Humans are inherently complex creatures, and of all the areas of economics no part can be more difficult than deriving a model for how people make choices and act within an economic context. And it is the modelling of economics agents that the limitation of our existing economic framework become most apparent. Agents are so called because they have agency, which means a thing or person that acts to produce a particular result. The basic premise of economics is that people have some conception of what they value. They will try to be efficient in the expenditure of their resources in order to achieve these valued ends, what is called economizing, and they will respond to external interventions called incentives in order to try and achieve these ends. These agents in the course of doing the activity of economizing will have to make choices. Thus a full and coherent microeconomic theory will need some account to all of these things. That is to say, what do people value, how do they make decisions, act on those decisions and how do they respond to incentives.
Ideas about people acting rationally that were first put forwards as conjectures got mathematics during the twentieth century into highly abstract models of human behaviour that today form the basis of microeconomics. But the disconnect between the foundational assumptions of the rational agent and how people really act in an economic context are becoming ever more apparent to use as reality once again bites back. As people increasingly reject the model of the rational agent this is once again opening up the debate as to how to model people within an economic context. The area today is rife with new experiments and new research as an area of economic science that became highly removed from other domains of social science begins receive a flood of attention from many other areas of the havioral science, such as neuroscience, psychology, and evolutionary psychology. In this new research we are starting to see emerge an alternative concept of the how people make decisions and act, a model that are empirical and data driven in their origins, leaving the theory aside and starting once again by looking at how people really act.
Out of this new behavioural approach a new model is emerging, one that is greatly more complex in that it incorporates context, it includes heterogeneity, it includes a diversity of psychological motives, it includes interdependency and most of all it includes context, everything that had been removed from the previous set of model is now flooding back in to try and give us a richer model to human economic decision making and choice. In this article, we will be exploring two different models given to capture this. We will talk about how standard economics offers this model of the rational individual sometimes called homo economicus, and we will draw upon the new area of behavioral economics which presents an alternative model to human behavior within an economic context.
Economics, on its most fundamental level, can be understood as the study of a certain dimension to the human condition. One of the most fundamental things we can say about the human condition is that humans value things, and we are motivated to strive for the things we value. Equally, we can note that we do not strive for the things we do not value. This process wherein we try to achieve the things we value is all pervasive in the human experience. We get up and go to work because of the remuneration and satisfaction it brings, we cook a meal because of a desire to eat, we take exercise because we value our health, we talk with friends because we value their company etc.
In all these situations people are involved in a certain goal-oriented behavior. They are doing certain things in order to achieve other things that they value more highly. In all instances when humans do not exhibit goal-oriented behavior of some kind, economics has little to say about them. For example, we might think about meditation as a state of the human condition that involves “just being” in some sense. As such economics can be contrasted with such a condition of being which is not engaged in a process of attainment. As Shakespeare might have said “to be or not to be” well economics deals with the human condition that is in the realm of “not being” in that it involved expending our current potential state of being towards achieving something that we value. This could be contrasted with many of the spiritual traditions such as Buddhism that explicitly try to renounce this endless pursuit of our desires and interests in replace of a state of being.
However, for the vast majority of humans and for the vast majority of the time we are endlessly engaged in this process of attainment, pursuing our valued ends through processes of investment, production, exchange and consumption of all kind. Economics can not be anything more than the study of this means-ends dimension to the human condition – it will never tell us about the ultimate meaning of reality or how to live at one with the universe – but equally, it should not be defined as anything less than this, in a narrow sense. Thus we should be careful as we elaborate the theory that fits within this overarching concept of the subject not to lose sight of it and restrict our analysis to something that is disconnected from this bigger picture.
Inherent in this mode of being wherein we operate to achieve a certain end is a logic that we try to increase the overall outcome at the most limited input. This difference between the input to a process and the output defines the efficiency of the system. This is not to say that we always try to maximize a single parameter. Many actions take place under a complex set of motives within a constraining environment, and those different motives and factors work to constrain each other. Thus we may or may not wish to have a job wherein we do nothing and get paid a thousand dollars a day. This is because there are other social and cultural factors that are limiting how much we might like to earn. But just because we are not trying to maximize a single metric does not mean that we are not trying to improve the whole outcome. We are trying to improve our overall welfare or well-being – and potentially that of others and other things – that means optimizing across a number of different parameters, social, natural, financial, cultural etc.
