Rational Self-Interest and Psychology in Economics

I am going to tackle a very serious subject – one of the axioms that are central to classical economic theory. Classical economics states that economic decisions are driven by rational self-interest.

I am parting with that axiom and suggest the following: That while some economic decisions are in fact based on rational factors, many more are based on psychological and emotional factors. And the amount of economic decisions based on these factors is vast.

I start here with the most obvious examples. A person who stuffs herself with food until she becomes obese and diabetic, or a person who spends all his money on gambling, is clearly not driven in consumption decisions by reason at all. Such a person is driven by factors that are not rational in any manner and that are in nature psycho-pathological. It occurs to me that similar psychological factors extend far beyond these obvious examples and apply to many people, including ones who are not gambling addicts or who are morbidly obese.

Here is an economic choice based in rational self-interest: A comfortable, affordable, fuel efficient vehicle. Here is an economic choice not based in rational self-interest: A hugely expensive, polluting vehicle such as the Hummer. Here is an economic choice based in rational self-interest: Nice looking affordable clothes. Here is an economic choice not based in rational self-interest: Super-expensive clothes that one buys because they are in fashion. Here is an economic choice based in rational self-interest: A functional, comfortable, affordable house or condo. Here is an economic choice not based in rational self-interest: A vast house that one’s wife has to spend six hours a day cleaning. Here is an economic choice based in rational self-interest: Nice simple shoes. Here is an economic choice not based in rational self-interest: Expensive trendy sneakers that one needs to sell drugs in order to procure. Here is an economic choice based in rational self-interest: One plastic surgery treatment when one’s features are disfigured. Here is not an economic choice based on rational self-interest: Many plastic surgery treatments when one is already beautiful.

Some economic choices are based in rational self-interest. They however do not begin to include the total sum of economic choices that people make.

The biggest argument against the idea that all economic choice is based on rational self-interest is not any of the above. Instead is the fact that many products that are bought, are bought not because of the quality of the product but because of the quality of the marketing. A consumer driven by rational self-interest would buy the superior product; but time and again – with Beta vs. VHS, with Borland vs. Microsoft, with mom-and-pop shops vs. fast food chains – we see inferior product dominating the market. The reason that these inferior products dominate the market is that their makers are better at marketing. And choices based on marketing are not choices based on reason. They are choices based on psychology.

Why are these choices based on psychology? Because that is what is targeted by most marketing campaigns. Very little of ads out there are simply and rationally stating the benefits of the product. They use all sorts of psychological devices to manipulate people into buying the product. Advertising very rarely targets reason exclusively; far more often it plays with people’s emotions. Which makes these emotions, as manipulated by the marketer, the centerpiece of a vast chunk of economic choices that people make.

Does this make most economic choices that people make wrong? No; but what it does show is that many of these choices are not based on what classical economic theory regard them to be based upon. Does this damn capitalism? No, but it shows where one of its major axioms is incomplete. Yes there are economic choices that are driven by rational self-interest; but there are many economic choices that are not driven by rational anything, and it’s important to take such things into account whether one is a consumer, a producer or a policy maker.

The consumer on his part needs to learn more about psychology so as not to be as vulnerable to psychological manipulation by marketers. The policy maker needs to see where someone is taking advantage of people and do what he needs to do to stop the unscrupulous practices. And the honest producer, such as Borland and mom-and-pop shops, need to see where their competition is using unethical ways of marketing and respond with effective and intelligent marketing on their own part. I do not advocate Communism. I advocate a more ethical capitalism. And that means, first and foremost, seeing where people are being taken advantage of and putting a stop to the unethical economic practices that play them for fools.

Of course a large part of the burden for this lies with the consumers themselves, who frequently are either not thinking or are thinking stupid. Many of these problems stand to be solved by broad-based education that teach people better thinking habits so that it’s not as easy to take advantage of them, and also so that they exercise greater discretion and responsibility in their economic decisions. The more choices are actually based on rational interest, the more the economy functions as advertised; the more they are based on psychological manipulation, the more the economy turns into an unethical and irresponsible plutocracy that treats people as idiots and laughs all the way to the bank.

At the very least it is important to make this clarification. An economic theory that fails to see a vast chunk of the reasons for people’s consumption decisions is a theory that is incomplete. The role of psychology in consumption decisions must be examined and credited for the large chunk of consumption decisions for which it is responsible. And based on that it can then be possible to determine which economic practices lead to people’s benefit and which economic practices do not.