Behavioural Economics in Markets

- Yashdeep Singh Dahiya , Economics Association

2017-02-19

Technical

A market is a web of transactions – transactions made by people. And analyzing their moves is never easy. A retailer, for example, can never be certain about the consumers’ actions – what choices they may make, what might attract them, how would they respond to a service, etc. This is where behavioural economics comes in to play.

Behavioural economics is a relatively new branch in economics– a very upcoming branch of great interest to modern economists. It is a blend of cognitive human psychology and economics, which makes it very interesting and complex at the same time. There have been numerous attempts in the past to determine the nature of stakeholders in a market – whether they are profit seeking rational beings, or irrational risk takers, or somewhere in between. Let’s have a look at some of the theories pertaining to this aspect.

Rational Choice Theory

This theory considers that human actors in a market have stable preferences and engage in maximizing behaviour. They would always make optimal choices. In other words, they are living calculators. But we know this is not true in many cases. We do take bold risks at times; and there’s no way to know when one might take a risk and when not. Also, every individual is differently wired – older people are known to be safe players while the younger tend to take more risks. This theory was proposed to make it much easier for the economists to express their ideas mathematically. But it didn’t work well in reality.

The Tulip Mania (1630s)

Tulip mania was a period in the Dutch Golden Age during which contract prices for bulbs of the recently introduced tulip reached extraordinarily high levels and then suddenly collapsed. This is the first known instance of an economic bubble.

Tulip bulbs were brought from Turkey to Netherlands in 1593. These flowers instantly became popular among the Dutch masses and, thus, began selling at higher prices. People, too, bought them in large numbers in hopes of selling them at an even higher price. Soon, it became a coveted luxury item. This continued until one day, when the costliest of the tulip didn’t sell in the market. This created panic among traders, and masses in general. They worried lest their tulip bulbs wouldn’t sell, too. Now everyone who possessed a tulip wanted to get rid of it as soon as possible. This left no buyers in the market and led to a sharp fall in its prices. Following is the graph depicting the sudden drop in the prices of the tulip.

Here we can see that initially there is a gradual and steady rise in the prices of the tulip, which turns steeper and steeper until it collapses. This situation is known as an economic bubble. This could be devastating for an economy and thus it is crucial to have appropriate regulations in place to avoid such an economic catastrophe.

Therefore, this case study disproves the Rational Choice theory as people kept on selling tulips at such high rates that the situation spiralled out of control. In fact, a tulip bulb in the 17th century could reach the price of a town house!

Prospect Theory

So, now that we know we humans are not living calculators, let’s have a look at the Prospect Theory. This theory suggests that decisions are not always optimal. Our willingness to take risks is influenced by the way in which choices are framed, i.e. it is context-dependent. Have a look at the following classic decision problem:

Which of the following would you prefer:

A) A certain win of $250, versus
B) A 25% chance to win $1000 and a 75% chance to win nothing?
How about:
C) A certain loss of $750, versus
D) A 75% chance to lose $1000 and a 25% chance to lose nothing?

The responses are different if choices are framed as a gain (1) or a loss (2). When faced with the first type of decision, a greater proportion of people will opt for the risk-less alternative A), while for the second problem people are more likely to choose the riskier D). This happens because we dislike losses more than we like an equivalent gain: Giving something up is more painful than the pleasure we derive from receiving it.

Furthermore, our choices are dependent on the information available to us. This is known as bounded rationality. People are “ecologically rational” when they make the best possible use of limited information provided, by applying simple and intelligent algorithms that can lead to near-optimal inferences.

Sentiments and market

Market is driven by sentiments – people’s emotions, their hopes, their discontentment, their enthusiasm, their anxiety, their trust, their mistrust. We often hear about rise or fall of the market index during a festival, an election or after the announcement of a new policy. What do these have to do with market at all? How can one day be different from the previous with respect to the market? There could be several factors at play. For example, during Diwali people want to buy new things, as according to Hindu beliefs it is a very auspicious time of the year. So they go to the market to purchase products. Retailers also offer special discounts to attract consumers and stay ahead in the competition. Hence, there is a lot of economic activity in the market. It is a win-win situation for both the consumers as well as the retailers. This, in turn, is reflected in the market index and it goes up. But during troubled times, the opposite happens. It is a very interesting phenomenon in economics, especially for the ones who observe it for the first time.

There is a lot of research being carried out in behavioural economics. The primary challenge for the economists now is to explain its concepts in terms of mathematical expressions. The findings of the studies carried out till date have been very helpful for various industries such as advertisement, retail, marketing, manufacturing, and most importantly for policy-makers. The regulations imposed by governments owe much to the research-work being carried out in this branch of economics. Its understanding is vital for an economy as, with proper application, it can carry an economy forward and avoid financial crises, such as a stock market crash, economic bubble and so on.