Today’s topic is standard economics, behavioral economics, being right, being wrong, and being partial.
Obviously, behavioral economics stands in opposition to standard economics. Does that mean that economics is wrong? No. It just means that it is partially correct. Behavioral economics basically views economists as a wonderful and interesting field. But when implemented in the real world, standard economics should take into account some other complexities.
As an analogy, imagine that you study metals. You understand metals, you have a theory of metals, and you study metals all the day. But you need to build a bridge. This knowledge of metal will only take you so far. The people who are more application-minded will say, "You understand metals very well, but what about the weather? What about vibrations? What about earthquakes?” The picture is a bit more complex when it comes comes to the real world. So this is the conflict between studying something purely as it is, which is perfectly fine. But when we want to implement it into the world we should take more things into account.
I think that behavioral economics asks economists to be more modest. It asks standard economists, to acknowledge that the real world is more complex than economic models and that more factors must be taken into account.
Now let’s look at different versions of supply and demand—an unbelievably important part of economics and central to lots of ideas.
One version says that when companies compete to supply something and consumers are price sensitive, they will drive profits down. So the theory, says that if we have two companies that are competing, consumers will compare and choose the cheapest one. If two companies are offering expensive services, and Company A decreases their prices by a little bit, all the consumers will choose that Company A leaving Company B without customers. So Company B will lower its profits to win back the customers, and the two companies will continue this pattern until profits margins are eroded. The idea is that consumer demand will tame the market and businesses will earn very little, if anything.
Now, generally, products try to differentiate themselves. Take cars for example, there's no real competition because there is such a variety. But there are some products that are really the same, like banks. Really, you might have a slight preference for one bank over another, but is there a real deal difference? Is anybody really loyal to their banks? Not really. Banks are wonderful institutions, that do some important work, but all of them are basically the same. There are very few people who say, “I have a Citibank personality.”
Banks are probably the best example for products that are substitutes. According to economic theory, what should happen to their profits? They should be very low. They should compete on prices because they are all interchangeable and people should choose the cheapest one, and therefore their profit margin should be eroded. But if you look at profitability of companies, banks are almost always at the top. What does this tell us?
It tells us that the idea that products that are substitutes would lead consumers to make choices based on price, and profits would erode. This doesn't seem to hold in the real world. Now, this is just a thought experiment. It's not evidence.
Another example is from something we call anchoring. So imagine I come to you with a bottle of wine and tell you that it costs $100. I then ask you to tell me if the cost is too expensive, to low, or just right. And you give your answer. And then I bring another version to you and I tell you that it costs $15 for this bottle of wine. Again I ask you to tell me if it costs too little, too much, or just right. Again, you give your answer.
Then I tell you to forget the answers you gave me.
Next I ask you the most that you would pay for the first bottle of wine. It turns out that people who thought about a bottle of wine in the range of $100 give a much higher answer. And the people thought about a bottle of wine int he the $15 range give a much lower answer. That tells us that the first time we think about a product influences how we think about it later.
It basically tells us that manufacturer’s suggested retail price influences the amount we are willing to pay. Now, when you think about supply and demand, people should know what they want and know what they're willing to pay for it. If people don't really know and they're influenced by the manufacturer’s suggested retail price, what does it say about people's ability to say something is too expensive?
Does this mean that standard economics is wrong? No. Is it perfectly correct? Also, no. Does it need lots of improvement? Yes. Especially when it comes to applied problems. This is what concerns me. I'm worried that sometimes we over apply simplistic theories, economics included, to real world problems.
I'm hoping that as we approach more real world problems, we will be a bit more cautious, take complexity into account, and hopefully come up with better theories, descriptions, and solutions. Here’s to more reasonable theories.
