RESEARCH METHODOLOGY

Questioning the Assumption of Rationality in Classical

Economics-
A Study of Behavioural Economics

Name: Dyaus Singh

College: Hansraj College
Roll No: 5572
Paper: Research Methodology (Skill Enhancement Course)
Course: BA Economic (Honours)
Sec: II

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Abstract-

Rationality implies that the agents taking part in economic transactions (buyers, sellers or other
intermediaries) are knowledgeable of all possible outcomes and are able to make logical and
consistent choices that maximize utility.

In this paper we explore, through the works of acclaimed psychologists and economic scholars the
emerging field of behavioural economics. It offers a radically different view of how people and
organizations operate, the various inherent biases and cognitive flaws of the human brain which hinder
decision making and the practical and theoretical implications of the same--challenging the rationality
assumption which is core to so many economic principles.

Literature review-
The following books are used for reference-

1. Thinking, Fast and Slow- Daniel Kahneman

The book summarizes research that Kahneman conducted over decades, often in collaboration
with Amos Tversky. The main thesis is that of a dichotomy between two modes of thought: "System
1" which is fast, instinctive and emotional; "System 2" which is slower, more deliberative, and
more logical. The book delineates rational and non-rational motivations/triggers associated with each
type of thinking process, and how they complement each other

2. Nudge: Improving decisions about Health, Wealth and Happiness- Richard Thaler and Cass
Sunstein

Nudge is a book written by University of Chicago economist Richard H. Thaler and Harvard Law

School Professor Cass R. Sunstein, first published in 2008. The book draws on research
in psychology and behavioural economics to defend libertarian paternalism and active engineering
of choice architecture.

3. Predictably Irrational- Dan Ariely

Predictably Irrational is a 2008 book by Dan Ariely, in which he challenges readers' assumptions
about making decisions based on rational thought.

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Introduction and Rational for the Study-
In an ideal world, people would always make optimal decisions that provide them with the greatest
benefit and satisfaction. In economics, rational choice theory states that when humans are presented
with various options under the conditions of scarcity, they would choose the option that maximizes
their individual satisfaction.

Behavioural Economics is an emerging field which draws aspects from both psychology and
economics to explore why people sometimes make irrational decisions, and why and how their
behaviour does not follow the predictions of economic models.

For example, according to the rational choice theory, if Charles wants to lose weight and is equipped
with information about the number of calories available in each edible product, he will opt only for
the food products with minimal calories.

Behavioural economics states that even if Charles wants to lose weight and sets his mind on eating
healthy food going forward, his end behaviour will be subject to cognitive bias, emotions, and social
influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes
that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering
ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet
temptation and fall off of the weight loss bandwagon, showing his lack of self-control.

The purpose of the paper is to show how important it is to safeguard against bad assumptions and
understand humans are emotional and easily distracted beings that make decisions that are not in
their self-interest.

Being aware of the flaws and biases will enable individuals to make better and more effective
decisions about stuff such as how much to pay for a cup of coffee, whether to go to graduate school,
whether to pursue a healthy lifestyle, how much to contribute towards retirement, etc. (the sorts of
decisions that most people make at some point in their lives)

Objectives of the study

 Prove hypothesis that assumption of rationality is wrong.

 Explain the main biases which affect decision making of individuals, businesses and
governments.

 Show relevant examples as well as anecdotal evidence to back the findings.

 Deriving analogies where due to assuming rationality we arrive at different conclusions in

theory and practice.

 Bridging the gap between theoretical outcome and practical reality to better understand
economics and human nature.

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Methodology
Research Methodology for compilation and analysis of data would be divided into the following two
types.

Primary Research- Primary Research would consist of questionnaires and mini-interviews of a

sample. The sample size would be diverse in terms of age, gender, economic and educational
background so as to provide a better estimate of the entire population. This estimate would be used to
validate the claims made by the hypothesis.

Secondary Research- Review of Literature on the topic at hand. Books, Articles, Internet blogs and
lectures.

Understanding Rational Choice Theory-

Adam Smith was one of the first economists to develop the underlying principles of the rational
choice theory. Smith elaborated on his studies of self-interest and the invisible hand theory in his
book “An Inquiry into the Nature and Causes of the Wealth of Nations,” which was published in
1776.

