Monday, January 7, 2008

The Economics of Fear

In altruism and behavioural economics, we took a very basic look at why the assumptions of traditional economics are insufficient for decision making. Another important factor in behavioural economics is the issue of fear. There are many examples of how this issue can influence economic decision making.


People are willing to pay a significant amount to prevent a small chance of losing a large amount of wealth. In the long run, insurance is more expensive than the benefits that accrue, but, people prefer the security of knowing they won't lose everything. However, with insurance there is also the issue of decreasing marginal utility of wealth. We don't miss the extra £50 a month insurance payment, but, we could not cope with losing our house.


This is an idea that people are influenced by events in the past. Even if circumstances have changed, people remember what it was like in the past and this remains a powerful influence over current economic decision making. For example, after a period of economic properity, people may keep spending in the sales, even though their future income prospects are less promising. Expectations of inflation are very much based on past data. High inflation begets more high inflation.

Influenced by Outside Influences.

Consumers are very much influenced by outside media pressures and perceptions of economic reality. For example, an interesing phenomena is how many Americans think America is already in a recession. The American economy is not a recession (even if house prices are falling and there is a credit crunch) Yet, people will talk as if there already is a recession. This fear of a recession can of course make a recession a reality. If people think they are in a recession, their spending will fall (even though their income may be rising) this will lead to lower aggregate demand and lower economic growth. The important thing is that people's spending is influenced not by their own income, but, perceptions of the general economic outlook.

A good example of this is the run on the bank syndrome. When people heard Northern Rock was in difficulty, people rushed to the bank to withdraw their savings. Because other people were rushing to the bank, many people felt they ought to. This was despite the fact that Northern Rock's problems did not affect savers directly. It was due to problems of refinancing mortgage loans. But, in this kind of situation there is often a 'herd' mentality - people follow what others are doing.

Bounded Rationality

Another issue is that people may be bound by limited information. Therefore, it is not so much fear as inadequate information which leads to irrational decision making. For example, how many American consumers would know the inflation rate and economic growth rate of the American economy.

Booms and Busts

Markets with supposed 'perfect information' are often subject to wild fluctuations. In periods of booms people jump on the bandwagon - buying share or houses. But, when market sentiment changes a little, the mood can swiftly change as people frantically sell, trying to get out before the market collapses. There are many examples of prices moving independently of economic fundamentals e.g. dot com bubble and bust of early 2000s.

1 comment:

Anonymous said...

I'm curious for your take on the current swine flu hysteria. Is the threat of death to the masses as great as the value of millions of doses of vaccines to big-pharma?