Neoclassical framework of economic theory is a set of ideas which are internally consistent and provides fairly logical insight into human behaviour at large. For example, if the probability of detection rises, socially undesirable activities like tax evasion falls, consumers buy less if price increases and so on. This domain comprises of, if not exclusively, consistent preferences, emotionless deliberation, unlimited cognitive capacity, Bayes’ rule of probability updation and exponential time discounting, among others.
There is a somewhat incorrect impression in the public domain that neoclassical framework has no scope for alternative approaches. This is not true. In fact, there is provision for incorporation of notions like non-exponential time discounting, reference dependent preferences, etc. Unfortunately, these extensions hardly provide any new insight.
Consider the case of reference dependent preferences. Such an extension reveals little additional information in the absence of a body of theory which analyses how human behaviour changes in the domains of gain and loss. Behavioural Economics is a synthesis of tenets from different subjects like Economics, Psychology, Sociology, Anthropology etc. It’s birth can be traced back to a less celebrated book written by Adam Smith, The Theory of Moral Sentiments. Smith had recognised many behavioural phenomena like altruism, planner-doer framework, loss aversion and others. Jeremy Bentham had stressed on the importance of psychological facets of utility. However, a somewhat aversion to Psychology as a discipline and the advent of the theory of revealed preference led to the gradual exit of psychology from economics.
It made a re-entry through the works of Allais, Ellsberg and Markowitiz in the 1950s and 1960s. The emergence of cognitive psychology also played a vital role in this revival. Among other avenues explored, behavioral economic theory has stressed on the importance of bringing in the entire range of emotional canvas as compared to just the cool, composed and calculative subsection for analysing economic behavior. Before proceeding further, it is necessary to provide an overview of the broad types of emotions that exist.
Following Elster (1998), social emotions include anger, guilt, shame, pride, hatred, etc. Counterfactual emotions are those borne out of unrealised outcomes like regret, disappointment. Anticipatory emotions include those stimulated by the anxiety about what may happen in the future like, fear and hope. Realised emotions are borne out of events that have already happened in the past like joy and grief.
Material emotions develop from possession of tangible items like jealousy. In another manifestation of emotions, intense physiological conditions, clubbed together as visceral factors, also influence economic behavior. Loewenstein (1996) has pointed out that such factors have a “disproportionate” impact on the behavior of that period, to the extent of even harming self-interest. Also, human beings typically underestimate the importance of visceral factors on past, present and future behavior. Following an empirical exercise, prior to the onset of labour, pregnant women were asked if they were open to the idea of using epidural during the child’s birth.
The study showed that a large proportion of those who had refused earlier, under the tremendous physical duress, resorted to the anaesthesia. At this junction, it must be pointed out that there is a difference between visceral factors and preferences. The former are more volatile and are induced by external stimuli or cues. Cue-conditioned consumption is an everyday phenomenon. Beautiful weather often calls for a glass of red wine, wonderful aroma of a freshly baked cake increases the desire to gorge on it.
Analysing the effect of cues on habit formation, Laibson (2001) has shown that there exists a threshold value which determines the agent’s decision to consume.