Essay

Even when people have precisely the relevant facts at their fingerprints, they often fail to make decisions consistent with the rational choice model. Give an appraisal of the previous statement, focusing on the reasons why people sometimes behave irrationally. Choose and evaluate an alternative model that may be consistent with this irrational behaviour.

Even when people have precisely the relevant facts at their fingerprints, they often fail to make decisions consistent with the rational choice model. Give an appraisal of the previous statement, focusing on the reasons why people sometimes behave irrationally. Choose and evaluate an alternative model that

may be consistent with this irrational behaviour.

First of all, to interpret this question correctly, we have to understand the difference between what is rational people behaviour and what is irrational. So, what is the rational behaviour? If trying to explain it in just a few words and in a way that it is understandable for most of people It is people decisions made which are correct according to classical economic models. In other words according to standard decision making models consumers always try to maximise their utility ( 'Utility Maximisation The device of explaining choice in consumption and labour markets by assuming that individuals have utility functions which they attempt to maximise.' (A Dictionary of Economics, 1997). Therefore we can understand that the rational behaviour can be explained as a behaviour when every person acting is based only on self-interest, self-control and rational. Or as Richard H. Thaler has explained standard model of economics of human behaviour includes at least three unclaimed traits: 'unbounded rationality, unbounded willpower, and unbounded selfishness' (R. H. Thaler, 2000). Another question that is much more difficult to answer and that needs deeper explanation of the previous question is Why do people act 'irrational'? Or Why and When do people act 'irrational'? I will try to answer the following question through the whole of this essay while using some examples and mostly basing my answers on interpreting and using Matthew Rabin work about a perspective on psychology and economics. Also I will try to answer in my opinion another keyquestion of this essay Why do economists sometimes fail to predict people behaviour while all the data seems to be correct? So, what is 'irrational' behaviour? Since 1955 when Nobel laureate Herbert Simon criticised classical economic models and proposed a term 'bounded rationality' it is tried to explain and model it till current days. Obviously, we can easily provide a proposition that 'irrational' people behaviour is a decision which is not made in a same way as it should be done according to classical people choice models provided by economists. Therefore, we can say that 'irrational' behaviour is

something that is not reflected by classical economical decision models and it require deeper research not only from economical but also from a psychological side. Here we come across to a pretty young economics science branch called behavioural economics which aim is to explain such 'irrational' behaviour and to improve classical or create we economical models which would help to make less mistakes in predictions and decisions. One of the most famous and successful out of all behavioural economists is M. Rabin which I have mentioned before. He has named in his essay that, there are many assumptions made by economists that are wrong about people. These include that people:

'are Bayesian information processors ; have well-defined and stable preferences; maximize their expected utility; apply exponential discounting weighting current and future well-being; are self-interested, narrowly defined; have preferences over final outcomes, not changes; have only instrumental/functional taste for beliefs and information.'

As we can see, M. Rabin provides some of the key-issues that are often reflected by rational economical choice models. However, these models very often are not supported by any behavioural or psychological evidence and are not always 100% correct. As M. Rabin says people do not always act on: ' 100% self-interest, 100% rationality, 100% self control' (M. Rabin, 2002). Therefore, why is not people choice always based on 100% self-interest, rationality, self control and similar factors. Why do they sometimes act 'irrational', not as rational economic models would predict them to behave? It is possible to name few main aspects which make them to act in such way:

People care about changes People care about others Care about now

Caring about changes. Every person care about changes of wealth. Therefore the satisfaction level of our consumption is not constant it is dependable to how much the consumption level at the moment is different from the level that consumer is used to, and therefore sense of well-being can be increased or decreased. Moreover, if for example, increase in consumption, from used level of it, is for a longer period time, people might get used to it and the sense of well-being might get to the same level as they felt before the increase. In addition to that, every person has got the feeling which M. Rabin calls: 'Loss aversion'. This sense sometimes drives people to act irrationally, as it tends people over reaction to the gains and looses. For example, if a person has already lost 10000, and has got an opportunity of gaining 5000 with a chance of loosing 1000, he is more likely to refuse this proposal, and opposite if he had sudden increase in income of 10000. In such case the behaviour of person can not be fully interpreted by utility-maximisation model. Moreover according to M. Rabin people tend to exaggerate how long sensations of gains and looses will last for. It means, people rarely think on longer-term aspects of looses and gains. As I have mentioned in my example above, loosing 10000 feels bad to person, so he tends to be more cautious in a shortperiod of time, because he rarely think that in a longer-term perspective 'all such looses will almost surely be wiped out in the longer term by other gains.' (M. Rabin, 2002) Caring about others. As it is defined in almost and economical model, self-interest is a driving factor of economic actors. Even though there is an economical hypothesis of people economical Altruism -'positive concern for others as well as yourself' (M. Rabin, 2002), it is not adequate for explaining a lot of people behaviours. The idea of altruism is that by such decisions they weight others utility positively in their own utility function. Therefore we can see that such assumptions are not enough to explain irrational behaviour, because people decision to be altruistic depends on few aspects: fairness on distribution of goods, intentions and motives of other people. The best example of such behaviour in my opinion is given by Robert H. Frank. So for example, if a person find a lost wallet on the road or somewhere else, in many cases he would return it to the rightful owner without any regret. As we can see, this completely argues the selfishness assumption

of economists while describing consumer behaviour. So we can make a conclusion that people care not just about the outcomes of their decision, but how did they come to those outcomes. Caring about now. In general, people usually like to experience pleasant things sooner than unpleasant. Therefore it might seem as rational behaviour and that it can be easily explained by classical individual choice models. However, the decision whether to experience the pleasant thing at the moment or not depend on time basis. Therefore, people might choose to experience unpleasant things at the moment in order to maximise their utility later in time. Moreover the decision made might be different in different period of time. If we ask a person to choose between two things in ahead, the decision that he has done a long period of time before the event or something, might be completely different than the decision, about choosing one of the events or something, done just before that, as more factors involve into his decision. Therefore we can see that this individual choice making can not be modelled just according to utility maximisation and other classical economical theories about consumer decision making. As I have described major factors which make people to act irrationally, some people might say, so what? Why is it worth that much attention and why do economists take so many time to research this quite young branch of economics? The answer is 'irrational' behaviour is not so 'irrational' in the end. Why? Because, from all the reasons I have explained in my essay so far, we can see that most of the decisions done look irrational while we look at it from classical economical models perspective. However, we can obviously make assumption that according to all these mentioned factors, in most of the cases people act systematic. If they act systematic, it means it might be and even is possible to model them and make very useful in explaining economic factors and much more. The best attempt to model such behaviour so far in my opinion is made by Kahneman and Tversky and it is called 'The Kahneman-Tversky Value Function (See the graph below). The graph below gives the example of: A) a person getting a gift of 100 and B) a person find 80 bill for the repair of broken water line after coming back from vacation that is given in R. H. Frank book.

The idea of this model is that: 'people evaluate alternatives not with the conventional utility function but instead with a value function that is defined over changes in wealth' (R. H. Frank). As we can see in the graph above, the value of loosing 80 is much larger than gaining 100. Also the value function is concave in gains and convex in losses. However Kahneman and Tversky say that they just try to summarize regularities of how people make decisions and they do not say that people necessary have to act like their value function predict. However there are to important feature of this value function: 1. People treat gains and losses asymmetrically, giving the latter much heavier weight in their decisions that former (R. H. Frank, 1997) 2. People evaluate event first and then add the separate values together. (R. H. Frank, 1997) However, still, there is nothing to prove that loose always cause more pain than the happiness a person would get from gain which leads to irrational considering every event separately, not their combined effect. To sum everything up, I have explained the majority of factors and hypothesis that make

people to act irrational way that is against the classical economic models. Moreover, the irrational behaviour is not so irrational in the end as in many cases it is systematic and therefore it must possible to model it in order to improve or replace classical economic models of individual choices. In the end, I have assessed one of attempts to model the irrational behaviour. However, even though there is already a lot of research done in behavioural economics, we can see that it still require a deeper research and attention.

Bibliography:

Black, J. (1997). A Dictionary of Economics. New York: Oxford University Press.

Mullainathan, S., Thaler, R. (2000). Behavioral Economics. Available from:

http://papers.ssrn.com/paper.taf?abstract_id=245828 # Rabin, M. (2002). A perspective on Psychology and Economics. University of California, Berkeley. Available from: http://repositories.cd.lib.org/iber/econ/E02-313

Frank, R. H. (1997). Microeconomics and Behavior (3rd edition), McGraw-Hill.