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Abstract

Economic psychology is the study of the behavior of individuals that involves economic decisions and the causes and effects of those decisions. This research-paper reviews some of the main areas of interest to economic psychology, including those at the microeconomic level (e.g., consumption, investing, working) and macroeconomic level (e.g., rates of inflation, unemployment, economic growth). The convergence and deviation of economics and psychology are also discussed.

Outline

The Nature of Humankind in Economic Theory and the Need for Psychology
Microeconomics and Psychology: The Behavior of Consumers, Investors, and Workers
Macroeconomics and Psychology: Perspectives on Inflation, Unemployment, and Economic Growth
Conclusions and Future Directions

1. The Nature Of Humankind In Economic Theory And The Need For Psychology

One might expect that the disciplines of economics and psychology are integrated because both study behavior. Historically, however, economics and psychology have been distinct, and the few intellectual contacts between them up to 1920 were unhappy ones for economists who, like Jevons, tried to exploit psychological principles (e.g., pleasure, pain) but failed to add much to economic theories. Apart from the unhappy experiences, another reason for the disciplinary separation is that, in the interest of precision, economics has chosen mathematics as its methodology and metaphor. Notwithstanding the separation, economics has made crucial assumptions about the nature of human decision making, which is also the subject matter of psychology.

One such assumption in neoclassical economics is ‘‘rationality,’’ in which individuals are said to choose alternatives that maximize expected utilities. In particular, the neoclassical view is that individuals rank all possible alternatives according to how much satisfaction they will bring and then choose the alternative that will bring the most satisfaction or utility (provided that they believe the alternative is attainable). However, psychological research has shown that people often do not choose the alternative with the greatest utility due to limited information processing capacity, motivational biases, and other psychological processes.

Examples of biases and errors in judgment constraining rationality are numerous. For instance, Simon argued that people often use cognitive heuristics, or shortcuts, to reduce the amount of information processing required for making a decision, but this may lead them to select an alternative that is merely satisfactory rather than the alternative with the highest utility (a process Simon described as ‘‘satisficing’’ and a form of bounded rationality). People are also known to give different weights to costs and rewards that are of the same magnitude (i.e., the opportunity cost effect). They are sensitive to framing and context, misjudge prior probabilities, and ignore sample size (i.e., the representativeness bias). They have an intransitive choice set (e.g., they might prefer A > B and B > C and yet they prefer C > A) and assign a higher value to an item once it becomes their possession (i.e., the endowment effect). Their preferences are present biased (i.e., a slight delay in gratification is perceived to be worse if the delay occurs today than if a delay of the same magnitude occurs in the distant future), as are their personal experiences (i.e., greater weight is assigned to recent experiences). Finally, individuals are sensitive to social comparisons and often judge their economic well-being in social terms rather than purely economic terms.

A second assumption in neoclassical economics, closely allied to the first, is that individuals act out of self-interest (narrowly defined). That is, people will choose the option that will give them the most. However, psychological research challenges this assumption as well. For instance, people are affected by satiation and personal considerations of fairness (e.g., when asked to split a pile of money between themselves and a stranger, many people choose a 50–50 split, whereas neoclassical economics would predict a 100–0 split).

Psychological research suggests that many individuals are unlikely to meet both the rationality and self-interest assumptions of neoclassical economics (although psychology and economics are not as far apart as is implied herein). Some economists suggest that the rationality and self-interest violations in neoclassical economics can be dealt with by redefining rationality and interest. Other economists argue that these breaches can be ignored because individual differences and biases ‘‘wash out’’ at the macro level of analysis.

An alternative strategy pursued by economic psychology is to model economic behavior in a way that is psychologically realistic. In particular, economic psychology is the study of the behavior of individuals that involves economic decisions and the causes and effects of those decisions. Most decisions are economic ones in some form, making economic psychology a broad field. Many of the areas of interest to economic psychology are also key topics of research in other fields such as applied psychology, economics, sociology, and political science. This research-paper provides a brief overview of the micro and macroeconomic issues of interest to economic psychology.

2. Microeconomics And Psychology: The Behavior Of Consumers, Investors, And Workers

The psychological approach to microeconomics examines the behavior of individuals and small groups with regard to diverse areas such as saving, buying, investing, gambling, working, giving, and paying taxes. For instance, theories of saving suggest that people choose how much to save by considering the amount saved by a reference group, choosing a fixed percentage of their disposable income, or varying their saving and spending of savings at different stages of their life cycle. This section reviews the behavior of individuals as consumers, investors, and workers.

