Behavioral Economics

Meet Consumer A. Consumer A needs a new computer so she can work from home. The computer must be reliable and have a large processor since Consumer A will be using it daily to do several complex tasks. However, Consumer A only has a limited amount of money to spend, so she must ensure that she gets the best computer possible for her money.

Before going to the store, Consumer A carefully researches her options, comparing prices and reading consumer reviews of different computers. Finally, being fully informed, she selects one that will best meet her needs. In this way, Consumer A is a textbook example of the “economic man” in neoclassical economic theory: the always rational and informed consumer who drives all economic activity.

Now, meet Consumer B. Consumer B just had a bad day at work. He’s depressed, bored and craving some excitement. He goes to the mall to do some browsing and sees a stylish new fishing pole on display. Consumer B hasn’t been fishing in six months and already owns two other fishing poles, but this particular fishing pole arrests his attention. Consumer B starts thinking about how much he would like to own this fishing pole and how exciting it would be to buy it.

Like Consumer A, Consumer B has a limited amount of money to spend, and the fishing pole is very expensive. However, Consumer B quickly rationalizes his purchase by arguing that it will make him happy. Without even knowing how well the fishing pole will work or when he will use it, Consumer B purchases it on the spot—with his credit card. This type of economic behavior is commonly referred to as “retail therapy”: shopping to improve one’s mood.
The concept of retail therapy, however, is surprisingly absent from neoclassical economics, despite being prevalent enough to warrant a phrase in the modern vernacular. For centuries, economists have assumed that people’s economic choices are always rational since they are motivated by need and limited by scarcity. But as retail therapy proves, that is not always the case. So where is the theory that takes into account irrational economic behavior like retail therapy?

That theory is called behavioral economics. Behavioral economics seeks to unite the basic principles of neoclassical economics with the realities posed by human psychology. The theory grew out of neoclassical economics in the early 20th century when neoclassical theory fell short of explaining the anomalies that occur within market economies.
Although behavioral economics arose from the writings of several notable economists, one of the theory’s leading principles came from economist Herbert Simon in the 1950s. Simon postulated that man could not always act logically because he possessed a “bounded rationality.” In other words, human minds are finite; they do not have unlimited information to solve problems, nor do they have all the time in the world to think about them. Humans also struggle to analyze problems objectively when the outcomes directly affect themselves, especially when viewing problems through a “frame” of personal experience warped by social or cultural bias.

To cope with these realities, humans apply their own rules of thumb, or “heuristics,” when making quick decisions. While it is inherently rational to do so, the rules themselves and the behavior they lead to may not be. In fact, heuristics, as described by leading behavioral economist Daniel Kahneman, are inherently irrational.

For example, in a common heuristic known as gambler’s fallacy, consumers take risks on what appears to be a future outcome in an instance of random chance, like a coin toss. Their logic is based on seeing the same outcome occur several times in a row and assuming a different outcome is due. The logic is, of course, faulty, since the odds for either outcome remain the same in every instance.
From Simon’s concept of bounded rationality sprang the idea that other aspects of humanity may be bounded as well, such as the self-interest that motivates the neoclassical “economic man.” Behavioral economists accept that other factors may drive consumers’ economic choices, like altruism or self-control.
Of course, an economic theory that allows for such variance in consumer logic and behavior poses a problem: how can economists rely on it to accurately predict economic outcomes? After all, pure neoclassical theory is much tidier by comparison, basing its mathematical models on a few basic, if convenient, assumptions.

Obviously, behavioral economists cannot rely as heavily on mathematical models to predict outcomes. Instead, they collect real world data on past consumer behavior and conduct experiments involving real transactions to gauge how consumers might behave in future situations. The goal in collecting such data is to eliminate unlikely outcomes so that likely ones come into focus. Although not as exact of a science compared to using mathematical equations, behavioral economists often manage to make startlingly accurate economic predictions. Economists have found that making realistic assumptions about human nature generally leads to a more precise result.

However, some economists still find reason to reject behavioral economics. Those who cling to pure neoclassical theory insist that the economic man is more rational than the natural man because market competition forces consumers to make rational choices. They claim that behavioral models based on data gleaned from experiments mostly illustrates one-time choices, not complex economic behavior exhibited over time. Also, economists who prefer the stark, impartial rigidity of neoclassical mathematical models view behavioral economics’ experimental approach with distrust. They say experiments and surveys can be skewed by participants’ biases. They see little application for behavioral models in real markets.

