Neuroeconomics: Why Economics Needs Brain?

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Table of Contents

Introduction
Weaknesses of standard economics solved by Neuroeconomics
How different lobes in the brain interlinked to the above responses
Key assertions of Neuroeconomics
Global financial Crisis and Neuroeconomics
How Neuroeconomics can help to improve Sales
References

Introduction

Neuroeconomics is the study of the economic cognition based on biological micro-foundations. Biological micro-foundations are neurochemical systems and pathways, for instance, brain mechanism, neurotransmitters and genes among others. On the other hand, economic cognition is cognitive activities that are linked to economic observation, beliefs and decision making process (Rustichini, 2005, p. 201).

The field of Neuroeconomics is less than a decade old and have approximately two hundred active neuroscientists and economists. Neuroeconomics is different from behavioural economics in that the latter is one-sided (mostly economists) while the former brings together behavioural economists, classical economists and other experts in economics and psychology (Camerer, Loewenstein & Prelec, 2004, p. 555).

The most frequently asked question is why economists should study the brain. Maybe it is because they need to enhance utility measurement. Nonetheless, the study of the brain can help in directing and catalyzing the development of new economic models and accelerating the rate of developing these models. Neuroscience provides new experiential method that offers novel empirical tests.

Neuroscience measurements assist people in understanding and managing themselves better (Camerer, Loewenstein & Prelec, 2004, p. 555). Therefore, Neuroeconomics provides fundamental changes in economic methods.

They go beyond the conventional economic practises to employ psychological insight as a motivation for developing economic models or take into consideration empirical evidences that confront behavioural assumptions of models in economics (Camerer, Loewenstein & Prelec, 2005, p.10; Rabin, 1998, p.12).

Weaknesses of standard economics solved by Neuroeconomics

Perception of the brain according to Neuroeconomists suggests a number of weaknesses on the concept of preference according to the standard economists. Physiological processes which are controlled by the brain can voluntarily or involuntarily influence individual’s choices and preferences (Camerer, Loewenstein & Prelec, 2004, p. 563).

The standard economics’ deduction of preference from a choice perspective does not provide sufficient explanation or discloses everything. Consider an imaginary case of two students, Tom and Jeri, who have both rejected an offer to buy Sausage at a reasonable price. The rejection of sausage reveals a common disutility for the same product.

But Jeri refused to buy the sausage because he is allergic to it. Consuming sausage cause him rushes, difficulty in breathing and to an extreme case can even be fatal. On the other hand, Tom refused to buy sausage because he had eaten a lot of it last summer and as a result has developed nausea for eating too much sausage.

Since then, his gustatory system links sausage with illness and that is why he refused to buy them even at a reasonable price (Camerer, Loewenstein & Prelec, 2004, p. 564).

Even though Tom and Jeri exhibit identical disutility, their physiological account tells us more. Jeri has inelastic demand for sausages and that means even if the offer was extremely good he won’t buy them. Conversely, Tom would attempt a couple of sausages for the right price.

In addition, their tastes will sooner or later change differently. For instance, Jeri’s situation may remain permanent, while Tom’s case might change if his craving strikes again or stops nauseating (Camerer, Loewenstein & Prelec, 2004, p. 564).

Another example of how the standard economics’ concept of preference can become even wider by neglecting the biological concepts is cases of accident. For instance, no builder can opt to fall asleep while working.

Naturally, imaginative economists can posit a trade-off between “sleep utility” and “risk of falling down from a building”, and suppose that the sleeping builder must have had higher u(sleeping) than u (falling down from a building). However, this description is a mere tautology. It is more important to think of the “choice” as a consequence of interaction of numerous systems.

From the biological perspective it is possible that the physiological system would have shut down the body when the builder got tired, and a controlled cognitive system which defends against sleep when closing your eyes was critical, and maybe lost the battle (Camerer, Loewenstein & Prelec, 2004, p. 564).

For standard economists, it is usual to model this incidence by assuming that it fully depends on the biological conditions. This raise a question whether the part of the brain that controls sight(cerebral cortex) was fully aware of the nature of the processes and assigned cognitive efforts (possibly cingulated activity) to manage them.

For instance, medical experts have argued that individuals often overlook mean-reversion in biological conditions and this explains why conventionally unrealistic facts such as suicide resulting from momentary despair, and consumers buying more food when they are hungry (Gul & Pesendorfer, 2005, p. 66).