2.1. Consumers

Consumer behavior is one of the most extensively researched areas in microeconomics. Initially, the field was dominated by approaches based on neoclassical economics. The most fundamental of these early approaches was expected utility theory, which argued that consumers have complete information about each product, evaluate that information in a deliberate and exhaustive manner, and ultimately choose the product that has the greatest utility (subject to constraints of money, availability, etc.). Critics argued, however, that it is unrealistic to assume that consumers choose the brand with the maximum utility because, as noted previously, individuals have limited information processing and make errors in judgment. Consumers are also unlikely to have all of the information about all brands, and the information they do have is subject to perceptual and motivation biases. For instance, one well-documented effect is that consumers place higher value on products that appear to be in short supply (a phenomenon that Brehm in 1966 explained as psychological reactance to the loss of freedom). Similarly, consumers’ reference point for deciding whether the price for a product is fair is not only the absolute price, as neoclassical economics posits, but also the change in price and frame of reference (i.e., prospect theory).

Consequently, the field of consumer behavior now largely draws on psychological insights. That is, although some recent consumer decision-making models do leave room for extended rationality (e.g., expectancy value theory), other models recognize that consumers do not maximize expected utility and might simply compare brands on a single attribute (e.g., the lexicographic model). The neoclassical economic approach to consumer behavior also assumes that consumer preferences are stable and makes no mention of where consumers derive their preferences in the first place. Hence, consumer socialization and social influence are major areas of study by economic psychologists. Psychological approaches to understanding consumer behavior also investigate the roles of emotions, motivations, lifestyles, and the self-concept that have largely been absent from the neoclassical view of the consumer.

2.2. Investors

A common model in neoclassical economics for predicting how individuals make investment decisions involving risk and uncertainty is the expected utility theory, according to which the probability of an outcome is multiplied by the utility of the outcome (and is added across all outcomes). For instance, an individual deciding whether to invest in a new venture would gauge the probability of the venture’s success times the financial payoff of that success. Hence, expected utility theory assumes that people objectively and rationally judge risk. In contrast, psychological research has shown that decision makers consistently over or underestimate probabilities, interpret independent outcomes as dependent ones, and weight gains differently from losses of the same magnitude (i.e., prospect theory). Moreover, personality differences mean that individuals differ in their perceptions of risk, in their willingness to take risks, and in their ability to delay gratification (which investing necessitates).

Social psychological processes also underpin risk taking. For instance, the ‘‘risky shift’’ effect, in which group discussion shifts individuals toward taking greater risk in decisions where the initial preference already favors risk, indicates clearly the transformational power of group dynamics in decisions that involve risk taking. This may help us to understand why overvalued markets continue to rise (and why undervalued markets continue to fall).

2.3. Workers

Another area of microeconomics studied by economic psychologists is how individuals behave at work. In the traditional economic view, the goal of an organization is profit maximization. On the one hand, this maximization might be achieved through a rational mathematical calculation involving the selling price, the output level, and costs such as labor, materials, and transportation. On the other hand, labor is about people and so is inherently psychological. That is, although the number of hours an employee works is prescribed by the firm, how much effort the worker exerts is dependent on psychological factors such as motivation, conditioning and reinforcement, social context, and ability.

For instance, needs-based approaches to work motivation suggest that humans have certain deeply felt needs and that each individual’s motivation to perform depends on whether the specific features of the job fulfill his or her needs. A second approach to understanding the amount of effort an individual exerts at work is reinforcement theory (and other learning and conditioning principles). According to this view, effort at work is a result of reward for positive performance and/or punishment for negative performance. A third approach examines how an individual’s work behavior and effort are influenced by the social context. For instance, research has demonstrated a ‘‘social loafing’’ effect whereby individuals exert less effort when they work in a group than when they work alone (although the effect varies by task difficulty and cultural values).

In addition to the issue of whether people are motivated to perform at work, the effectiveness of the workforce depends on workers’ job-related abilities. Here, psychological research finds scientific ways in which to match the skills, education, and training of individuals with the requirements of the job. Economic psychology also studies the effect of unemployment on the individual. In particular, it examines the negative and positive sides of unemployment, the psychological stages an individual goes through when losing a job, and the link between unemployment and health.

3. Macroeconomics And Psychology: Perspectives On Inflation, Unemployment, And Economic Growth

Macroeconomics studies the overall levels and changes in societal economic activity. Topics include economic growth, inflation, recession, unemployment, and income distribution. Often, economists explain the overall levels and changes in economic activity as issues involving the demand for goods and services, the money supply, and/or (more recently) the supply of goods and services. For instance, macroeconomic approaches to solving inflation are to decrease the demand for goods and services, decrease the money supply, and/or increase the supply of goods and services. However, each of these approaches overlooks, to varying degrees, the psychological aspects of economic activity and the position of that action in a larger sociocultural environment.