Nevertheless, behavioral economics has succeeded in explaining market anomalies where neoclassical economics could not. For instance, it has been used to examine the roles played by human greed and fear in the 2008 financial crisis. The promise of windfall profits lead financial companies to create and sell highly complex credit default swaps without fully understanding their risk. When the stock market crashed, fear drove usually adventurous hedge fund investors to withdraw their money from the market, even when they could have bought good stocks at record-low prices. Behavioral economics can explain other phenomena as well, such as why some prices or wages refuse to change with market forces (price stickiness), why stock markets perform worse on Mondays (calendar effect) and why some investors choose to hold onto poorly performing stocks while selling high-performing ones (disposition effect).

Development Economics

Development economics is a branch of economics that focuses on how to improve the economies of developing countries. Its major concern is the development of third world economies. Development in such countries is met by improving the basic amenities to promote the welfare of its citizen and to maintain a certain set standard of living for all its citizens. The sectors that should be improved according to the development economists are Health sector, education, employment, and inflation, domestic and international economic policies. This branch of economics is specially tailored to the developing country to help them transform into a prosperous nation through progressive economics.

Development economics concepts might differ from one nation to the other because of the existence of unique features for different countries like political and social background. The concepts of macro and micro economics is greatly borrowed in the development economics on structures of developing economy and efficient domestic and international growth.

The economic development field looks at both the traditional measures of economics like the GDP and more modern measures of the Economy like the standard of living and equal rights opportunities. Development economics can also be seen as the only branch of economics that is concerned more on political processes. It is very keen on the economics agenda that have been passed by the political class in each economy. The most fundamental features of development economics became very clear after the world war two. Although some primitive form of this economy were still practiced by some countries, especially the major empires. The need to expand the concept of development economics came after the war-ravaged nations started the process of economic building. The world war two had left major economies especially in Europe in shambles.

Development economics is surrounded by many theories. The earliest being the linear stages of growth model. The basic ideas in this theory is that economy development and steady growth is to be achieved through the pooling and holding of huge capital from domestic and international savings. The theory failed immediately after being advanced because it did not recognized the necessary preconditions for takeoff. The other development theory that was advanced by developing economy was the international dependency theory. This theory suggests most of the economics problems facing the developing economy were from external forces beyond their control. There was a huge outcry on this theory and this gave birth to the neoclassical theory of development economics.

 The neoclassical theory suggests that economic development can only be achieved if government removed all the controls and regulations to make the market free and allow demand and supply to play the important roles in economics equilibrium and controls. The theory has been adopted by many institutions such as the World Bank with some few differing points on the degree to which the market should be free. A market friendly approach is adopted by the World Bank and allows for some government regulation. The market free schools of thought suggest a free economy that is not influenced by external factors rather than the market forces.

Environmental Economics

For centuries, traditional economics has been used to explain how people can create wealth and improve their lives through the supply and demand of goods and services. Starting in the 1960s, however, people began to realize that traditional economics failed to take into account other factors that greatly influenced quality of life, such as social welfare and the environment. Thus, environmental economics was born.
Environmental economics seeks to measure the external environmental effects, or costs, of economic decisions and propose solutions to mitigate or eliminate those costs to better manage natural resources and promote social well-being. Unlike traditional economics, which focuses on private ownership of property, environmental economics primarily concerns itself with the management of common or public property, such as lakes, rivers, game and parks.

Environmental economics functions on the theory of “market failure.” Simply stated, market failure occurs when markets fail to efficiently allocate limited resources in a way that benefits society most. For example, assume that a town has a large, freshwater lake. A parts manufacturing facility, responding to a market demand for car parts, moves into the town and begins using the lake water to process the parts. Without pollution controls in place, the water is soon contaminated, becoming unsafe to drink and killing all the fish. Since the lake was the town’s main source of food, recreation and drinking water, its citizens are forced to move away to find a new water source–leaving the manufacturing facility without a ready labor pool or a nearby consumer base. As a result, the company’s labor and shipping costs increase dramatically. Though the company simply responded to market forces by using the lake, its actions resulted in massive inefficiency caused by environmental degradation. Environmental economists seek to remedy such inefficiency by establishing environmental regulations, pollution quotas and property rights so that market suppliers can become wealthy without negatively impacting others.