Another weakness in standard economics is the principle of modelling in utility of income. According to standard economics, utility of income depends only on the values of goods and service and is independent of the income source. But according to Camerer, Loewenstein & Prelec (2005, p. 12) the selling price for earned goods is superior when the assigned good was paid for than for those unpaid for.

Zink et al. (2004, p. 511) also established that when individuals earn money, rather than receiving it in form of reward, there is a high activity in the striatum (region in the brain). Therefore, according to them earned money is factually more satisfying in the brain than unearned money. The fact that utility in the brain depends on the income source is possibly more significant for welfare and tax policies (Zink et al. 2004, p. 512).

How different lobes in the brain interlinked to the above responses

Homeostasis mechanisms have been greatly linked with electrical stimulations in hypothalamus and limbic structures which deep regions in the brain. According to a controlled experiment carried out in a rat using implanted electrodes established electrical stimulations in the lateral hypothalamus.

The animal crossed electrical grid several times before reaching the level, i.e., the brain regions that produced automatic stimulations otherwise known as the pleasure/reward centres (Camerer, Loewenstein & Prelec, 2004, p. 559).

From this experiment it is apparent that brain cells are subjected to direct electrical stimulation. In reaction to a stimulus, a feeling is a normally multidimensional, i.e., qualitative, quantitative, and effective sensation. Effective sensation is the one that is linked to pleasure and displeasure and mainly relies on the quality of the stimulus.

A small range of the stimulus (chemical, thermal and mechanical stimulus) is capable of arousing pleasure. The property of a stimulus to arouse pleasure or displeasure is often referred to as Alliesthesia. Both chemical and mechanical stimuli can produce Alliesthesia (Cabanac, 1979, p. 5).

The preference acquired or averted from the alimentary stimuli also presents a case of Alliesthesia. The ability of different stimulus to become rewarding or punishing is also linked to Alliesthesia. Alliesthesia helps individuals to detect danger around them. The Alliesthesic stimulus is controlled by the central nervous system with reference to homeostasis (Cabanac, 1979, p. 5).

When Alliesthesic stimulus is received in the parietal lobe (areas that controls motor actions from the central nervous system) it directs it to the temporal lobes which abodes the hypothalamus. Temporal lobes are responsible for memory, recognition and emotions in the human body.

The hypothalamus will react to the chemical stimuli accordingly and these are communicated to the rest of the body through the homeostasis process (Cabanac, 1979, p. 6).

Key assertions of Neuroeconomics

Neuroeconomics is identified as a research that unreservedly or clearly makes two fundamental assertions. The first assertion is that psychological and physiological facts that are relevant to the theories of economics. Particularly, they can be used to support or reject economic methodology or models.

The second assertion is that the things that makes people happy (true utility) are different from what they actually opt for. For that reason, welfare economists are urged to use true utility instead of choice utility (utility governing choice) (Camerer, Loewenstein & Prelec, 2004, p. 565). Besides the above two assertions, Neuroeconomics fronts a further challenge to the standard economics.

It argues that economics should take advantage of the latest advancement in neuroscience, particularly in the improvement in measurement. It asserts that the recent improvements may make it possible to unify economics and brain science (Caplin & Leahy, 2001, p. 57).

According to the standard economists, the term utility maximization and choice are one and the same. The utility function is normally an ordinal index that explains how people rank numerous results and how they behave given specific constraints. The relevant data normally describes consumption choices given the individual constraints.

The data are used to calibrate the model and the resulting calibrations are used to forecast the future choices and equilibrium variables, for instance, consumer’s tastes and preferences. For this reason, the theories of standard economics identify choice constraints from history behaviour and relate these constraints to prospective behaviour and equilibrium variables (Gul & Pesendorfer, 2004, p. 1403).

The standard economists emphasizes on disclosed preferences since economic data appear in this form. Economic data normally discloses what the consumers want or have opted for in a specific situation. These data enables economists to differentiate between what the consumers opted for and what they actually choose. The standard economics provides no technique of using non-choice data to measure preference constraints.

The consumer’s coefficient of risk aversion, for instance, can not be established through psychological test but can only be disclosed through consumer behaviour choice (Gul & Pesendorfer, 2004, p. 1403).

If economists come up with new theory based on non-choice parameters then the novel theory can results in new predictions in behaviour and this can be examined with disclosed preference evidence or if it does not the alterations becomes inane.