In this process of striving for the things we value we affect our environment in specific ways to achieve our valued ends. We call an entity that takes an active role to produce a specific result an agent. Thus we use the term bleaching agent, which is a chemical that is specifically designed to act on other substances, such as a textile, in order to achieve the desired result of removing color from it. Agency, in a social and economic context, means the capacity to make choices and to act independently on those choices to affect the state of the environment so as to achieve the things of value. Thus economic agents are abstract models of individuals or organizations which have this capacity for agency.
There are a number of important elements to agency. Firstly, there must be some value system. The system has to have some logic under which it processes information in its environment. The system has to have a means to effect its environment and be able to adapt and respond to changes within the environment. A plant is an agent because it will actively strive to attain more light and nutrients. Its value system is based on what is called exergy. There is some logic built into the biomechanics of the plant that enables it to affect its state and adapt to its environment in order to move towards the light and nutrients that are required for it to grow and increase its exergy.
Likewise, a person cycling a bicycle is acting as an agent, their goal is to stay moving forwards on the bicycle and they use their brain in order to process information according to a certain logic that enables them to adapt to the environment in moving towards their goal. The same is true for a person at work, a criminal trying to steal cars, a business organization, a trader making investments, a government, they are all agents.
In order to get agency, we have to have some form of value system. The value system ultimately is what tells the agent which way is up and which way is down and thus forms the foundations for defining which direction the agent should go in. A value system is a hierarchy of values that all agents possess and may be demonstrated by their choices. The first question we have to ask then is what do people value or how do they value things? Human beings are clearly complex creatures with a diverse set of values. We value many things, food to eat, water, safety, warmth, shelter, comfort, we value, friendship, self-esteem, social status, sense of community, independence, excitement, adventure, and the list goes on.
Human values and resulting motives have been studied most extensively in philosophy and psychology. Probably the most generalized and all-encompassing model we can draw from this is the hierarchy of needs, that brings these various needs and motives together into a generalized framework and parallels many other theories of human developmental psychology. This framework structures values and the corresponding complex set of needs that humans exhibit into a hierarchy that is believed to describe the pattern that human motivations generally move through, from more basic values and motives to those that are more complex in nature.
The most fundamental basic or primary human requirements are for physiological needs, which are the physical requirements for human survival. If these requirements are not met, the human body cannot function properly and will ultimately fail. Physiological needs are thought to be the most important. Thus people value such things as satisfy these needs first, such as food, water, security, which are basic requirements for all biological creatures. These are what are called “deficiency needs” they are thus called because deficiency needs are said to motivate people when they are unmet. Also, the need to fulfill such needs will become stronger the longer the duration they are denied. For example, the longer a person goes without food, the more hungry they will become. As such these primary needs define a world of scarcity as they exist in relation to a deficit. These primary values are objects that satiate that deficit.
Lower in the hierarchy are what we might call subjective needs. That is to say, they are needs that the individual – the subject – requires. They involve a direct relationship between the subject and the object of desire. Higher level or secondary needs are needs for connection with something other than ourselves and our personal needs. Secondary values are associated with a connection to a broader social, cultural or natural environment. In a more concrete form they are the connections we have with other people and things, in the form of friendships, partnerships, community, culture, natural environment etc. and the value we get – for example in the form of self-esteem and belonging – from the role we play within these larger systems of organization.
Ultimately this desire to be part of something greater than ourselves and the value we derive from it leads to self-transcendence. “Transcendence refers to the very highest and most inclusive or holistic levels of human consciousness, behaving and relating, as ends rather than means, to oneself, to significant others, to human beings in general, to other species, to nature, and to the cosmos” – Abraham H. Maslow, Farther Reaches of Human Nature. As such we may say that secondary needs are motivated by objective values in that the value is derived from forming part of some objective system and the role we play within that. The value is not in a single thing but in the connections that we have with other things. This is in contrast to subjective values that derive from the attainment of some object that the subject desires to fulfill their specific needs.
People’s values are not absolute, they exist in relation to the needs that have already been met. This model posits that people are motivated to achieve certain needs and that some needs take precedence over others. Our most basic need is for physical survival, and this will typically be the first thing that motivates our behavior. Once that level is fulfilled the next level up is what motivates us, and so on. In such a way our value system alters and adapts in response to our current state. This is as much true for the individual as for a whole society, the values of an advanced economy will be very different from those of a primary economy.