Types of market failure include externality, non-exclusion and non-rivalry. Externality refers to the effect of an economic choice that is not factored into a product’s price. Non-exclusion exists when restricting someone’s access to a resource would be too costly. Non-rivalry means that a benefit provided to one individual, business or country can be enjoyed by others, reducing the incentive for economic actors to contribute to the public good. Some aspects of all of these can be seen in the example above. Because the lake was common property, the manufacturing facility was able to use it freely (non-exclusion). With unlimited use of the resource and no pollution controls in place, the facility could cheaply produce many parts to meet demand (externality). The townspeople had up until then kept the lake clean and properly managed, from which the company benefited without ever contributing to it (non-rivalry).

In order to address these market failures, environmental economists must first assess the value of environmental resources and assets. This can be quite tricky, since environmental resources are often viewed as having value beyond their economic use. People may want to preserve resources for undiscovered future use, to bequeath to future generations, or to simply enjoy their existence. Economists can calculate a resource’s non-use value by researching nearby land values, surveying the public, or examining what people are willing to pay to access or protect the resource. Once the value of the environmental asset is determined, economists can then establish policies that will preserve the long-term viability of the resource while still allowing it to be used for economic gain. Thus, environmental economics plays an important role in managing and allocating scarce natural resources.

Health Economics

Health economics is one of the many branches in economic. Most of the concepts surrounding this branch are both the micro and macro economics placed in the context of efficiently and effectiveness in the production and services delivery in the health sector industries. The concept of health economics can be explained in layman language as the study of economical functioning of health care system in an economy. It involves matters affecting the health of individuals in a society. An example of application of the health economics is the study of cigarette smoking and its effects on the economy from the health expenses perspective. Economics bills have been introduced to curb smoking related expenditures and health care.

Kenneth Arrow is credited to have been the founding father of health economics by writing an article that set it differences from other branches of economics. The distinguishing factors which Kenneth pointed out were; the huge government intervention in this economy different from the other type of economics where market forces are left to take cause on market direction. Health economics is also characterized by monopoly that discourages barriers to entry, a lot of externalities and information present is only known to a few groups of individuals. Health economics also allows for middlemen to act between the buyers and the sellers. Under health economic the health specialist is the one making the decision. His/her decision is restricted by prices of the products or the services. The physician should thus make a decision that maximizes the output and minimizes the total cost of that service. The decisions to be made by the health specialist are to prescribe medication or ordering a lab test.  A health economist evaluates several financial information regarding costs, charges and expenditures. The knowledge gaps between the health specialist and demand for such services creates an advantage for the physician called the market information asymmetry.

Demand in health economics is derived from demand for health. Demand for health care is a bit different from the other goods since households choose to allocate scarce resources to consume and produce health. Most economists view the households or individuals as consumers and producers in the health sector. Health is capital investment and can degrade over time if proper investments are not put in place. Health has a direct satisfaction and follows the laws of diminishing marginal utility. It increases productivity up to a certain limit were it starts to go down. Huge focus on health economics is evaluation micro economics concepts of each individual. Governments in different countries have various economics techniques for appraising new and existing medical equipments. Economic techniques evaluation methods are cost minimization analysis, Cost effectiveness analysis and cost utility analysis. Health economics can be divided into several sub categories. The sub categories are medical economics, mental and behavioral economics. Medical economics deals with the application theory of economics to the health markets. It is used in cost benefits analysis of medical products and treatments. It often uses models in decision making process. Behavioral economist is still in its infant stages.

Monetary Economics

The dollar bill is a symbol of America as iconic as the Statue of Liberty or the American Flag. Consumers all over the world recognize the green paper as a valuable commodity and will often go to great lengths to obtain it. It has many nicknames, including bread, greenback, dough, bacon, moolah, cheddar, dinero and loot. Someone wanting to acquire a certain product needs only to hand a store cashier the number of bills denoted on the product’s price tag, and the item becomes his.

In itself, however, the dollar bill is nothing more than ink printed on paper. It cannot be used to build useful objects or woven into clothing. It cannot be melted down and molded into a pot or a piece of jewelry. So from what does the dollar derive its value? How does it retain that value over time, even when other currencies exist? How can other paper currencies have more or less value than the dollar? Moreover, what is the role that the dollar plays in economics?