Rational choice theory states that individuals use rational calculations to make rational choices and
achieve outcomes that are aligned with their own personal objectives. These results are also associated
with maximizing an individual's self-interest. Using rational choice theory is expected to result in
outcomes that provide people with the greatest benefit and satisfaction, given the limited option they
have available.

An example of a rational consumer would be a person choosing between two cars. Car B is cheaper
than Car A, so the consumer purchases Car B. Or a rational investor is one that will quickly buy any
stocks that are priced too low and short-sell any stocks that are priced too high.

Many mainstream economic assumptions and theories are based on rational choice theory.

The invisible hand itself is a metaphor for the unseen forces that influence a free market economy.
The invisible hand theory assumes self-interest. But also suggesting that these rational actors acting in
their self- interest can actually create benefits for the economy at large.

Like all theories, one of the benefits of rational choice theory is that can be helpful in explaining
individual and collective behaviors. All theories attempt to give meaning to the things we observe in
the world. Rational choice theory can explain why people, groups, and society as a whole make
certain choices, based on specific costs and rewards.

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 HEURISTICS AND COGNITIVE BIASES

Anchoring Bias-

Anchoring bias is a cognitive bias that causes us to rely too heavily on the first piece of information
we are given about a topic. When we are setting plans or making estimates about something, we
interpret newer information from the reference point of our anchor, instead of seeing it objectively.
This can skew our judgment, and prevent us from updating our plans or predictions as much as we
should.

Imagine you’re out shopping and find a pair of earrings that you know love, but they cost $100, way
more than you budgeted for. After putting the expensive earrings back, you find a necklace for $75—
still more than your budget, but hey, it’s cheaper than the earrings!

In another study, people were asked for the last two digits of their social security number. Next, they
were shown a number of different products like computer equipment, bottles of wine, and chocolate.
For each item, participants indicated whether they would be willing to pay the amount of money
formed by their two digits. For example, if somebody’s number ended in 34, they would say whether
or not they would pay $34 for each item. After that, the researchers asked what the maximum amount
was that the participants would be willing to pay.

Even though somebody’s social security number is nothing more than a random series of digits, those
numbers had an effect on their decision making. People whose digits amounted to a higher number
were willing to pay significantly more for the same products, compared to those with lower numbers.

This phenomenon is a sharp contradiction to the rational human being we study in economics, the
Homo Economicus. Acc to Economic Theory the maximum amount a person would be willing to pay
would be independent of factors other than income of the consumer and actual price of the good. But
as we’ve seen this is not the case in reality.

Anchoring can even influence courtroom judgments, where research shows that prison sentences
assigned by jurors and judges can be swayed by providing an anchor.

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Availability Heuristic
The availability heuristic describes our tendency to use information that comes to mind quickly and
easily when making decisions about the future.

The availability heuristic can lead to bad decision-making because memories that are easily recalled
are frequently insufficient for figuring out how likely things are to happen again in the future.
Ultimately, this leaves the decision-maker with low-quality information to form the basis of their
decision.

For example, after seeing a movie about a nuclear disaster, we might become convinced that a nuclear
war or accident is highly likely or after seeing a car overturned on the side of the road, we might
believe that our own likelihood of getting in an accident is very high. People see news reports about
people losing their jobs and start to believe that they are in danger of being laid-off. And stories and
ads about lottery winners, leads to overestimation of one’s own likelihood of winning the jackpot and
we start spending more money each week on lottery tickets.

We come to all these conclusions without actually computing the statistical probability of the
likelihood the event.

If each one of us analyzes information in a way that prioritizes memorability and nearness over
accuracy, then the model of a rational, logical chooser, which is predominant in economics as well as
many other fields, can be flawed at times. The implications of the availability heuristic suggest that
many academics, policy-makers, business leaders, and media figures have to revisit their basic
assumptions about how people think and act in order to improve the quality and accuracy of their
work.

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Bandwagon Effect

The Bandwagon effect refers to our habit of adopting certain behaviours or beliefs because many other
people do the same. This phenomenon can affect all sorts of decisions we make in our lives. It occurs
from human tendency to feel included, to be on the winning side and groupthink. The primary worry
is that it can override the individual critical thinking that often goes into making good decisions.
Decisions that benefit many other people do not always benefit us.

