NCPA - National Center for Policy Analysis

Psychology Meets Economics

July 31, 2000

Conventional economic theory teaches that people make economic decisions based on rational self interest, using all available information. But a new generation of economists has factored in human foibles to demonstrate that people act irrationally. For example, they procrastinate -- and when they eventually do make decisions and act, they sometimes act out of emotion, rather than reason.

  • They procrastinate on saving for retirement -- putting off tough decisions and consuming today at the expense of their future well-being, even leaving sizable sums in low-interest bank accounts.
  • They shop for hours to save pennies, then make snap decisions on big-ticket items.
  • They run up huge credit-card debts even when they have ample resources to pay them off.
  • When people perceive that they are being unfairly treated, they retaliate -- even when the cost of retaliation is very high.

Matthew Rabin, an economist at the University of California at Berkeley, has reportedly been able to quantify the impact of human foibles on conventional economic theory. His colleagues say he has formalized behavioral economics.

Rabin sees the problem for individuals as one of self-control. People put off the chore of financial planning because it takes a lot of work and there is an insignificant cost of delaying those decisions until tomorrow. But then it's the same thing the next day. For that problem, Rabin recommends on-the-job seminars for retirement planning.

Source: Charles J. Whalen, "Putting a Human Face on Economics," Business Week, July 31, 2000.


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