Economics: Psychology vs. Rational Self-Interest

The main premise behind classical economics is that people are driven in their consumption decisions by what Adam Smith called rational self-interest. That premise is not correct. Most consumption decisions are not driven by rational self-interest; they are driven by psychology.

I do not mean only the person who overeats or the person who wastes his money on gambling. I also mean the person who spends huge amounts of money on fashionable clothing when he could get good-enough clothes for one tenth the price. I also mean the person who buys a Hummer when he could have a Jeep for one-fifth the money expended. I also mean the person who procures a huge house that he has to work relentlessly for many years in order to pay off. I don't just mean decisions of people who are obviously sick. I also mean the decisions of many normal people.

Another obvious influence of psychology on economics is in marketing. Most marketing is based on psychology. There are very few ads that simply and rationally state the benefits of a product. They use all sorts of psychological manipulative techniques. We see the obvious outcomes of that in inferior products dominating the market for reason of superior marketing. Beta had the better product; VHS got the market. Borland had the better product; Microsoft got the market. Mom-and-pop shops had the better product; instead the market is dominated by fast food chains.

Does this make Keynes right in claiming market to be based on "animal spirits?" While that term is too judgmental, a more reasonable claim to be made is that the market is dominated by psychology. Is that good or bad? Could be good, bad, both or neither. But what this definitely demonstrates is that it's not people's rational self-interest that comprises capitalism and drives the "invisible hand."

I knew a poet in Tucson who proposed this as a metaphor for the civilization: A mechanism that extracts eros and powers the economy. As he explained, "Man sees on the TV a naked woman, man feels 'want to breed with the naked woman,' man goes out and buys stuff, and that powers the civilization." Here is a claim not frequently considered: That behind people's economic decisions is erotic striving. That of course is an outgrowth of psychoanalytic theory, which is at the root of psychology.

In any respects, what actually drives people's economic decisions is only rational interest in some cases. Most economic decisions are based on psychology. This is the case with both economic decisions that work and economic decisions that don't work. Certainly there is very little to recommend the economic decisions of someone who overeats or gambles; but we see psychological role in all sorts of decisions, including not as overtly disastrous ones.

It is of the essence to understand the role of psychology in economics, because its role is vast. I don't just mean psycho-pathological choices; I mean regular choices. I mean buying super-expensive clothes just because they are fashionable. I mean buying VHS instead of Beta and Microsoft instead of Borland. I mean having McDonalds instead of going to a mom-and-pop shop. I mean driving up housing prices in irresponsible speculation when there is no real-world reasons to justify this craze.

Is capitalism bad? No; but it's not based on what its basis is claimed to be. Psychology, not reason, forms the basis of a vast chunk of economic choices. Many choices come from manipulation by marketers. And any number of others come from reasons that are psychological rather than rational (achievement of self-esteem, atoning for insecurity, desire to prove oneself or feel glamorous, and any number of other factors).

Perhaps the most important issue here is the definition of rational. Which interests are rational, and which ones are not? Clearly gambling away one's savings is not a rational choice. But there are many other irrational choices that are not as obviously irrational. And any number of them are committed by your average person.