The examinable implication of theory in standard economics is its content. Once these contents are established, the non-choice evidence that prompted a new theory becomes irrelevant (Gul & Pesendorfer, 2005, p. 68).

Similar to its welfare criterion, standard economics utilizes consumers’ choice behaviour. When an alternative or a substitute is deemed to be superior to the good in question, if an only if, given the opportunity, the consumer will opt for the substitute over that particular good. Therefore, welfare criterion is synonymous with choice behaviour (Thaler, 1980, p. 39).

In standard economics, consumers’ choices may possibly improve when constraints are loosened up. For instance, consumers may make relatively superior choices when they are given adequate information, additional resources or additional time to make decision (Gul & Pesendorfer, 2004, p. 1403).

Nonetheless, standard economics lack therapeutic ambitions, i.e., do no attempt to assess or enhance consumer’s objectives. Economics has failed to distinguish between decisions that make best use of happiness, decisions that reflect a sense of duty or decisions that are as a result of reaction to some impulses.

In addition, economics takes no position on the question of which of the available objectives consumer should follow (Gul & Pesendorfer, 2005, p. 73).

Neuroeconomics has helped individuals to decide in economic and strategic situations since it focuses on psychological and physiological processes that are fundamental in decision-making processes. It attempts to relate the decision-making procedures to psychological processes in brain or account of emotional experience (Gul & Pesendorfer, 2005, p. 78).

Global financial Crisis and Neuroeconomics

In the year 2007-2008 the world was hit by the worst financial crisis whose ripples effect are still being felt up to now. The global economic and financial crisis generated challenges at all levels of the economy decisions. Governments in Europe and emerging markets faced an urgent need to act concurrently in different fronts. Systematically and politically sensitive economic sectors had to be bailed out.

The general downfall in economic activities had to be counteracted and vulnerable population groups had to be protected from declining incomes. These costly actions were taken in a context of falling government revenues and shrinking domestic and foreign financing, with medium to long term consequences for budgets and debt (Greenspan, 2008, p. 5).

The global financial crisis started when consumers defaulted to payback their mortgage debts/ loans. Effects of the crisis include regional banks failure and collapse of several financial institutions. In general, many European financial institutions saw enormously decline in capital associated bad debts and plunging values of collateralized debt repayments.

The massive losses have led to escalation of interest rates in risk management for the banks and have decreased their capability and willingness to take risk. This is evident in stringent lending conditions, withdrawn lines of credit bonds and increased loan spreads (Carlin, Lobo & Vishwanathan, 2009, P. 2236).

A million dollar question is would Neuroeconomics have helped to reverse the situation? In most economic studies risk is equated with variation of results. But for most individuals, risk is multidimensional, particularly the emotional aspect of it. Studies have shown that potential results which are more calamitous and difficult to control are more risky (Camerer, Loewenstein & Prelec, 2004, p. 569).

Financial experts have emphasized that risk is the probability of loss, particularly massive loss and is usually estimated by the variance of the loss portion of the outcome distribution (semi-variance). Risk aversion is driven by instantaneous fear responses which are modulated by a small area in the brain known as amygdala.

The Amygdala provides a rapid and grimy response to potential fear. The fear response can be regulated or overruled by the cortical input. The fear responses normally do not disappear totally but is simply being suppressed by the cortex (Camerer, Loewenstein & Prelec, 2004, p. 570).

Risky choices normally tend to be ambiguous and therefore involve a lot of gambling. Interplay of cognitive and effective processes are normally involved in choices among risky gambles. Therefore, a lot of attention should be paid to a new stream of relevant data when making decisions on highly risky ventures.

The increasing familiarity with brain functioning is likely to improve economic theories/models and other economic domains. This will help policy makers to make rational decisions when it comes to more sensitive and risky ventures (Camerer, Loewenstein & Prelec, 2004, p. 571). Neuroscience measurements have a comparative advantage over the measurements used in standard economics.

This is because Neuroeconomics “leaves no stone unturned” and therefore its measurements generates more dependable indices of significant economic variables, for instance, consumer confidence and welfare (Editorial, 2004, p. 71).

Neuroeconomics is also able to relate hypotheses regarding particular brain mechanism with unobservable intermediate variables and with observable variables.

In addition, Neuroeconomics attaches scrupulousness to the functioning parameters of the theories/models in the standard economic models (Camerer, Loewenstein & Prelec, 2004, p. 572). Therefore, application of Neuroeconomics would have helped to detect the looming global financial crisis. However, the thought that Neuroeconomics would have helped to avert the crisis is a subject of major debate.