3.1. Inflation

The neoclassical economic view asserts that individuals objectively gauge the rate of inflation. This ‘‘expected inflation’’ allows individuals to make decisions about saving, purchasing now, and going into debt. However, psychological research has revealed that people often do not accurately remember past prices and make poor guesses about the future rate of inflation. Furthermore, wage increases during times of high inflation may be perceived as positive by workers because ‘‘money illusion’’ leads them to evaluate wages on their nominal value rather than their real value. On the other hand, people assess their satisfaction with wages not only by comparing wages with an absolute standard but also by comparing them with a reference group. Hence, people may demand increases in wages simply to keep up with their neighbors. This illustrates that inflation is, in part, a social psychological phenomenon.

In 1984, Maital and Maital also suggested that inflation can be profoundly psychosocial and can be researched using the prisoner’s dilemma experimental procedure. In this case, an individual can gain financially if he or she demands a large wage increase and raises the prices of any products the individual may sell. However, if everyone in society does the same, the result is inflation. In addition to seeking to contribute to an understanding of the causes of inflation, economic psychology examines the psychosocial effects of inflation on the individual such as helplessness and perceived lack of personal control.

3.2. Unemployment

Whereas the effects of unemployment on the individual are an area of concern in microeconomic psychology, how society explains unemployment is a focus in macroeconomic psychology. Three broad types of social explanations have been identified: individualistic (e.g., laziness or lack of effort on the part of unemployed people, fussiness of unemployed people when it comes to taking jobs, poor education, qualifications of unemployed people), societal (e.g., policies of the government, less competitive industries that go bankrupt, prior overmanning in industry, weak trade unions), and fatalistic (sickness and physical handicaps among unemployed people, bad luck). Individualistic explanations are most common among conservative (rightwing) voters, whereas societal explanations are stronger among labor (left-wing) voters. This underscores that individuals’ beliefs about how the economy functions is less about economic models and more about morality and political persuasion.

3.3. Economic Growth

One final macroeconomic area of current interest is how cultural values and personal attitudes are linked to economic growth. The strict economic view is that the economic growth of a nation stems from conventional economic factors such as labor force and capital. However, Reynaud argued in 1981 that these factors per se cannot fully account for economic growth and that psychosocial factors must also be considered. In support of Reynaud’s position, some theorists claim that cultural values such as the Protestant work ethic and individualism produced the economic growth seen in Western nations (i.e., a cultural determinism claim). On the other hand, other theorists suggest that economic development leads to changes in cultural values (i.e., economic determinism).

In addition to the issue of economic determinism versus cultural determinism, researchers are divided regarding the extent to which human values are aligned with economic growth and development. One form of modernization theory suggests that development proceeds in a series of linear stages; hence, as nations develop, their cultural values will become more similar to those of developed nations. However, the extent that the values of nations are converging is unclear because the values that predict economic growth are shifting as Asian economies expand.

4. Conclusions And Future Directions

Despite the polarized way in which economics and psychology have been presented here, the two disciplines are in fact deeply interconnected. Central and historically significant branches in psychology also assume that individuals are rational and act out of self-interest. For instance, attribution theory assumes that people are naive scientists who seek rational explanations for their own and others’ behaviors, behaviorism assumes that organisms act out of self-interest by seeking rewards and avoiding punishments, and social exchange theory suggests that individuals compare their inputs and outputs with those of others to gauge whether the relationships are satisfactory.

Similarly, economics is more psychological than is reported here, as evidenced by the 2002 Nobel Prize in economics being awarded to Daniel Kahneman for his work on human judgment (which integrates economics and psychology). Another example of psychological constructs being central to economic analysis is Katona’s use of the attitude construct in his consumer optimism–pessimism index.

Notwithstanding that some models incorporate both psychology and economics, the two fields need greater integration. For instance, Lea and colleagues argued in 1987 that economic psychology should examine how the individual affects the economy and vice versa (i.e., dual causation). More recently, in 1995, Lewis and colleagues called for a better understanding of postmodern economic behavior and how economic behavior has communicative and identity functions.

One way in which to integrate psychology and economics is to propose models that include the neoclassical economic view and the psychological perspective within the same conceptual framework. These models would accept that the rationality and self-interest assumptions of economics and the alternative explanations offered by psychology both are applicable, depending on the context and the individual. For instance, Allen and Ng’s dual-process model of how human values guide consumers’ product decisions, as described in their 1999 article, suggests that consumers make both rational and ‘‘nonrational’’/emotional choices, depending on the type of product or on the motivation driving the consumer. That is, consumers motivated by a need for instrumentality will make a rational, attribute-by attribute judgment of the product’s utility, whereas those motivated by a need for self-expression will make a holistic, emotion-laden, and spontaneous judgment of the product’s image. Similarly, hybrid approaches were proposed in the important area of social welfare by Taylor-Gooby in 2000 and in how people’s views about the economy affect their political party choices by Allen and Ng in 2000.

References:

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