Social and political movements are often fuelled by the bandwagon effect. History has shown that
dangerous populist (sometimes fascist) movements are driven by a snowballing uptake of political
messages aimed at resonating with ‘ordinary people.’

During the dotcom bubble of the late 1990s, dozens of tech startups emerged that had no viable
business plans, no products or services ready to bring to market, and in many cases, nothing more
than a name (usually something tech-sounding with ".com" or ".net" as a suffix). Despite lacking in
vision and scope, these companies attracted millions of investment dollars in large part due to the
bandwagon effect.

Thus, it is not difficult to see why being aware of the bandwagon effect is very important while
studying economics. People making decisions about what to consume and the like are often driven by
what people around them are doing. To some extent, this is a beneficial and useful tendency; if
other people's preferences are similar, their consumption decisions are rational However, this kind of
bandwagon effect can create a problem in that it gives every consumer an incentive to free ride on the
information and preferences of other consumers. To the extent that it leads to a situation where
information regarding consumer products might be underproduced, or produced solely or mostly by
marketers, it can be criticized. 

While studying quantity-price relationship of commodities, omitting this effect and assuming people
would act rationally is how discrepancies between theory and reality arise.

This can have grave implications such as in finance, for instance, investors may see a large uptake in
capital as a signal to follow suit. A buying frenzy can ensue, where prices are driven up by
widespread speculation that they will continue rising. This is known as a “price bubble,” which can
crash with spectacular consequences for investors and average people alike. The 2008 housing crisis
exemplifies such a phenomenon.

Loss Aversion
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Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is
psychologically twice as powerful as the pleasure of gaining. The loss felt from money, or any other
valuable object, can feel worse than gaining that same thing. Loss aversion refers to an individual’s
tendency to prefer avoiding losses to acquiring equivalent gains. Simply put, it’s better not to lose
$20, than to find $20.

In our everyday lives, loss aversion is especially common when individuals deal with financial
decisions and marketing. An individual is less likely to buy a stock if it’s seen as risky with the
potential for a loss of money, even though the reward potential is high. Notably, loss aversion gets
stronger in individuals as the stakes of their choice grow larger. 2

Additionally, marketing campaigns such as trial periods and rebates take advantage of an individual’s
tendency to opt into a presumed free service. As the buyer incorporates that specific software or
product into their lives, they are more likely to purchase it, as they want to avoid loss they will feel
once they give up the product. This tends to happen because scaling back, whether on software trials,
expensive cars, or bigger houses, is an emotionally challenging decision.

An individual’s socioeconomic status and environment prove to be very influential in regards to their
level of loss aversion. Individuals with a higher mean income, situated in wealthier villages, were
found to be less loss-averse9. Additionally, wealthy individuals or powerful individuals were more
willing to take on risk

With the most important decisions an individual will face, they will have to incur losses or give up
something in return for something else. Loss aversion can prevent people from making the best
decisions for themselves to avoid failure or risk. Though being risk-averse is useful in many
situations, it can prevent many people from making logical choices, as the fear of loss is too intense.

Framing Effect
The framing effect is when our decisions are influenced by the way information is presented.
Equivalent information can be more or less attractive depending on what features are highlighted.
Essentially, the same facts presented in two different ways can lead to people making different
judgments or decisions.

This plays a very important role in consumer economics. Choices will be influenced by how
information is presented.

For example, saying the cost of gym membership at £500 a year sounds a lot and may deter
customers. But saying it costs just £1.37 a day ( less than a cup of coffee) sounds more attractive to
consumers. At £1.37 they may be more tempted to purchase. In another study done by Daniel
Kanheman, presenting a brand of biscuits claiming they are 90% fat free had a much higher rate of
consumption than saying the biscuits had 10% fat.

As we can see in both the examples, the items are the same but the way they are presented are
different. A rational consumer would be indifferent between the two choices. But the way human’s
make decisions, We are susceptible to this sort of framing because in accordance with “prospect
theory,” we tend to avoid certain losses. A loss is perceived as more significant, and therefore more

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worthy of avoiding, than an equivalent gain. The way something is framed can influence our certainty
that it will bring either gain or loss.

