Notes Psychology of Economic Behaviour
Meeting 1 – 08/02/2018 – Thinking like an economist
This course brings economy and psychology together. It’s about how psychology can add to the
explanation of economic behavior, economics as a field, and how economics can add to psychology. If
we want to understand behavior, economists have some idea about this, and we as psychologists have
some ideas about this. We now even have a field, behavioral economics, which combines these
insights. The entire field is growing, thanks to Kahneman amongst others.
The aim of this course is to know more about economic behavior. It’s a lot more than just buying, it’s
about saving, investing, etc. What do we do with our money? Should we invest in a bitcoin? Should we
save our money? This is totally influenced by psychology!
The exam is april 10, USC, 13:00 – 16:00. Make sure you register to this exam ☺. These are open-ended
questions and are based on the readings of each week. If you know the theory and the main insights,
he asks examples about these readings. E.g. “what explains savings according to this and this author?”
This course builds up: it starts with main assumptions from economy and see where psychology can
add. Today we focus on the basics of economy – and see that many assumptions are too simplistic! It’s
not that they are stupid, but there’s more to it than meets the eye. Psychologists keep adding things,
which makes the theories very complicated – there’s an advantage in having a simple model like
economists do. You have a simple answer, and you have an answer!
Thinking like an economist
The way economic theory works is based on a set of assumptions. To understand these assumptions
you need to go back to who put them in economic theory. Economic theory was dominated by Adam
Smith and Carl Menger.
A book Adam Smith (1776) wrote was the “Wealth of Nations”. In that book he introduced a lot of
concepts that come to dominate the field. One of these was being a rational economic man. He wanted
to know what would happen if everybody would only work towards his/her own advantage He said
that would be the best for everybody. Why would that be the best? There is kind of an invisible hand,
if everybody only thinks about their own advantage, the invisible hand, which is the market
mechanism, will see there is no problem. We will live in a world without unemployment. If you have
some people who want to offer their labour, and there are many people offering their labour while
there is only a little bit of demand for it, the market mechanism will make sure that those who offer
the labour will have to lower their demands, the wages have to go down, and then the demand can be
high enough to ensure there is no unemployment. He had very much faith in this market mechanism.
That was a bit too optimistic… However, it is still in economic theory, that economic actors only think
about themselves. Economists do see that some people do something for others, but they are working
with these assumptions. It describes what should happen, or what’s best, but the assumptions are a
bit too simplistic – they do not really describe the economic actor. We have to understand the decisions
we make, and there comes psychology into play.
Carl Menger (1871) started putting in some psychology. He wrote the book “Grundsätze” and
described utility for the first time. Utility is a psychological concept. It acknowledges the utility might
be different for different individuals; some might value a product more or less. He also talked about
motives, he distinguished different motives. Not just that we want to have as much as possible, but
distinguished motives. Like Maslow, who distinguished a hierarchy of motives: first of all people want
to secure their basic needs. When that is completely satisfied, you move on to next levels, and end up
,at level 5, self-actualization. Menger had the same idea, but possibly even a better idea. He had a
model and talked about that you have some things that have to be satisfied first, and when that is
satisfied you come to increasing levels (like Maslow). You need to be satisfied, before you can think
about other things. He says: level 1 is food, and level 5 is tobacco. First of all, we are motivated to have
enough food. You start from 1 and try to reach point 10. You start satisficing that level until point 10
and then already look to level 2. You satisfy level 2 until you come to point 9; then. Then already you
start looking at the next level. It’s a bit more subtle
than Maslow, who says you need to completely
satisfy one level before moving on to the next.
Menger says you can satisfy it to some extent, and
then you can already move on to the next level.
Menger acknowledges you don’t have to satisfy it
completely, you can also have it partly satisfied in
order to look at the new level. So, it is more subtle
than Maslow. (Note: this picture will not be on the
exam).
Van Dijk also introduced this picture because he introduced the idea of utility, which is a psychological
concept. Now, if you take this any further, you go to micro economics.
Micro-economics
Adam Smith was concerned about the entire society. He was interested in macro-economics. You also
have micro-economics, which focuses more on the insights, on the utility. And they can help us
understand individual decision making. According to the rational consumer theory, you can know
exactly what somebody is going to do when you know somebody’s preferences, income, and the prices
of all things. You can then create an indifference curve, which displays two things (all economic
theories do this. It’s not that you don’t care about other things in life, but it is for the model). This is
used to map your preferences. For example, books and CDs. It
shows all the combinations of Books and CDs that have the
same utility to you as a person. For example, if you look at the
lowest curve, you see the combination of 5 books and 5 CDs fall
on this line; or 10 CDs and 2 books. You are indifferent to these
combinations that fall on this line; you are indifferent. You
couldn’t care less which combination you get, you will be
similarly happy.
