In the first part of this series, my fellow econ colleague Khadija Zaidi and I shared the intuition behind the economic concepts of utility maximization, trade-offs, opportunity costs, as well as externalities and market failures. This time, we will dive a little deeper into some of these concepts, so make sure you check part I 😊!
Concept #1: Irrational behavior
As mentioned in part I, standard economic theory assumes that individuals are rational and thus, they always choose what maximizes their utility. Believing that we always decide what is best for us seems sensible, right? Well time after time, humans have shown that we are prone to “irrational behavior”.
Fortunately, scientists have shown that we depart from the expected rational behavior in a systematic manner. This related to Dan Ariely’s assertion that we are predictably irrational. As we can identify some of the puzzling irrational behaviors, economists have developed new models of utility maximization that consider such deviations. The transition from the homo-economicus, a perfectly rational agent, to a more realistic human is at the core of the field of Behavioral Economics.
Given that every day we are faced with multiple decisions, having some insights of this area comes in handy to better understand ourselves and thus, find ways to “trick” ourselves to make better decisions. So, what are some of the common irrational behaviors?
Cognitive bias is the most frequently cited irrational behavior. There are several of this type of biases. One that impacts our decision-making process is anchoring, which broadly speaking refers to relying on the first piece of information we receive as our reference point. For instance, the first price we see for a particular good or service, might be our reference point when we are shopping.
Moreover, we can also rely on heuristics, which are mental short-cuts that speed up our decision making process. While heuristics can be appropriate for some circumstances, they can also lead us to cognitive bias. A common one is the availability heuristics, which refers on how we make judgments regarding the likelihood of an event based on easily recalled information. These heuristics might lead us, for example, to overestimate the probability of certain outcomes as impactful events are usually more memorable, but they are indeed rare occurrences.
Furthermore, present bias is the tendency to go for instant gratification. This bias is useful to explain time-inconsistent behaviors, such as desiring to exercise more but putting it off for tomorrow (or later), only to regret that decision in the future. While these choices might seem harmless, over time they can not only have individual costs, but also generate negative externalities, such as increased health expenditures on the aggregate level if we don’t take care of ourselves.
Fortunately, knowledge is power, and if we are aware that we are susceptible to engaging in any of these behaviors, we can take steps to avoid them. Financial incentives, for instance, might be used to motivate ourselves not to procrastinate by rewarding ourselves each time we stick to our plans.
There are many additional irrational behaviors, including the sunk cost fallacy, which is the one we will explore next…!
Concept #2: Sunk costs fallacy, get your money’s worth.
Sunk costs are those that have been incurred and cannot be reversed. These costs can include both monetary and non-monetary resources, such as time and effort invested in something. For example, we may find ourselves investing in a good or service upfront, such as an online course or devoting a significant amount of time to a project, only to realize that it does not maximize our utility now.
In this scenario, we might continue to use the product or service in question (or working in our project), merely because we have already invested either money or time in it. This tendency can extend to even more important aspects of our lives, such as relationships in which we have spent time and effort.
If this is the case, we are committing the sunk costs fallacy, as sunk costs should not be part of our present decision-making process given that they are irreversible. Instead, we should think at the margin, meaning we should maximize our utility considering the cost and benefits from now on.
Concept #3: Information asymmetry, adverse selection, and moral hazard
As you are probably aware, government market interventions, such as taxation, subsidies, and regulations, can face strong opposition. However, as we discussed in part 1, government interventions are usually aimed at correcting market failures, which are the situations where resources are not allocated efficiently by the market. For example, as we showed with the example of externalities, the market either delivers too much or too little of certain products or services.
Another source of market failure is information asymmetry, which refers to the situation when agents on one side of the market have much better information than those on the other side. We are constantly dealing with this situation when we buy a product or service, as the seller has better information than us on its quality and attributes. In some cases, the knowledge gap between the buyer and the seller can lead to a market failure known as adverse selection.
For instance, if we are uncertain of the value or quality of a market good or service, the maximum price we are willing to pay for them might be lower than the minimum price a seller with a high-quality product or service would be willing to accept. Consequently, the high-quality sellers would have no incentives to be part of this market, leaving it only to lower quality suppliers.
In some markets, such as insurance, the buyer, rather than the seller, is the one who has more information about his or her own risk (e.g., health status). As high-risk individuals have larger incentives to participate, insurers would charge premium that is above the price low-risk agents would be willing to pay, resulting in an adversely selected market consistent of only high-risk individuals.
Without any countervailing mechanisms to minimize or eliminate asymmetric information, the markets of both examples would collapse. Thus, mandatory insurance, for instance, is an intervention that prevents adverse selection, as both high- and low-risk individuals have no choice but to participate in the market.
Information asymmetry is also linked to the problem of moral hazard. Again, insurance markets are the ideal scenario to explain this concept. Once an individual is insured, his or her incentives can change. For instance, individuals can engage in more risky behaviors, as they know they will not have to absorb the full costs of their actions. Similarly, individuals can consume more expensive or more medical treatments than needed, as the price with insurance is lower than the price, they would pay without it. Thus, cost-sharing via deductibles and copayments are way insurers try to mitigate insureds’ moral hazard.
To sum up…
While this is not an extensive overview of the subject, it provides important insights into how economic concepts are present in our lives. Being aware of these concepts allows us to apply them in our day-to-day, obtain a better grasp of the underlying mechanisms of how and why certain things work and eventually make better, well-rounded decisions. We hope you have enjoyed this series and that it has brought you closer to the subject of economics.
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