Friday, July 8, 2011

Behavioral Economics

The reigning orthodoxy in economics holds several assumptions. These assumptions include that humans act rationally, meaning they attempt to maximize utility, meaning satisfaction, through consumption. It is assumed that people have sufficient knowledge to know exactly what to consume to maximize utility as well as the going market rates.

On the other side of the equation, firms are also assumed to act rationally, that is they attempt to maximize profit. In order to do this, firms must have perfect knowledge about their own cost structure and know the demand curve that they face. Firms must also know about the cost structure for their competitors if they are not a monopoly. Any firm in an at least semi competitive market, not a monopoly or oligopoly, must know the market price at any given time. On top of this, firms my have perfect knowledge of the tax and regulatory structure.

While these assumptions are obviously not true, they are good first order approximations and are only strictly applied in introductory courses. To some degree, more advanced courses will attempt to relax these assumptions to get the model to fit reality better.

Behavioral economics, on the other hand, rejects these assumptions. The Austrian school of economics starts with the axiom that humans act and specifically they act purposefully. While they Austrian school attempts to approach the question of human action from a serious of deductions based on their primary axiom, Behavioral economics set out to find out why people act and how do they act from an empirical stand point.

While we can certainly know through none empirical methods, it is the empirical testing that allows us to confirm what we derive. If people do not act rationally with perfect knowledge, how do they act? Do they gain utility solely through consumption or can giving up consumption for some other purpose actually increase a person's utility? These and more are the question posed by Behavioral economists.

There are many interesting potential areas of study within the field of Behavioral economics.

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