Early economists coined the idea of homo economicus, economic man. They believed that people are rational self-interested beings in the marketplace. This idea was challenged at the end of the 20th and beginning of the 21st century. Why did this happen?
The Non-Rational Human
There’s little doubt that we are not fully rational in all the elements of our lives. It’s also certainly true that we are not entirely self-interested. But the notion of homo economicus functioned in microeconomics as one of Max Weber’s ideal forms; it was an idealization that was close enough to reality. The argument went that it could be used as a meaningful lens through which to make sense of what we see in the marketplace. Empirically, it was contended, this idealized idea of rational homo economicus worked well enough that it’s how we ought to think of ourselves.
But are we really like that? That’s a scientific question. Modern psychology has shown that often we make decisions based on completely non-rational bases. Our amygdala will lead us to instinctively act, and our rational brain catches up later, filling in the blanks in the story about how we reached a decision to act through thoughtful deliberation.
The truth is that we’ve often acted before we thought—there’s certainly a reason why the checkout lanes at the grocery store are filled with candy. Economists have shifted gears in order to catch up with psychological research, giving rise to what’s called behavioral economics. Humans do not make rational decisions when it comes to financial matters. Indeed, we’re programmed not to.
This is a transcript from the video series Redefining Reality: The Intellectual Implications of Modern Science. Watch it now, Wondrium.
In 2014, lottery sales in the United States topped $70 billion. No one plays the lottery because it’s in their rational best self-interest. You are more than likely going to lose your money. The lottery is stacked against you. Indeed, that’s the point; states have lotteries to raise money. They know it’s a bad bet, which is why they let you make the bet in the first place. But we play, to the tune of $78 billion.
Advertising is not based in rational argumentation. What gets you to choose one brand over another is not based on rational calculation. Once you’ve selected a particular product one time, odds are you’re going to select it again. Brand loyalty is a real phenomenon. We are creatures of habit and if someone can help us establish a certain habit, we will turn to that product even if it would make rational sense to switch. We make charitable donations; we give our money away. Surely that isn’t self-interested, even if we do claim a tax deduction.
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Inherent Cognitive Bias
We will violate our self-interest out of principle or out of spite. There are times when we will forego an economic exchange because we object to something the other party has done or stands for. We steer clear of shops whose owners we have a legitimate or illegitimate bias against, even if it would be in our own best interest to buy from them.
The effects of social psychology—groupthink, cognitive biases which cause us to stereotype those unlike us, and comparative optimism which makes us irrationally expect positive outcomes––are all in play when we look at financial activities.
Sociological aspects are involved as well. The personal savings rate in the US in 2014 was 4.1%. In Switzerland, the rate was 13.1%. What accounts for this difference? Surely, we can’t explain that difference using a universal model of humans as rational self-interested.
Experiments in Simulated Economies
Behavioral economists set up controlled experiments. Using computer simulated economies, they can see if certain sorts of behaviors recur, with what frequency, and in what populations.
For example, computers can be used to set up an eBay-like marketplace where test subjects are given fictional products and an amount of money to spend. Participants will be told that they’ll walk away from the experiment having been paid for their time, and the amount they are paid will be determined by how well they do in the fictional marketplace. This makes the test subjects truly self-interested and goes a long way in guaranteeing that the subjects will take the experiment seriously.
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Status Quo and Availability Bias
In these set-ups, behavioral economists look for effects like the status quo bias. We will often forgo rational risks in order to play it safe, to protect what we already have. It seems that we have an innate bias to protect against loss, even when we’re giving up better opportunities for likely gain. We resist change out of fear that the unknown will be worse, even if we have good, rational reason to believe it’ll be better.
Another bias is the availability bias in which events that are vividly imaginable are deemed more likely to occur than they actually are. If you watch television detective programs like Law & Order you’re affected by intense visions of crime, and one effect is that you make irrational financial decisions based on a false notion of how likely you are to be a crime victim yourself.
Complex Human Behavior
How do we account for these effects in our understanding of markets? The ideal form of homo economicus was nice in that it allowed us to set up a situation that was easily modeled, and from which we could generate equations that govern economic phenomena.
But as science has progressed, we realize that the world it describes is not our world. Science itself—social psychology and sociology—has provided new data and a new picture of the human.
This is a more complex creature and that’s a better representation of us. It does away with the idea of a perfectly rational and completely self-interested human that classical economists thought was essential to make economics a science. It replaces that with a picture of a human being that’s messier, more complicated, and often mistaken. While this new picture may be less flattering, it also gives us a more accurate sense of the reality of markets, both local and global.
Common Questions about Homo Economicus
The idea of homo economics is that human beings in the marketplace always operate purely out of rational self-interest.
Modern psychology has shown that often we make decisions based on completely non-rational bases.
The experiments of behavioral economists reveal effects like the status quo bias. We will often forgo rational risks in order to play it safe, to protect what we already have. Another bias is the availability bias in which events that are vividly imaginable are deemed more likely to occur than they actually are.