Economics and Psychology

Economics is a science which is constantly progressing and interacting with other sciences. Studies in the economics literature discuss how people display a behavior in the economic decision- making progress. Psychology is a science which explains behavior of people and it cannot be ignored that psychology has a profound effect on economics. Human psychology and behaviors show complex structures, stereotyping people as indicating homogeneous behavior is criticized by many academics and researchers. In this study, it is examined how human psychology guides people when they make economic decisions and the purpose of this research is to analyze how the relationship between economics and psychology has progressed and to explain behavioral economics in this framework.

(Source: http://ideas.repec.org/p/okn/wpaper/0001.html)

Economics is the science of how resources are allocated by individuals and by collective institutions like firms and markets, the psychology of individual behavior should underlie and inform economics, much as physics informs chemistry; archaeology informs anthropology; or neuroscience informs cognitive psychology. However, economists routinely—and proudly—use models that are grossly inconsistent with findings from psychology. A recent approach, “behavioral economics,” seeks to use psychology to inform economics, while maintaining the emphases on mathematical structure and explanation of field data that distinguish economics from other social sciences.

(Source: http://www.pnas.org/content/96/19/10575.full)

Modern economics and psychology are both sciences of human behavior. Although they have a common theme, their relationship still swings between pure co-existence and selective interaction. In the begginnings of economics, economists like Smith, Benthan, marshall and many others were aware of, and even analysed, the psychological foundations of preferences and beliefs. However, psychological considerations in economics were lost when neoclassical economics started its triumphant progress within the science of economics. Economists found themselves able to explain individual behavior by relying solely on ordinal utility or preferences. This concept has no material content but serves to formally account for the influence of changes in relative prices or cost of individual demand and supply. As a consequence, this theory of "revealed behavior" departed completely from any psychological consideration. Using the fully rational model of decision-making, the economic approach became successful in many areas outside of the economy, like politics, law, history or art. This tendency toward "economic imperialism" was questioned by psychologists like Herbert Simon, Amos Tversky and Daniel Kahneman, who challenged the neoclassical economic model of man on the ground of its strong rationality assumptions. These (and may other) scholars showed that, under certain important conditions, individuals violate the rationality assumptions on which much of economic imperialism is based, in particular consistency. One important aspect is that individuals have limited cognitive capacities to maximise their utility subject to constraints and therefore revert to "satisficing." Another aspect is that individuals are subject to various behavioral anomalies. For instance, they are subject to reference point, anchoring, endowment, sunk cost, availability and framing effects, which also systematically violate the rationality assumption on which conventional economics is based. These insights came mainly from psychology (though in some cases, such as, for example, with the Allais-paradox, economists also observed violations of rationality).

By incorporating ideas from psychology, the movement of behavioral economics started to suggest modifications to economic theory. This integrative approach of economics and psychology searches for a new general model of human behavior. It widens the spectrum of inspiration that economics can gain from psychology.

(Source: B.S. Frey et A. Stutzer, http://www.bsfrey.ch/articles/362_01.pdf