You always aim for the highest indifference graph; each curve further away from the origin has a higher
utility to you. You rather have 6 books and 6 CDs (middle graph) than 5-5: the middle graph has a
higher utility. According to economic theory, this is what your preferences look like. It acknowledges
that the exact shape will differ for individuals (some like to read more, some like to listen to music
more), but for each individual it will look something like portrayed in the picture: there are different
curves, higher curves have a higher utility and each curve will have this shape.
About the shape; it’s a negative sloped line. It has to go like this, because otherwise the utility cannot
be the same. If you have more of the one, you should have less of the other to have the same utility.
If you get offered more CDs and you want to stay on the same utility line, it means you should have
less books (otherwise you become happier with it and your utility goes up; you move to a different
line).
It’s also slowing down, it’s convex. That means that the more CDs you have, you are more reluctant to
give up a book in order to add one more CD. If you have many CDs, what does it matter to have another
one? To go from 1000 CDs to a 1001 CDs, you don’t want to give up another book – you almost want
to give up nothing. This is because it adds so little if you already have a lot.
, Properties of an indifference curve:
1. The further away from 0, the higher the utility
2. It has a negative slope, this is because you’re dealing with substitution. If you have more of
the one, you should have less on the other
3. Convex to 0: the more X you have, the less value you put on increasing X (the less of Y you
want to give up for that). If you have enough CDs, you don’t want to give up a book to add
another CD; adding one more doesn’t give you a lot more utility, so you’re reluctant to give it
up.
So, in such a simple graph are a lot of assumptions. According to economic theory you can now know
what people are going to do, if we know how much money somebody has – their budget. If you know
what you can afford, you can draw a budget line. For example, if books and CDs all cost 10 euro, and
you have 100 euros, you can buy 10 books and no CDs, 10 CDs and 0 books, or 5 books and 5 CDs. You
can map that in the graph and see what combinations fall into your budget. You can achieve everything
that is at or below your budget line. Everything above it, is not reachable for your budget.
Then now, we know the budget, we know the prices and we know the preferences (indifference curve).
According to economic theory you can now predict what somebody is going to do, because of the
simple fact that people are egoistic (go for themselves) and also individuals want to maximize: you
want to reach the highest utility curve you can reach given your budget. Even though you know there
might be higher curves out there, you know you cannot reach them.
It’s a nice theory, a nice model. But then you have to ask the question: was this the way you made your
decision? Did you know your utility curves, your budget line, all possible utility curves, that you wanted
to maximize? Probably not… then, you have a nice model which shows how people make their
decisions, but it’s not how the decisions are actually made. The assumptions that the model of rational
economic man is based on, looks like something that resembles us. It may look like us, but he’s not us.
He’s from somewhere else and has powers we don’t have. He’s like superman! But we are different.
And that’s what this course is about. We are not superman. This model does not keep into account
whether we have all the information, whether we actually try to maximize, whether we’re only self-
interested (greed). It also does not take into account our stable preferences (which actually change),
habits and our emotions, while many decisions are driven by these factors. These lack in economic
theory, and need to be put in there to understand behavior. That is what this course is about.
Greed
Greed means that we always want more. Seuntjes et al., (one of the articles from this week) investigate
how widespread this phenomenon is. They show that there are individual differences: some people
are more greedy than others. They say: you have a disposition for greed.
In the beginning of the article, they distinguish greed from different things. Greed is distinguished from
▪ Maximizing – You want to have the best deal, the best outcome at the end (net results). Being
greedy sometimes puts people into settings where they don’t maximize, even hurt themselves
actually! Wanting to have / having more of everything does not mean you are maximizing the
utility. It’s not the same!
▪ Materialism – Their idea of what greed is, is also not the same as materialism. We can be
greedy on many aspects, it’s broader than money! You can also be greedy in the domain of
sex, for example. Some example have the disposition to be greedy on a lot of different
domains, that’s what they want to show in the article.
▪ Self-interest – Self-interest comes into play only when there are other people involved, and
you put your own interest first. This is also different from greed!
▪ Envy – The same goes for envy, which is also about comparing to other people and not about
wanting more yourself – it’s not the same!