Think of someone who unwisely chooses a high-risk investment portfolio because their broker
emphasized the upside instead of the potential downside, or a citizen who votes for a protectionist
candidate because media coverage has only highlighted the negative repercussions of past trade
agreements
The framing effect can have considerable influence on public opinion.

Endowment Effect

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The endowment effect describes how people tend to value items that they own more highly than they
would if they did not belong to them. This means that sellers often try to charge more for an item than
it would cost elsewhere.

Let’s say a few months ago, you bought a concert ticket for $100. You just found out that you won’t
be able to make it to the concert after all, so you decide to resell your ticket. You price the ticket at
$150, because just selling it at market value would feel like you were losing out.

The endowment effect can impact us both as buyers and as sellers. When buyers and sellers approach
a transaction, they often have different reference prices. Buyers don’t want to pay more than they
think an item is worth, but sellers don’t want to sell for less than that item’s market price. 4 So, for
example, if you were trying to sell a mug that normally retails at $3, you probably wouldn’t want to
settle for anything less than that, because then you would feel like you’re losing out. However, for a
buyer who’s just casually interested in getting a new mug, $1 might be the most they are willing to
pay.3

In other words, the endowment effect happens when there’s a gap between a buyer’s willingness to
pay and a seller’s willing to accept a certain price. Sometimes this gap appears because, when trying
to decide what a reasonable price for something is, buyers will look to the lowest available price as a
reference point, while sellers look at the highest ones. For example, if you were reselling a $250 ticket
for a basketball game, and you saw that some people were reselling similar seats for $400, you might
feel like a sucker if you sold for less than that. Meanwhile, people who are looking to buy tickets like
yours see that others have gone for closer to the original price, and so they’re not willing to pay your
higher price.5

APPLICATION OF
BEHAVIOURAL ECONOMICS

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Ideas about cognitive flaws and biases explored and highlighted by Behavioural Economics have
proved to be very helpful in various fields replacing traditional economic theory. The following are
few fields where application of this phenomenon has led to more efficient production, optimization
and greater consumer satisfaction.

Nudge is a concept in behavioral economics, political theory, and behavioural sciences which
proposes positive reinforcement and indirect suggestions as ways to influence the behaviour and
decision making of groups or individuals. In simple words, nudges are road signs that gently guide
you towards the best route.

‘Nudge’ theory was proposed originally in US ‘behavioral economics’. But, it was popularized by the
2008 book, ‘Nudge: Improving Decisions About Health, Wealth, and Happiness‘, written by
American academics Richard H Thaler and Cass R Sunstein. The book is based strongly on the Nobel
prize-winning work of the Israeli-American psychologists Daniel Kahneman and Amos Tversky

Success Stories in Governance-

 In Israel, the issuing or renewal of an ID, passport or driving license, became conditional
upon answering the question of becoming a registered donor. The default option was an ‘opt-
in’ provision, which greatly increased the list of registered donors by targeting the status quo
bias.
 Similarly, in Singapore—known for a number of innovations in governance—providing the
average electricity usage of the locality on the back of bills has nudged households to think
about their own energy consumption, driving them towards reducing it to the average levels,
an example of the groupthink effect.
 Copenhagen’s experiment of using green footsteps to lead to trash bins helped reduce littering
by 46%.
 Perhaps the most famous example of nudge theory in action concerns urinals. An airport
manager frustrated with dirty toilets in Amsterdam’s Schiphol Airport once etched small fly
into the centre of men’s urinals. Famously, this small intervention led to an 80% reduction in
spillage as it turns out that when men have an object to aim their urine at, they can’t help but
try and hit it.

India

In India, where social and religious norms play such a dominant role in influencing behaviour;
behavioural economics can, therefore, provide a valuable instrument for change.