These are the questions explored in monetary economics. Monetary economics examines how currencies enter the marketplace and become accepted as mediums of exchange for goods and services. It also analyzes government regulation of money and financial institutions, the structure and interaction of monetary systems, financial history and the demand for money—basically, anything involving bankers and banknotes. Because the exchange of money pervades the economic system at every level, monetary economics is largely a study in macroeconomics.

Monetary economics formally emerged as a field of study in the 1950s through the concept of monetarism as described by economist Milton Friedman. Monetarism postulates that government regulation of a nation’s money supply can ensure economic stability by keeping prices and inflation under control. In this way, monetary economics is an offshoot of Keynesian economics, which calls for an active government role in balancing economic fluctuations. Prior to Friedman’s observations, however, monetary economics had informally been in play for decades.

To understand the need for monetary economics, it’s important to know the purpose and characteristics of money. Prior to 1200 B.C., humans bartered and traded commodities to obtain the goods they wanted. This method of exchange, however, depended on a “coincidence of wants”: the consumer had to possess a good the merchant wanted for the exchange to occur. Also, determining the value of one item compared to another was very difficult. Almost no standard price for goods existed. The bartering system, therefore, was often slow, frustrating and riddled with inefficiency. Consumers soon demanded an easier way to exchange goods.
Standardized currency eventually became the solution to inefficient exchange. Currency first appeared in China around 1200 B.C. in the form of cowrie shells. The shells possessed intrinsic value since they were used to make jewelry and other ornaments.

They were also small and easy to carry in large quantities. Merchants only had to demand a certain number of shells for their products, and consumers could buy them. Metal coins emerged as an alternative between 1000 and 500 B.C. Coins also had inherent value because they were made from scarce metals and could be melted down and shaped into tools or weapons.
Paper currency, also known as fiat currency, however, possesses no inherent value and can be generated quite easily in large amounts, leading to inflation. The value of money partially depends upon its scarcity. When too much is released into circulation, consumer demand for goods and services rises rapidly, driving up prices. As a result, the purchasing power of the currency is reduced. Sometimes prices can rise too quickly, shutting many consumers out of the market and causing economic disruption. China discovered this drawback to using paper currency in the 1400s when the country printed too much money. The consequences were so severe that China stopped using paper currency for several hundred years.
Economists sought to resolve paper currency’s inflationary problem by backing each banknote with a standard unit of precious metal. The metals were stored in government reserves with banknotes issued in their place. The most famous example is the gold standard adopted by the U.S. in 1873. The gold standard valued each dollar at 1.5 grams of gold, which would be granted to anyone wishing to exchange their paper for hard currency. While the gold standard kept inflation in check, it also greatly restricted the amount of money that could be circulated. This became a problem during war when countries on the gold standard became indebted to each other. Paying foreign debts in gold strained U.S. gold reserves, leaving consumers with unbacked currency.

Money, like almost anything in a market economy, is subject to the law of supply and demand. Market demand for money determines its value. When supply exceeds demand, monetary value plummets, creating inefficiency and placing a great strain on the economy. When demand exceeds supply, consumers and businesses may lack the means to conduct important transactions, causing the economy to stagnate or crash. Monetary economics, then, seeks to keep the supply of money balanced with demand. Whenever it fails, the results are often disastrous.

Take the Great Depression, for example. Adherence to the gold standard through World War I had greatly reduced U.S. gold reserves. When the stock market began falling in 1929, consumers panicked and rushed to banks to exchange their paper currency for gold. The run on the banks drained gold reserves further and left the Federal Reserve without the liquidity, or hard cash, it needed to deal with the economic crisis. As a result, the stock market crashed, interest rates skyrocketed, paper money became worthless, businesses went bankrupt and unemployment soared. Shortly thereafter, in 1933, the U.S. abandoned the gold standard and later established fiat currency as the new legal tender. Since that time, new monetary economic policies have been used to manage the dollar’s value and keep it stable.

Keeping currency stable is important because money functions as more than just a means of exchange. Money establishes a single standard of value, known as a unit of account, for goods and services and is widely used as a store of value. In other words, accumulating money makes one wealthy because, as long as it is accepted in the marketplace, money can be used to obtain virtually any good or service. Money takes on different forms as well. To an economist, money exists as paper currency, commodities (e.g., gold and oil) and credit. Therefore, instituting policies that protect asset liquidity, credit availability and commodity value promotes economic stability, investment and growth.

