Psychology of Economic Behaviour
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1 – Introduction to Economic Psychology: The Science of Economic Mental Life and Behaviour ......... 2
2 – Theories of Economic Decision-Making: Value, Risk and Affect ....................................................... 5
3 – Future-Oriented Decisions: Intertemporal Choice .......................................................................... 10
7 – The Psychological Meaning of Money ............................................................................................. 14
8 – Mental Accounting and Economic Behaviour ................................................................................. 17
9 – How Laypeople Understand the Economy ...................................................................................... 20
10 – The Citizen’s Judgements of Prices and Inflation .......................................................................... 23
11 – Materialism and the Meanings of Possessions ............................................................................. 26
19 – The Economic Psychology of Gambling ......................................................................................... 29
26 – Living in Poverty: Understanding the Financial Behaviour of Vulnerable Groups ........................ 33
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, 1 – Introduction to Economic Psychology: The Science of Economic
Mental Life and Behaviour
1.1 – Introduction
Contributions of economic psychology
- It provides economics with a realistic and insightful understanding of human rationality in
the economic domain.
- Both household and personal economic decision-making are becoming increasingly complex
and have significant consequences for our quality of life and psychological wellbeing.
- People’s thoughts and feelings about material possessions, money, prices, the economy and
inflation are at the core of economic mental life, and psychology of such things is fascinating
and worthy to study for its own sake.
Economic psychology: defining characteristics
- The science of economic mental life and behaviour
- A branch of applied psychology
- The study of ‘how individuals affect the economy and how the economy affects individuals’
- An interdisciplinary field of study
1.2 – The emergence of the discipline
From Adam Smith to George Katona
The origins of economic psychology can be traced to Greek philosophers and, more recently, to
seventeenth-century economists who reflected on psychological matters, notably Adam Smith.
- Adam Smith → explored the concept of self-love and the importance of being able to take
others’ roles, as in the social interactions necessary for trading.
- Jemery Bentham → characterized utility as the permanent hedonistic pursuit of pleasure and
avoidance of pain, along with calculations to maximize utility.
- John Stuart Mill → conceived the model of the homo economicus, a rational individual who
makes rational decisions that maximize utility, is self-interested, capable of learning from
experience, and with stable, consistent preferences.
Economic psychology as a discipline can be traced to the late nineteenth century. First article by
Gabriel Tarde.
- Tarde → claimed that economic phenomena demanded a minute analysis of the psychology
involved in them.
To some authors, modern economic psychology starts in the mid-twentieth century, with George
Katona.
- Katona → was responsible for some of the first large surveys of attitudes, beliefs and
expectations regarding economic behaviour. He created the ‘Index of Consumer Sentiment’
(ICS) that assesses people’s economic expectations.
Economic decision-making
Herbert Simon → fundamental criticism of the behavioural assumption of mainstream economic
theory, based on homo economicus, was that they were just that – assumptions; neither based on,
nor tested against, empirical data. Simon found that business people did not seek to maximize their
profits, as would be expected from standard economic theory. Rather, they set target levels above
which they would be satisfied that their business would be more than viable.
→ laid the ground for subsequent psychological theories of decision-making, such as
prospect theory.
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,Another major development in economic decision theory concerns choices between alternative
courses of action whose outcomes are distributed over time. These are known as intertemporal
choices. Koopmans developed a discounted utility model based on the rational principle that, other
things being equal, one should have a time preference for a positive event sooner rather than later.
Behavioural economics and economic psychology
Behavioural economics → the branch of economics that uses psychological concepts and theories to
better understand economic behaviour.
- The discipline was born of a interaction between Daniel Kahneman and Amos Tversky.
- Economic behaviour can violate homo economicus’s (expected) utility maximation principle
because people’s evaluation of the same good can vary, depending on whether they own it
or not. They explained this endowment effect in terms of prospect theory’s value function,
which assumes that:
o Economic outcomes are evaluated as gains or losses relative to a reference point
o People are loss averse
- The other key element of their explanation is that owners ‘frame’ the evaluation of the good
from a different reference point to non-owners.
- Behavioural economics has impact on public policy → vb. Organ donation
Similarities behavioural economics & economic psychology
- Both acknowledge many of the same historical roots, with both, for example, identifying
Herbert Simon as a founding parent.
- Both disciplines are essentially empirical sciences, placing a premium on the validity of
theories tested against behavioural evidence.
- Both are applied sciences motivated to develop effective support for individuals and society
in the economic domain.
Differences between behavioural economics & economic psychology
- Their main differences concern their ontological and epistemological assumptions and the
research ethics of their parent disciplines
Behavioural economics Economic psychology
Dominated by the approach to the Draws broadly on contemporary
psychology of judgement and decision- psychology, which includes the primary goal
making developed by Kahneman & Tversky of modelling mental life
Deems a narrower range of methods to be Is prepared to employ a more eclectic range
scientific, and requires data to be either of research methods, including the study of
from the real economic world or to be behaviour in realistic, hypothetical
motivated by meaningful incentives scenarios and a range of methods to elicit
self-reports
Deception is not acceptable Allow deception of research participants, as
long as an appropriate ethical code is
adhered to
Adopts a distinctive political position
concerning the role of interventions to
effect behavioural change, libertarian
paternalism
o Libertarian paternalism → those in power use behavioural economic research
findings to change the decision environment so that people are more likely to make
the decision that those in power deem to be in the people’s best interest.
1.3 – Research methods
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, Quantitative research methods have dominated economic psychology, although qualitative methods
have made important contributions, often within multi-method strategies.
1.4 – Economic mental representations
Money is a scale of economic value used across society to monitor and record balances of credit and
debt that are transferable to third parties.
- This definition focuses on the role of money as a tool to facilitate the practicalities of trade,
and in economic theory it is seen as an interchangeable tool usable in any economic
transaction.
- However, psychologically money is not completely interchangeable, since the way people
use money depends on how they mentally categorize it.
1.5 – Financial behaviour and economic activity
The quality of decisions to spend, save or borrow is central to the financial wellbeing of individuals
and households. There is a psychological framework that defines what it means to be a financially
capable citizen who makes informed decisions on such matters. It argues for a deeper notion of
capability that includes, in addition to appropriate knowledge and cognitive skills, people’s reflective
and automatic motivations and the social and physical opportunities that their environment provides
for capable action.
Understanding individual and household saving and borrowing is important to economists, since on
the aggregate level such behaviour affects the macro-economy.
1.6 – Life-span perspectives
The developmental framework of Bronfenbrenner can offer insights on economic behaviour.
1.7 – Economic psychology and society
Various characteristics of charitable causes influence donation behaviour, including the extent to
which those in need elicit empathy. Cognitive bias in charitable giving: singularity effect → the
finding that donations are greater when the target of help is an identifiable individual rather than a
group.
Poverty, generally defined as gap between the material resources people need to live and those they
actually have, clearly has a negative impact on subjective well-being.
Environmental problems are large-scale social dilemmas in which social norms may be used to
overcome some of the problems of financial incentives for behaviour change in the interest of saving
the planet – the ultimate societal challenge of our times.
1.8 – Summary
Economic psychology, the science of economic mental life and behaviour, is increasingly relevant as
people are expected to take more responsibility for their household and personal economic
decisions.
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