 Efforts in Bihar, to improve the quality of health-care service delivery by front-line workers
takes into account popular ‘rituals’, like keeping a baby away from the ground in a cot
(palna), or marking decorations around her hearth (chulah), for transmitting messages that are
culturally acceptable
 Many Indian schemes that employ insights from behavioural economics have met with
success. For example: The Swachh Bharat Mission (SBM) and the Beti Bachao, Beti
Padhao (BBBP) scheme, Give it up (LPG subsidy).
 Nudging in India can further be used to, Increase tax compliance: Citizens can be sent
variations of text messages on how their taxes make a difference to public services.
 Reducing drop-out rate in poor families by informing parents increase in monthly gains by
children spending one more year in school.
 Increase savings rate: People can be offered specially designed savings accounts that locked
up funds until a self-specified target was met.

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  NITI Aayog (think-tank of the Modi Government), proposed setting up a ‘nudge unit’ in
partnership with Bill and Melinda Gates Foundation but efforts never materialized.

These anecdotes elegantly illustrate the basic insight at the core of applied behavioural science – small
and inexpensive interventions based on insights into human psychology can help influence human
behavior in predictable ways.

PRIMARY RESEARCH

Survery was designed to put the ideas explored in this paper to test. Following are the questions were
based/inspired by the ones used by Daniel Kahneman as well as Hans Rosling (A Swedish academic
and scholar).

Q) A town has two hospitals: one large and one small. Assuming there is an equal number of
boys and girls born every year in India, which hospital is more likely to have close to 50 percent
girls and 50 percent boys born on any given day?
A) Larger
B) Smaller
C) About the same

The most common answer was C. We normally expect things to follow a proven pattern regardless of

size. A small sample size (i.e. the small hospital) will often contain extreme proportions, while a large
sample size (i.e. the large hospital) will more likely reflect real-world distributions. The heuristic
shown here can be used to understand some forms of prejudice – if you haven’t been exposed to a
large number of people from a certain group, you are more likely to have incorrect assumptions about
them.

Q) A team of psychologists performed personality tests on 100 professionals, of which 30 were

engineers and 70 were lawyers. Brief descriptions were written for each subject. The following
is a sample of one of the resulting descriptions:

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Jack is a 45-year-old man. He is married and has four children. He is generally conservative, careful,
and ambitious. He shows no interest in political and social issues and spends most of his free time on
his many hobbies, which include home carpentry, sailing, and mathematics.

What is the probability that Jack

is one of the 30 engineers?
A) 10-30 Percent
B) 40-60 Percent
C) 60-80 Percent
D) 80-100 Percent

Any answer except A (the

correct response being precisely
30%) means one has have fallen

victim to the representativeness/framing heuristic. When observe that a large percentage of

participants overestimated the likelihood that Jack was an engineer, even though mathematically,
there was only a 30-in-100 chance of that being true. We as humans have an irrational affection for
rich details. We especially like ones that we believe are typical of a certain kind of person (e.g. all
engineers must spend every weekend doing maths puzzles), is yet another shortcoming of our
decision-making processes.

Q)Imagine that you decided to see a play and you paid £50 a ticket for an official Edinburgh
Festival show. As you are about to enter the theatre, you discover you’ve lost the ticket. The
theatre keeps no record of ticket purchasers, so the ticket cannot be recovered. Would you pay
£50 for another ticket to the play?

A)Yes
B) No

Q)If you answered no

(otherwise skip it), consider
the following question. Imagine you decide to see a play at the official Edinburgh Festival. The

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tickets are £50, and you pay at the door. As you get ready to enter the theatre you discover
you’ve lost a £50 note. Would you still pay £50 for the ticket to the play?

A)Yes
B) No

Both scenarios result in a net loss of £50. As we can see while only 54.2% of respondents answered
yes in the first question the number increased to 61.1%. It is likely the fell victim to what Kahneman
calls the “framing effect”: being swayed by the way in which questions are worded rather than
responding just to their substance. The framing effect is also used to explain the influence of positive
and negative information on our decisions – for example, why consumers prefer to buy minced beef
labelled 80% lean rather than 20% fat.

Q)Choose between getting £900 for sure or a 90% chance of getting £1,000.
A) 900
B) 90% chance

Q) Choose
between
losing £900 for sure or a 90% chance of losing €1,000.
A)900
B) 90%

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The answers to questions 5 and 6 are connected. The results of this simple problem set, for which
most participants answer A in Question 5 (78.7%) and then B in Question 6 (80.9%). This supports
the claims of the famous prospect (loss aversion) theory: when people faced a gain, they became risk
averse; when they faced a loss, they became risk seeking. Essentially, we just out potential gain or
loss relative to a given reference point and not in absolute terms.

