This blog post explores how human emotions and psychology impact economic choices, examining the changes and significance psychology has brought to economics.
Every day, the media discusses investor sentiment while explaining movements in the stock or real estate markets. People tend to buy when expectations of rising stock prices grow, and conversely, decide to sell when declines are anticipated. This demonstrates that economic activity isn’t driven solely by numbers and statistics; human emotions and psychology play a crucial role. Yet, economics itself doesn’t teach much about psychology. This is why many were genuinely puzzled when Daniel Kahneman, a psychologist, was awarded the Nobel Prize in Economics in 2002. What possible connection could economics and psychology have?
Of course, it is well known that the economics of John Maynard Keynes, who emerged during the Great Depression of the 1930s and modified the philosophy of laissez-faire, was based on reflection on the psychological aspects of human beings. He argued that economic activity is not solely driven by rational calculation but is often influenced by irrational human psychology. Keynes specifically used the term “animal spirits” to explain how economic decisions are heavily influenced by emotions, intuition, and fear of uncertainty. However, John Maynard Keynes did not scientifically delve into human psychology itself. He emphasized that our decisions are always made in situations where the future is uncertain, and that the uncertainty we face is mostly difficult to grasp even probabilistically. He believed it was human destiny to have to choose something even when the future is unknown. Therefore, he thought human behavior sometimes relies on intuition and is sometimes driven by impulse, rather than possessing the rationality assumed in economics. He believed business investment is influenced more by the entrepreneur’s animal spirits than by interest rates. However, while this adage emphasizing the importance of human psychology circulated among economics students, it did not go so far as to change the approach of economics based on rationality.
Yet, research by probabilistic cognitive psychologists like ‘Daniel Kahneman’ provided an opportunity to change the methodology of economics. They discovered that people tend to rely heavily on subjective reasoning when judging probabilities. For example, when judging the probability that A belongs to B, people are more influenced by how much A resembles B than by information that actually affects the probability. Or, the easier it is to recall specific examples of A, the more likely people are to judge that A has a higher probability of occurring. These findings suggest that when humans make judgments, they rely heavily on experience or memory rather than simply following rational and logical processes. Additionally, while individuals adjust their evaluations as new information is added, their final estimates tend to lean toward their initial assessments. This subjective reasoning, while a convenient cognitive method, is prone to systematic biases or serious errors.
Building on these findings, they advanced their research to critique existing perceptions of rational human behavior. One such study examined the inconsistency between decision-making regarding gains and decision-making regarding losses. Through a wide variety of experiments, they discovered that people exhibit inconsistency: they avoid risk when gains are possible, but prefer risk when losses are possible. While this behavior is understandable, it contradicts the most fundamental assumption about rational behavior under uncertainty—namely, consistency in attitude toward risk. Daniel Kahneman and others interpreted these experimental results as showing that people dislike losses, not risks. This is because losses always appear larger than gains.
Such research findings suggest that economics cannot fully explain human behavior based solely on simple mathematical models and assumptions of rationality. Humans are not mechanical beings seeking to maximize profit, but emotional beings who sometimes make irrational choices. This research has significantly impacted economics, which has traditionally approached social phenomena based on certain assumptions about rationality. It demands that we start from observations of human behavior rather than assumptions about it. It will be interesting to see how much and in what ways psychology will transform economics.
