This blog is on how psychology and economics are interrelated and people behave purposefully but not always rationally. This is another economic thought that is evolving very fast and is attracting lots of attention. This makes a lot of sense to our human brain as we start understanding our actions.
In the traditional economics, it was believed in the consumer theory that consumers are rational who are capable of making well-informed decisions which are in their self-interest. In simple words, neoclassicals believe that consumers will gather all the information and then they will weigh costs and benefits for every purchase they make. They will take time and then make a utility maximizing decision.
But behavioral economics has come up with another theory which says that this may not be true in most of the cases. Economist Herbert A. Simon, Nobel prize winner for his work in behavioral science, first proposed the idea of bounded rationality in 1955. According to him, people are affected by ‘bounded rationality’ and ‘bounded self-control’ which may lead to irrational decision making. What are these? Let us delve a bit deeper.
Bounded rationality- This concept refers to the fact that there are three factors which can prevent the consumer from making a rational and informed decision. These are limited time, information failure, and too much choice.
The consumers may not have all the time to gather information, weigh the pros and cons and then make a decision. For example, we might make a suboptimal decision if we have a shortage of time. Let’s say, when we are out for lunch during office hours. We have just one hour, and we cannot spend time just gathering all the information and then choose our lunch. We are mentally in a state of hurry.
Another factor for bounded rationality is 'too much choice'. This might make the consumer overwhelmed. He may not feel motivated to analyze and evaluate the pros and cons for each product he wants to buy. For example, just choosing a suitable hand wash soap or something as simple as toothpaste has become difficult because of too many alternatives.
The third main factor is imperfect information. It could be too complex/technical information for a layman, or unclear, or asymmetric for the consumer to make an informed decision. Our brain gets paralyzed with too much complex information. Just buying a laptop in today’s world can sound so daunting. A layman may not even understand what features they should be looking for and we make an uninformed decision by looking at the reviews or what our friends or relatives say about it.
Bounded self-control- This concept explains that even though the consumer may have all the information and know what is a rational choice but still they don’t go for it due to limited self-control. We might have right knowledge, right information but limited self-control to follow through that decision.
For example, people know that smoking is not good for health but they tend to still smoke because of maybe nicotine addiction.
Even though we know that overeating is not good for us or going to the gym is a rational choice for the consumer, still we may not be able to do it regularly.
Henceforth, the behavioral economists say that due to these two reasons of bounded rationality and bounded self-control, the consumers tend to apply ‘heuristics’ a mental shortcut or ‘rule of thumb’. The consumers tend to go with the 'gut' feeling. Instead of getting into analysis paralysis and not making a decision at all, they end up making a ‘satisficing’ decision which may be a suboptimal decision. The consumer may not be able to maximize his utility but still the decision made provides some satisfaction to the consumer. The consumer ultimately uses mental shortcuts simply because it's easier to make decisions this way.
According to the behavioral economists, there are many other emotional, social and psychological factors that might influence our decision-making process. These are called ‘cognitive biases’, a topic for my next blog😊
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