Q) Globally, what percentage of girls finish primary education?

A) 10-20 Percent
B) 30 Percent
C) 65 Percent
D) 90 Percent

Only 4 people got the correct answer. Most of the news we read consists of how women are denied
education and which is true in certain parts of the world but the percentage of girls enrolling in
schools is increasing every year (due to advancements in technology and greater democracy and civil
liberties). This is an example of the availability heuristic and how it affects our thinking.

Q) How often in a week do you generally hang out with friends?

A) 0
B) 2-3
C)5-6

Q) On a scale of 1 to 5, how happy are you these days (5 being the happiest)?

Ans:_________

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Regardless of how one answered, it’s likely that the answer to the first part of the question is
positively correlated to your answer to the second part. Most people rate their happiness higher if they
had more nights out with friends and lower if you had nights out. However, when the order of these
questions was reversed, as was done by two German researchers, people’s happiness became
untethered from their night out life.

This experiment demonstrates how our brains respond differently to different challenges. When faced
with an objective question (in this case, ‘How many dates/nights out did you have last month?),
followed by a subjective one (How happy are you these days?), people often simply carry over their
answer for the first to the second. This heuristic is called substitution.

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PROBLEMS AND LIMITATIONS OF THE STUDY
Behavioural theory is already very useful in understanding consumer behaviour on the market and for
understanding citizen’s decisions facing with various choices in their daily lives. However there are a
few notable limitations worth mentioning, not so much as to criticize the field but more so to improve
its application.

A common critique of behavioural economics is some (not all) members of the discipline have a
tendency to overclaim and generalize, based on small studies carried out in different contexts, often
on university students in academic settings. Even the sample size chosen in the survey mentioned in
this paper gives only a broad estimate of how the population thinks. Efforts were made however to
ensure people belonging to varying age groups, gender and socio-economic backgrounds were
represented.

Secondly, although nudges have proved to be very helpful in public policy and consumer economics--
changing minor behaviours in a modest way but not in changing deep rooted psychological problems
such as alcoholism, drug dependency and street violence. The many unsuccessful nudges are also
grossly underreported.

 While they can be a low-cost and simple way to shift many behaviours, it’s important to remember
that not all behaviours are equally easy to shift. Interventions must match the nature of the problem
and the realities of existing preferences, incentives and psychology. Through careful design and
transparent reporting of interventions—both successful and unsuccessful—behavioural science can
continue to advance, providing opportunities to improve outcomes across domains.

CONCLUSION

Through this paper we observe the falsity of standard economic theory and the price we pay for having
undue faith in rationality of humans. The biases and heuristics that control are everyday decision making
and come to the realization that irrationality might actually be the ‘real invisible hand’.

A concerted behavioural economics approach can be applied to virtually every area of the business, from
governance and employee relations to marketing and customer service. It is probably most useful in the
areas that we know the least about—such as the relationships between compensation and performance,
risk and reward, loyalty and consumer habits, and pricing and purchasing behaviour.

Nudge Units have transformed the problem-solving approaches and helped design efficient and cost-
saving incentives to achieve basic civic means.

While it has its limitation, the field is a relatively new one and the greater adoption of which will help in
understanding humans and bettering livelihoods.

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BIBLIOGRAPHY/REFERENCES
Articles-

https://thedecisionlab.com/
https://health.economictimes.indiatimes.com/news/industry/nudging-india-towards-better-health-
incorporating-behavioural-economics-into-healthcare/73286326
https://hbr.org/
https://www.researchgate.net/topic/Behavioural-Economics
https://www.jstor.org/stable/40753012?seq=1
https://www.lineex.es/en/cognitive-biases/
https://www.thechicagoschool.edu/insight/business/everyday-examples-of-behavioral-economics/

Books-

Thinking Fast and Slow- Daniel Kahneman

Predictably Irrational- Dan Ariely
Nudge- Richard Thaler and Cass Sunstein

Images/Graphs

https://images.google.com/

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