Of course, like any theory, monetary economics has its shortcomings. Examining all the ways money interacts and shapes economies is quite complex and involves nearly all aspects of an economy. Although monetary economics is primarily concerned with regulating the money supply, it is also used to interpret changes or fluctuations in interest rates, currency exchange rates, prices, and the net worth of businesses and individuals. At times, monetary economics has failed to explain certain phenomena, such as why some markets remain unresponsive to economic policies designed to stimulate growth. Economists have also made errors in creating policy, leading to economic recession. Critics of monetary policy occasionally question the validity and desirability of such intervention in economic activity. However, economists who study and implement monetary policy are often some of the most powerful and influential people in the world: Alan Greenspan, Ben Bernanke, Paul Krugman and Timothy Geithner, to name a few.

What Are the Branches of Economics?

Economics is one of the basic core courses in almost all college degrees. It is the academic study of how money operates, and the interaction of money between consumer and business. Economics can be best divided into its two main branches: Macroeconomics and Microeconomics. Each of these main divisions and its sub-classes serves to illustrate all the distinct functions of various economies.

Macroeconomics
Macroeconomics is the study of the entire economy -- its behavior, main elements and overarching systems. The scale of these macroeconomic discussions are typically on a country level and utilizes facts from that country's economic performance -- gross domestic product, inflation, government interest rates and unemployment. This also touches upon international trade and the overall impact of imports and exports has on a country's economic growth.
Sub-Branches of Macroeconomics
Some important sub-topics in macroeconomic discussions are the factors affecting a country's stabilization policies and supply-side economics. Stabilization policies include the ability of a government to control its economic growth through employing fiscal and monetary policies during boom and recession periods. Supply side economics deals with the country's production rate of its goods and how it can leverage absolute and competitive production advantages against competing countries: creating a product mix for optimum export levels and growth.

Microeconomics: General
Microeconomics is the study of transactions between people and businesses and how the flow of money operates between these basic entities. This includes business investment and personal savings. Microeconomics also focuses on the supply and demand relationship between buyer and seller and how this ultimately determines equilibrium prices of goods and services.
Sub-Branches of microeconomics
Microeconomics sub-branches are the study of specific monetary activities that are enacted by either businesses or individuals. Some significant knowledge bases are the network effect and consumer theory. The network effect outlines the ability of a micro-economy to generate additional cash inside its system self-sufficiently. This is illustrated by the money growth effects of consumer-bank, business-investment and consumer-business relationships. Consumer theory is the study of how quantitative and qualitative factors affect consumer spending and saving. Some topics in this theory include the effect of lending interest rates, labor investment and technological trends have in encouraging consumerism.

What Are the Main Branches of Economics?

Economics is the study of how modern economies work. There are two main branches of economics, macro- and microeconomics, but there are other divisions. Within these branches, the production, distribution, and consumption of goods and services are analyzed in order to understand how economies and people within those economies interact and function.

Microeconomics
Microeconomics focuses on the economic behaviors of individuals in many aspects, including decision making, production distribution, and market results. Microeconomics, as the name suggests, deals with small units or individuals or smaller companies. It deals with concepts such as markets, which can be for products or services; production, which exchanges commodities for consumption in return for money or other services; cost; specialization, which refers to divisions of labor; and supply and demand.
Macroeconomics
Macroeconomics studies economic systems on a larger scale, including national income, consumption, investment, large-scale behavioral patterns in regards to economic growth, employment, inflation, and national and international trading. It is concerned with an overall economy and an economy's Gross National Product, or GNP. Factors such as stability, means of production, technology all come into play when analyzing economies in accordance with macroeconomics.

Positive Economics
Positive economics is a branch which focuses on objective analysis. This takes the past economic picture into account when envisioning and making decisions for the future. This is opposed to normative economics, which relies on value judgments rather than empirical evidence. With empirical evidence, positive economics can evaluate how economies have reacted to certain variables in the past and then apply these reactions to how future economies will react under similar situations.
Applied Economics
This is the branch of economics which employs economic theory into business practice. This occurs in a range of fields and turns abstract ideas into concrete practices. Applying theory to practice helps show the true status of a company's economy whereas pure theoretical thought does not show the true picture of a current or emerging economic position.