6 Psychology of Macroeconomic processes

Question 1

Economics

Compare behavioural, keyneisan and classical economics.

Answer 1

Here’s a concise comparison of Classical, Keynesian, and Behavioral economics:

1. View on Markets:
   
   • Classical: Markets are self-regulating and reach equilibrium naturally.
   • Keynesian: Markets can fail; government intervention is needed during downturns.
   • Behavioral: Markets are influenced by irrational behaviors and biases, which can lead to inefficiencies.
2. Role of Government:
   
   • Classical: Minimal government intervention (laissez-faire).
   • Keynesian: Active government intervention to stabilize the economy.
   • Behavioral: Government should intervene to correct irrational decision-making (nudging).
3. Focus on Supply vs. Demand:
   
   • Classical: Focus on supply-side factors (production and labor).
   • Keynesian: Emphasis on demand-side factors (aggregate demand).
   • Behavioral: Focus on psychological factors affecting both supply and demand decisions.
4. Employment:
   
   • Classical: Full employment is the natural state; wages adjust to clear the labor market.
   • Keynesian: Unemployment can persist without government intervention.
   • Behavioral: Psychological factors, like loss aversion, can cause labor market inefficiencies.
5. Rationality:
   
   • Classical: Assumes individuals are fully rational.
   • Keynesian: Assumes limited rationality, especially during crises.
   • Behavioral: Individuals are often irrational and influenced by biases.
6. Economic Fluctuations:
   
   • Classical: Self-correcting in the long run.
   • Keynesian: Requires short-term government action.
   • Behavioral: Driven by emotional and cognitive biases, like overconfidence or herd behavior.

In short, Classical economics relies on self-regulating markets, Keynesian focuses on demand management and government intervention, while Behavioral emphasizes the impact of irrational human behavior on economic decisions.

Question 2

What is the prospect theory?

Answer 2

Prospect Theory, introduced by Kahneman and Tversky, explores how people make decisions under risk, particularly emphasizing loss aversion. In their studies, they found that people tend to prefer choices framed as gains and avoid those framed as losses, even when both options are objectively identical.

In your example:

• Medication A: 5 out of 100 people will die (loss framing).
• Medication B: 95 out of 100 people will survive (gain framing).

Although both have the same outcome, most people prefer Medication B because it emphasizes survival (gain), while Medication A emphasizes death (loss).

Key insights from Prospect Theory:
- People disproportionately avoid losses, even when the outcomes are the same as a gain.
- Decision-making is influenced by how options are framed, not just by the final outcome.

In business, framing decisions in terms of potential losses (like the fire insurance example) tends to be more persuasive than framing them in terms of gains because people are more motivated to avoid losses than to achieve gains.

Question 3

Explain the nudge theory.

Answer 3

Nudge Theory (Thaler & Sunstein, 2008):

• Definition: A nudge alters behavior predictably without restricting options or changing economic incentives (e.g., placing fruit at eye level).
• Key Characteristics:
  
  • Easy and cheap to avoid.
  • No mandates (e.g., not banning junk food).
  • Non-coercive approach, termed “liberal paternalism”.
• Examples:
  
  • Placing a fly image in urinals to improve cleanliness.
  • Arranging healthier food choices at eye level.
• Effectiveness:
  
  • Some studies show nudges improve behavior (e.g., dietary changes).
  • Meta-analyses provide mixed results on long-term effectiveness.
• Ethical Concerns:
  
  • Nudges influence subconscious decisions, raising questions about transparency and manipulation.
  • People may be unaware of the external factors affecting their choices.