The human brain is a complex system and has parallel processes running at the same time. Thus many different motivations from various levels of the hierarchy can occur at the same time and interact to give a certain outcome. In striving for our desired ends we rarely take into account only one form of value but instead are typically making a tradeoff between different forms of value.
Motivations come with certain goals and objectives that organize one’s thinking and there is an organizational principle to these motivational systems. Motivation organizes our thinking, perception and action tendencies. The human brain is not an empty vessel performing calculations in a vacuum like a computer, but instead, information is received and processed within a given emotional and motivational state that strongly conditions what information is received, how it is interpreted and how we act on that information.
Agents have motivations that drive them to value things. In order for agents to pursue their valued ends, act and affect their environment towards achieving those outcomes they need some logic under which to do this. That is to say, they need to take in and process information according to rules so as to generate a response that will lead to their ultimate desired end. If we want to understand how economic agents behave we thus need to define, to some extent, how this is done.
There are fundamentally two foundations upon which actions are based. Our actions may derive from individual deliberative reasoning, and this would be called a rational action, or they may derive from some other non-deliberative source, such as instinct and emotion, heuristic or social cues etc. Rational means designed or conducted according to reason. Reasoning is a process whereby data is amassed, processed according to some logic in order to produce a conclusion that is both logically consistent and in accordance with objective data.
Thus a rational decision is one where an agent amasses all relevant information, processes it according to a consistent and objective logic and then acts in accordance with the outcome of that process. In so doing the agent acts independently, they act on their own internal logic in an autonomous fashion. Thus for a decision to be rational, there are a number of requirements, firstly that the agent has all the relevant information and that any information that is not fully known can have a probability distribution assigned to it.
Secondly, the agent must act according to a consistent and objective logic set, which means that the choices made will not change unless there is some alteration to the objective factors determining the decision. Agents have to have a fixed set of preferences and these preferences have to be complete – the person can always say which of two alternatives they consider preferable or that neither is preferred to the other. An actor is acting rationally when they take account of available information, probabilities of events, and potential costs and benefits in determining preferences, and act consistently in choosing the self-determined best choice of action.
Although the term rationality simply means according to reason, the requirements for achieving this are only met in some circumstances or some of the time. Rationality requires that we have intelligent calculating agents operating in simple environments. In such circumstances, it is reasonable to say that people often act rationally in pursuing the things they value. However, just as often we will be dealing with contexts wherein agents with limited intelligence and propensity for reasoning will find themselves in relatively complex environments. In such circumstances, agents do not use reason to determine their actions but use a variety of alternative means, that are contingent upon the social, physical or cultural context within which the decisions are being made. That is to say, that the rationality of an agent is bounded when it reaches a limit it switches to alternative means for making decisions. This limit is both contingent on the particular subject – there propensity to use reason – and the environment – how complex the environment is.
Much of the time people operate in environments where there is incomplete information, radical uncertainty may exist, where they do not wish to expend the energy and time to reason through their actions, we don’t want to take the responsibility of our actions, there are time limitations, social power dynamics or a series of other limiting factors involved. In such circumstances we defer our decisions to heuristics, which are shortcuts, we use social and cultural norms, we copy what others do, we allow random events to determine our decisions.
In order to make choices, agents need some set of rules under which to make their choices. This set of instructions or rules can be based on some simple linear cause and effect model, what may be called an algorithm, or they may be much more complex models, what may be called a schema. With this capacity of agency comes autonomy. In their choices and actions, agents define themselves as independent from other things and thus define their own identity with associated responsibility for their actions.
The decisions we make feed through to the choices we make and ensuing actions with associated consequences. In the act of performing this process of striving for the things we value we have to inevitably expend resources. As many economists try to derive all economic phenomena from micro foundations, the theory of choice can be seen to play a key part in the whole enterprise. The two primary interpretations for this are rational choice theory and what might be called behavioral choice theory. With rational choice theory, choices are seen to be made rationally, preferences are seen to be fixed and externally given. In such a model choices are seen to be an optimization process over a given set of well-defined preferences that can be all directly compared according to some common criteria called utility – in its more concrete form this is typically money.
