Let’s rewind to when I was in my 11th grade economics class, learning about consumer behavior for the first time.
There I was, reading about the concepts of utility and maximization of satisfaction when I came across an assumption that has left me puzzled to this day:
“We assume the consumer is rational.”
This set my head spinning. Rational? Consumers? Where?
When presented with a situation, we’d like to think we can make the most well informed, analytical and logical decision as consumers – but in reality, it’s a lot easier said than done. The course of economics has changed as psychology has charted the irrationality of consumers; from where the concept of behavioral economics was born.
Back in 1759, Adam Smith formed the basis of his theory “Homo Economicus”, a figurative human being characterized by the infinite ability to make rational decisions. This model served as the perfect skeleton for neoclassical economists to predict business plans and gave rise to Indifference Curves.
The concept of Indifference Curves revolves around rational consumers who will derive equal satisfaction and utility from any number of combinations of two goods. The concept goes on to include a Budget Line, stating the consumer shall only spend as much as is required to derive maximum satisfaction.
Here are some key attributes of a “rational consumer”:
- To possess perfect knowledge of the market
- To look into every single combination and possibility for maximum satisfaction
- To make consistent and transitive decisions
However, the Homo Economicus theory defined a narrow standard of self interest by which rational humans should behave. Economist Kate Raworth illustrates the economic man below, standing alone, with money in his hand, ego in his heart and a calculator in his head.
This image of a “rational” economic human seems almost irrational, given that there is so much more at the core of a human that just ego and endless wants. According to a study conducted in Israel (Grant, 2013), third-year economics students rated altruistic traits – such as helpfulness, honesty and loyalty – as being far less important than did their freshman equivalents, which paints a worrisome picture. It seems the more we learn of the Homo Economicus, the more we grow to be like him.
This theory was swiftly challenged by JM Keynes, Daniel Kahneman, Richard Thaler to name a few. Behavioral economics debunked the Homo Economicus paradigm and stated human instincts are driven by emotions, passion, temperament, habits and tastes- making it near impossible to make a hundred percent rational decision.
The neo classical economists believed that when faced with a decision, the human brain would make logical decisions driven by the motive of maximum satisfaction within given budget constraints, which would indicate the figure positioned to the right.
We all know this isn’t the case.
We relate to the picture on the left 100 times more than we’d ever relate to the picture on the right, and such has been proposed by economist Herbert Simon in his “bounded rationality” theory which replaced the beliefs of classical economists. According to the bounded rationality theory, humans make decisions based on the information available to them, and do not possess perfect knowledge of the market. The idea of Homo Economicus was replaced by the idea of “Satisficers”, a portmanteau of satisfy and suffice coined by Herbert A. Simon, where people satisfy their wants without looking into every single possibility and decide based on limited information, in the interest of time constraints, and sometimes, even on a whim. We are more likely to make inconsistent choices, influenced mainly by social norms, ethics, time, peer pressure and faith.
Imagine sitting at a restaurant with a pesky waiter who’s rushing you into making an order. Due to the social pressures and time constraints, you’re going to be more likely to make a suboptimal decision without looking into all the available options. That is bounded rationality in the flesh.
Richard H Thaler and Cass R Sunstein soon entered the behavioral economics field as well, with their proposed “Nudge Theory”. The theory states that consumer decisions are influenced by small suggestions and positive reinforcements.
In the image below, Homer is influenced by the product placement of fruits, and thus alters his initial decision of eating donuts due to the choice architecture chosen by the storekeeper, Apu.
We experience social nudges on a daily basis, and it is a major contributing force which influences our decision making. You’re more likely to purchase an item online based on the positive reviews provided by the online community, or feedback from recognized companies such as TripAdvisor, etc.
The Nudge Theory proved so powerful that the UK set up an official government unit called the Nudge Unit to test and implement public policy based on the theories of behavioral economics.
The branch of behavioural economics opened up a new avenue for companies to market their brand better, and to tap into the human cognitive bias with their advertising tactics.
The bandwagon effect is a well acclaimed economic effect which is leveraged by multiple brands in order to polarize the crowd and influence their tastes and preferences. Maybelline positioned their brand as “America’s favorite mascara” which sends out the message that not only is their mascara the most preferred amongst the masses, but it also rubs off some patriotic sentiment.
Oral B used the same tactic, with their slogan “Australia, you’ve made the switch”. This suggests Australians felt obliged to make a switch from their previous toothpaste to Oral B, hopping on the bandwagon yet again. It sends out the message that if everyone else is buying it, so should you.
A noteworthy example of herd mentality and irrational exuberance is the DotCom Bubble – which depicts the impact of the “herding effect” in the stock market during the early 2000s, during the initial stages of the internet network. Due to wild speculation and estimation, individuals bid up the stock market prices of dot-com companies (public internet companies) and thus, even companies generating no revenue were valued highly. Due to inflated valuations of companies, sending positive signals to investors, the dot com bubble further inflated and indices such as NASDAQ reached an all time high. However, the dot com bubble soon burst when it was realized that the rate of growth of the companies could not match up to the high stock prices. The crash of the bubble proved fatal for almost half the dot com companies in the market, and the surviving 48% of companies had lower valuations, all in all, destroying $6.2 trillion of household wealth.
The causes of such bubbles have been attributed to the psychological aspects of human behaviour, such as irrationality and cognitive biases.
Therefore, we spiral into our irrationality and more often than not, cave into these marketing strategies.
In conclusion, the human brain is anything but rational.
Unless of course, you’re Spock.
– Mehak Singh (Writer, Econ Declassified)
Leonard, K. (2019, February 4). Examples of Bandwagon Advertising Propaganda Techniques. Chron.
Medipally, S. (2018, August 1). Herding and The Dot Com Bubble. nickledanddimed.com. https://nickledanddimed.com/2018/08/01/herding-and-the-dotcom-bubble/#:~:text=The%20dot%2Dcom%20bubble%20eventually,investors%20due%20to%20a%20speculation.
Raworth, K. (2017, June 19). This is the new economic model for humanity. wired.co.uk. https://www.wired.co.uk/article/so-long-rational-economic-man
Wheeler, G. (2018, November 30). Bounded Rationality. Stanford Encyclopedia of Philosophy. https://plato.stanford.edu/entries/bounded-rationality/
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