If you want to understand the classical view of economics and how people make decisions, you need to read The Economic Approach to Human Behavior, in which economist Gary Becker (1976) described a number of ideas that can be thought of as the mainstays of classical “rational choice” theory. The rudimentary principle of the theory is that the decisions that people make are the result of a cautious balancing of costs and benefits. In addition, these decisions are informed by existing preferences. Under normal circumstances, classical economics assumes that people make optimal decisions. In Becker’s book, the theory assumes that human actors have stable preferences and engage in maximizing behavior. Becker, who applied rational choice theory to subjects ranging from crime to marriage, believed that academic disciplines such as criminology could learn from the “rational man” assumption advocated by neoclassical economists since the late 19th century. (Classical criminology, in fact, was largely of this school of thought).
The decade of the 1970s saw a divergence in this traditional mode of economic thinking. Some radical economists began to think that actual human behavior does not seem very rational, and the cost-benefit analysis of classical economics failed to consider that inconvenient fact. Psychologists, on the other hand, have never held a rational view of behavior. The partly rational, partly irrational view of human behavior developed by psychologists would heavily influence the economic thinking that was to come. Amos Tversky and Daniel Kahneman published a number of papers that appeared to undermine ideas about human nature held by conventional economics.
Perhaps the best example of this work was the development of prospect theory. This theory holds that we dislike losses more than we like an equivalent gain. In other words, giving something up is more painful than the pleasure we derive from receiving it. In other words, the pain of loss outweighs the pleasure of a commensurate gain. Let’s say your surgeon tells you that a certain potential life-saving procedure has a 95% success rate. Most people will likely consent to the procedure. If, on the other hand, the surgeon tells you that there is a 5% chance that you will die, you are less likely to consent. Rationally, the statements are the same. Our perceptions change depending on whether we focus on the loss or the gain.
Prospect Theory counters the classical theory of utility maximization. Utility maximization assumes people act rationally and consume in such a way as to obtain the most satisfaction out of money and time spent. This assumes that the consumer knows all information available and all potential outcomes. Further, consumers will act without emotion and select the option that gives them the most satisfaction. The most common criticism of that perspective is that people act impulsively and have a hard time correctly assessing probabilities. Often, there is not enough time to think about decisions carefully, and insufficient time to sort out the relevant information from background noise.
As any college professor that assigns research papers can tell you, most people have extreme difficulty accessing the quality of information. This is especially true when it comes to the stock market. The average investor does not know where to go to get the most accurate information on the overall health of the market and has an even a more difficult time sorting through all the information regarding any particular stock. By the time a retail investor can digest all available information from television news, the internet, coworkers and financial advisors, the price of the stock may well have fluctuated so much that the decision made is the wrong one.
The importance of psychologically informed economics was later reflected in the concept of “bounded rationality,” a term attributed to Herbert Simon’s work of the 1950s. According to this paradigm, our minds must be understood relative to the environment in which they evolved. Decisions are not always optimal. There are restrictions on human information processing, due to limits in knowledge and or information, as well as our computational capacities.
The economist Richard Thaler, a founder of behavioral economics, was inspired by Kahneman & Tversky’s work. Thaler developed and popularized the concept of mental accounting. The fundamental assumption behind this theory is that people think of value in relative rather than absolute terms. For example, Thaler found that people treat money differently depending on factors such as the money’s origin and intended use rather than thinking of it in terms of simple accounting where a person has money coming in and money going out. In the human mind, it seems, money is of many different types.
An important term underlying the theory is fungibility, the fact that all money is the same and has no labels. In mental accounting, people treat assets as less fungible than they really are; they frame assets as belonging to current wealth, current income, or future income. Consider unexpected gains: Small windfalls (e.g., a $50 scratch-off win) are generally treated as “current income” that is likely to be spent, whereas large windfalls (e.g., a $10,000 productivity bonus at work) are considered “wealth.”
Another example from mental accounting is credit card payments, which are treated differently than cash. Mental accounting theory suggests that credit cards decouple the purchase from the payment by separating and delaying the payment. Credit card spending is also attractive because on credit card bills individual items (e.g., a $50 expense) will lose their meaningfulness when they are seen as a small part of a larger amount due (e.g., $1,000).