company, but in actual markets there are hundreds of millions of shares changing hands daily, with countless buying and selling the same at a given instant. Individual investors trade a lot, they incur transaction costs and yet the stocks they buy subsequently do worse than the stocks they sell.
The failure to process information and reach the perfect conclusion from analysis isn’t the only human flaw. After determining the optimum, Homo Economicus is next assumed to choose the optimum. Real humans, even when we know what is best, sometimes fail to choose it. Be it the later regretted impulse buy, the calorie laden chocolate cake, the missed early morning lectures or just stretching the assignment deadline, there are countless moments where despite knowing the optimum we don’t choose to follow it.
Another major Flaw of the Homo Economicus is unbounded selfishness. Although economics doesn’t rule out altruism and charity, it only manages to define it within the purview of self-interest – we are charitable when we hope to gain something to our own benefit from it. As Olson (1965) noted, ‘people are sometimes motivated by a desire to win prestige, respect, friendship, and other social and psychological objectives’, altruism, for economists, was not self-sacrificing for others’ needs. But, this doesn’t explain some of the demographic from the World Giving Index. In 2013, Burma was the country with the largest proportion of people donating money to a charity (85%); more people donated money to charity in India than anywhere in the world, with over 244 million people having donated, and we’re talking of a country with low income. In matters of self-interest, sometimes a nicer car furthers your social standing more than a charitable donation. Volunteer work is also rising and even simple things like giving up your seat in the metro falls beyond the self-interest assumption.
In order to account for these problems and many more, the branches of behavioral economics and neuro-economics were established. Delving into these branches of economics, social scientists have established three main counter-points to the faulty assumptions – bounded rationality, bounded willpower and bounded self-interest. Bounded rationality reflects the limited cognitive abilities that stand in the way of human problem solving. Bounded willpower captures the fact that people sometimes make choices that are not in their long-run interest. Bounded self-interest incorporates the re-assuring fact that humans are often willing to sacrifice their own interests to help others.
Research showed that Economics, Psychology or Neuroscience couldn’t be propped up on their own in understanding human science. Economics makes the rationality assumption, psychology studies behavior, analyses it and then uses this analysis to define behavior (also called the Circular Reasoning Problem) and neuroscience just looks at the cellular level to understand human behavior, ignoring the necessary social context. All three require support from the other to counteract its own set of limitations and assumptions. But with a comprehensive view of all three in mind, better and more holistic models can be drawn up with lesser chances of failure.
Colinsk, John, Journal of Economic Literature Vol. XXXIV (June 1996), pp. 669–700, Why Bounded Rationality? http://www2.wiwi.hu-berlin.de/institute/bier/conlisk.pdf
De Bondt, Werner F. M. and Thaler, Richard, The Journal of Finance, Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul.,1985), pp. 793-805, Does the Stock Market Over-react? http://efinance.org.cn/cn/fm/Does%20the%20Stock%20Market%20Overreact.pdf
Amos Tversky and Kahneman, Daniel,Science, New Series, Vol. 185, No. 4157. (Sep. 27, 1974), pp. 1124-113, Judgment under Uncertainty: Heuristics and Biases http://psiexp.ss.uci.edu/research/teaching/Tversky_Kahneman_1974.pdf