An Introduction to Market Information, Incentives and Behavioural Economics

Economics: It sounds like an obscure subject with very little relevance to our everyday lives. It has been generally accepted that it is a study for professionals in business, finance, government, and many other fields. But in reality, we always talk about the rising cost of living, taxes, government regulation in regards to the spending and so on. Economies are man-made and are dependent on the behaviours of humans which can be predicted but there are no certainties, thus economics as a science has more in common with ‘soft science’, such as psychology, sociology, politics and more. In this article, I will be discussing two major sections: “market information and incentives” and “Behavioural economics”

Market information and incentives

1. Some contracts require work/duty to be performed

2. This requires effort and time (the pay is given)

3. If nobody’s watching there is an incentive (a motivator. Traditional incentives are rewards for certain actions and thereby yielding the desired outcome. The effectiveness of incentives has changed as the needs of Western society have evolved) to put in less effort than agreed

4. People will neglect their duties if they can

This is the model of economic behaviour, first proposed by Kenneth Arrow, an American economist publishing ideas such as Social Choice and Individual Values, Essays in the Theory of Risk-bearing, and more. On the other hand, Adam Smith (the founder of modern economics, publishing ideas such as The Theory of Moral Sentiments, Lectures on Jurisprudence and more), in the 18th century, assumes all participants in the market are well-informed and are logical. But this is not always the case: Arrow pointed out that whilst two sides can agree on conditions and requirements of the contract, there is no guarantee that either party will fulfil it. Where one party does not or cannot observe the other, there is an incentive for the unobserved party to not fulfil the conditions and not deliver on all clauses of the contract. This is known to be a moral hazard. Take the example of the insurance market—People may have an incentive to take more risks because the insurance company can cover the cost of any damages. This could lead to insurers offering less insurance cover, as they are afraid that they can encourage risk-taking and therefore bearing excessive cost. Possibly, this can lead to the markets failing; those with insurance will pay too much for it and many people would be excluded in the insurance market. Of course, it will be a lot more complicated than that but that’s the idea. And so Arrow suggests that in these circumstances, there shall be a government intervention to correct the market failure. Moral hazards can emerge anywhere where the principal is trying to get the agent to behave in a certain way. Moral hazard has more recently become an essential issue in political arguments following the 2008 financial crisis. The Euro crisis of 2012 is also thought to be an example of a moral hazard at its role: countries such as Greece were suspected of having to run the country on the grounds of the country “being too big to fail”.

Behavioural Economics

Before the 1980s, standard economic theory was that every individual was to think “rationally”. They were to weigh the cost, and loss by oneself and come up with the best possible decision. This was the expected utility theory. But as many studies have discovered, people do not always make rational decisions which will reward them with the best possible outcome.

1. When faced with making a decision where the outcome is uncertain, people do not calculate gains and losses through mathematical probability but instead, they 

2. Are affected more by whether they stand to gain or lose and how the question is framed.

Early studies of behavioural economics were conducted by two Israeli-American psychologists, Amos Tversky and Daniel Kahneman. Their key paper is named Prospect Theory, An Analysis of Decision Under Risk and it outlines the theory that marked the start of a new branch of study known as behavioural economics. It mostly depends on how people deal with risk calculation as they are known to be irrational at times. Tversky and Kahneman found out that people don’t tend to follow the standard assumptions about one’s behaviour, especially when the consequences are uncertain. People are found to respond in a way that violates standard theory of how one ‘should’ respond to certain events. Instead of taking self-interest into an account, people tend to be swayed by how the decision is presented. 

Conclusion

I wanted to highlight in this article that some things which might seem overly complicated and professional can be broken down and explained in a simpler way. I personally opine that anything can be learnt without much complication. Thank you for reading another one of my articles.