The assumption of rational choice theory is that an individual’s behavior is directed by the primary motive of maximizing self-interest based on personal preference. Rational choice theory is able to show with detail how an individual can act rationally according to their own preferences, it says little about where individual preference come from and how they may change over time. With rational choice theory, preferences are provided exogenously but there is no explanation of how they are formed. Choices are seen to be made in an isolated context where each agent faces an impersonal set of fixed options and then makes their choices independently from others. When we do not need to take into account differences in people’s motives, and context we can often define one single representative “normal” actor that accounts for a whole population of agents.
In contrast, a behavioral model would see choices not as being fixed and hardwired but as adaptive, depending on context. Here fixed preferences are replaced with motivation. Whereas preferences in the rational choice model are seen to be fixed and exogenously given – like you are born with them – motivation is context dependent as preference changes depend on which motivational systems are activated within a given context. Motives come first and these motives then define the value of things, thus value can be seen to be more dynamic.
Choices are not fixed but instead agents are continuously adapting their expectations based upon current and previous information they receive in order to adjust their expectations about the future. One example of adaptive choice would be individual reinforcement, in which agents reinforce choice probabilities based on their prior choices. Another example would be social reinforcement, where an agent reinforces their choice probabilities based on the choices of other agents in similar decision environments.
In such circumstances where context comes to play a part in the choice making process it is required that we look at the network of connections that the agent is embedded within, social, cultural, environmental etc. both in time and space and also look at the nature of those connections i.e. are they reinforcing or dampening each other out. Unlike the rational model to choice theory that leads to a much simpler model – because agents are making similar choices in isolation leading to stable outcomes – this model takes us into the world of complexity in that it requires modeling choices as heterogeneous, interconnected and leading to unstable or non-equilibrium outcomes.
Finally, these agents in the course of doing the activity of economizing will have to make choices and they may respond to external interventions called incentives in order to try and achieve these ends and this is another important consideration both in microeconomics and management. A basic premise of economics is that people respond to incentives. The fact that people are trying to achieve some end through efficient methods, means that if we change either the context or the ends they will change their behavior.
Because in the rational choice model the choices actors make is seen to be defined by an optimization calculation – taken in isolation in relation to some fixed set of preferences – it is seen that if we change the values to the parameters involved in the calculation we can change the choices made. That is to say that the standard model to incentives focuses on altering the ends that are given to agents in order to alter their motives. These payoffs are called positive incentives, where the positive-incentive value is the anticipated pleasure involved in the performance of a particular behavior, such as eating a particular food or drinking a particular beverage.
The theory of incentives is one of the major theories of motivation and suggests that behavior is motivated by a desire for reinforcement or incentives. Thus, in contrast with other theories that might suggest we are motivated into our choices by internal drives, incentive theory instead suggests that we are pulled into action by outside incentives. According to this view, people are pulled toward behaviors that offer positive incentives and pushed away from behaviors associated with negative incentives. In other words, differences in choices from one person to another or from one situation to another can be traced back to the incentives available and the value a person places on those incentives.
The management paradigm that follows naturally from this insight is that if we change the payoffs to the agents then we can alter their choices and design the organization towards achieving what management see as the desired results. When we incorporate the idea of context into how people make choices then incentive theory can change from one that is solely focused on the explicit payoffs, to focusing more on the network of connections within which they make choices and act and how altering this set of connections can, in fact, alter how agents make their choices.
Behavioral economics is currently exploring an alternative model to incentives that looks at the broader context within which agents are making choices, this can be the physical environment, the social environment or cultural context. One example of this is advertising, where advertising functions by creating a cultural or psychological context around a product that works to alter the agent’s perception of it and thus alter their behavior towards purchasing the product. Of course, advertising as a means of affecting people’s behavior has long since been known to business management but it remains excluded from our standard choice model. Already new terms and even new professions have built up around the behavioral approach to incentives, such as choice architecture and nudge theory. Where choice architecture is using this basic premise that context matters to incentives and then designing the physical, social or cultural context within which choices are made to achieve the desired results.
For example, the use of a default choice is one method through which choices can be influenced based on psychological factors that would not affect the choice if people were, in fact, making reasoned decisions. It has long since been shown that typically consumers are more likely to choose options that are presented as a default – where default is the preselected option that individuals must take active steps to select another option, for example signing someone up for a newsletter as the default option when they register with an organization. Likewise, the physical context can be used to alter choices, such as having open offices where the physical office space is specifically designed to enable interaction between members. All of these illustrate that people are not simply considering the end payoff but are instead also affected by the set of connections within which they find themselves making the choices and by altering those connections it is possible to alter the behavior.