Contribution Of Behavioral Economics To The

Contribution of behavioral economics to the

understanding between income and happiness

by Kanchiny Ramachandran

It has been accepted that traditional economic modeling is no longer accurate, especially in measuring an individual's happiness, as studies have shown that other factors rather than income also play a big role in an individual's happiness. New better models that incorporate links between economics, sociology, and psychology have been developed in order to better understand consumer choice. One of these models are aptly named "Behavioral Economics," as it attempts to provide better understanding of economic decisions by applying psychological principles of individual behavior to economics. Though it may not provide all the solutions to all economic phenomena, it provides more insight to the relationship between income, happiness, and the reasons behinds an individual's economic decision.

Behavioral Economics is defined as the "combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications" (Mullainathan n.d). It attempts to explain areas in which consumer behavior does not match traditional economic modeling. The areas that do not match traditional economic modeling (basic choice theory) can be described with the following questions:

* Why do some people unhappy even though they've had a pay raise?

* Why aren't all rich people happy?

* Why do people buy lottery tickets even if the probability is so low?

* Why do people give to charity if it doesn't increase the individual's income?

One of the main assumptions of the traditional economic model is that utility increases with income, which is directly related to happiness. However, this is not the case as studies have shown many cases where income increases but happiness remained. For example, in Japan between 1958 and 1987, the income per capita increased by 500% due to the sudden increase of consumption of newly available technologies, but yet there was no improvement in mean subjective well-being (Richard 1995, p40).

This is explained by behavioral economics, by saying that individuals take "reference points" of the norm and compare themselves to it. Karl Marx gives the example that, "A house may be large or small; as long as the surrounding houses are equally small, it satisfies all social demands for a dwelling. But if a palace rises beside the little house, the little house shrinks into a hut" (as quoted in Lipset, 1960, p. 63). Karl Marx uses the word "hut" to describe how the individual would feel, obviously disappointed now that his house feels like it has been reduced, even though it has not changed in size. In this case, the individual took the palace as a "reference point," and compared his house to it, and thus feels insignificant because the norm has now increased.

Another main assumption of traditional economics is that individuals only decide based on rational decisions; decisions that would increase the income of an individual. However, this assumption is highly flawed as it can not explain why people give to charity, and why some consumers will go out of their way to "punish" a store for poor services or ill business practices. "Research tells us that a satisfied customer will tell about 3 others...unsatisfied tell an average of 12 others about their unsatisfactory service experience."(Dr. Rinke 2000).

Behavioral

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