An Introduction to Behavioural Economics and a flaw in the conventional Economic System
Before I can start elaborating on all the problems with the original economic system, I will first explain what the system we use is. All our economic methodologies formed from one main idea in the 1800s, Adam Smith’s “Invisible Hand”. This was the concept that Adam Smith first developed modern economics on. It works in a relatively simple way; the critical premise is that a market will always correct itself, and an “invisible hand” will guide the market to the correct shape. You can see this happen in a Demand & Supply Diagram.
If we look at graph 1, we can see a market equilibrium where supply and demand meet. If the product’s price is lower than the equilibrium, we can see that there would be excess demand; firms and producers would use this signal and raise the price to make more profit. The price will not automatically reach the equilibrium price. However, it may go above it. In this case, we then see an excess of supply, so firms may reduce their price to sell more. So, while we would never reach the exact right price, the market would tend to get closer to it and go up or down slowly. This example assumes ceteris paribus – that everything is held constant except one factor, price in this case. There are reasons that would cause the Demand or Supply curve to shift left and right, but we aren’t concerned about that for this article.
This methodology led to the economic systems that shaped the world. However, like everything in economics, many assumptions went into making it. The biggest one is that consumers are rational. A rational consumer means that an individual can make a perfect choice for their situation. They can perform incredibly complex mathematics to determine the best product for them and whether they can buy it at a specified price in just a matter of moments. This is all unrealistic as no individual is actually able to do all of those calculations. An additional problem with this is that these systems were primarily developed during the 18th and 19th century - where how consumers, firms, and governments were vastly different. Therefore, many of these assumptions can be said to be outdated or just outright wrong.
This is where behavioural economics comes into use. Behavioural economics is built upon the foundations that consumers are not rational; instead, consumers may not always make the best choice for them. This is known as “Bounded rationality. Bounded rationality effectively states that consumers are rational up to a certain point where after they just care about satisficing their needs and wants. This is often done through a set of rules of thumbs; each consumer has different preferences and prioritises various aspects. One individual may prefer to save cost and satisfice their need with a cheaper product. In comparison, some may spend more than what is optimal for a better experience or slightly more premium product – again, everyone has a different taste. However, applying behavioural economics can show us that Demand and Supply curves can shift due to behavioural factors: a default bias – where you pick the default option – or FOMO – the fear of missing out - to name a few.
Behavioural Economics is a relatively new field of economics, with research in it only being conducted from 1976. Still, it can provide many interesting insights into how consumers act if conventional economics cannot explain it.