How Neuroeconomics can help to improve Sales

One of the main functions of marketing executive is understanding, explaining and predicting behaviours of different clusters of consumers and how it is relevant in the market. This involves a lot than simply influencing consumers to buy goods and services. The concept of neuromarketing is provides more insight in the field of marketing and involves neuroeconomic knowledge to enhance marketing (Rustichini, 2005, p. 202).

Pricing is a fundamental tool used by many companies to position their products in the market. Despite of numerous literatures related to product pricing, many companies tend to use these knowledge when setting up prices, resulting in sub-optimal situation for both consumers and companies (Editorial, 2004, p. 74).

Understanding psychological aspects of pricing is very significant for companies striving to make optimal decisions and as a matter of fact has utility in a wider sense. The current techniques used in pricing research are behavioural in nature and relies on what actually takes place when individuals process pricing information.

If truth be told, pricing perfectly lends itself to neuroimaging research. Neuroimaging helps marketing executives to understand how prices are processed and provides them with all the information required to make rational decisions (Editorial, 2004, p. 75).

Exchange being a principle concept in marketing, negotiations is of massive significance. For instance, consumers encounters situation where they have to negotiate prices or benefits with the company, especially for capital goods. Unpleasant consumer experience means loss of customers and therefore companies must come up with strategies which ensures all the parties (consumers and the company) are satisfied.

Game theory has proved to be a very useful tool in economics and marketing studies when assessing interactions in situations where contradictory payoffs exists and are known to the participants. Game theoretical models have become very significant in the development of neuroeconomic research.

Neuroeconomic game theory research provides marketing executives with substantial insight into cortical activity in decision-making. Neuroeconomic game theory research tends to focus on competitive and cooperative characteristics rather than the negotiation process that may result in certain behaviours (Editorial, 2004, p. 74; Rustichini, 2005, p. 204).

Another prominent factor in marketing is trust. Many companies have spent massive resources to build consumer trust in their brands and products. The subject of trust not only involves company and consumers but also companies themselves. Inter-organizational dealings, for instance, joint ventures, tactical treaties, and business-business transactions among others rely on mutual trust.

On the other hand, consumer trust is very important when especially when it influences purchasing behaviour (Gul & Pesendorfer, 2005, p. 70). Neuroeconomic researches on the concept of trust beyond rationality have been carried out over the recent past.

These studies have established that the caudate nucleus in the brain, which is normally hyperactive when learning about stimuli-response relations, is very significant in tentative games that require some form of trust. Trust between companies can be ascertained by the reaction of the agents involved in the negotiation process.

Neuroeconomic exploration and understanding of the trust concept will help the marketing executives to have greater ability to discover the antecedent factors to trust, and this will help the company to build trust with their customers and other business partners for mutual benefit (Editorial, 2004, p. 76).

The study of the impact of various marketing activities on the society is also very significant. This subject has not been restricted to marketing and economics alone; it has also been explored in other fields such as communications, sociology, politics and psychology. Most of these studies have been concerned with the impact of advertising messages on society. However, marketing ethics is more than advertisement.

It also covers unhealthy marketing activities and their negative results, for instance, harmful effect of constant bombardment of marketing and product purchasing addition. This subject has also been tackled in neuroeconomic game theory research since it involves payoffs.

Application of neuroimaging will also helps marketing executives to understand the impact of certain marketing techniques, as well as more insight into main problems related to business relationships and answers to economic questions that have proven to be elusive (Editorial, 2004, p. 77).

References

Cabanac, M 1979, Sensory Pleasure, Quarterly Review of Biology, vol.54 no. 1, pp. 1-29.

Camerer, CF, Loewenstein, G, Prelec, D 2004, ‘Neuroeconomics: Why Economics Needs Brains’, Scandinavian Journal of Economics, vol. 106, pp. 555-579.

Camerer, C, Loewenstein, G, & Prelec, D 2005, ‘Neuroeconomics: How neuroscience can inform economics’, Journal of Economics, vol.43 no.1, pp. 9–64.

Caplin A, & Leahy, J 2001, ‘Psychological Expected Utility Theory and Anticipatory Feelings’, Quarterly Journal of Economics, vol. 6, pp.55-80.

Carlin, B I, Lobo, MS, & Vishwanathan, S 2009, ‘Episodic Liquidity Crises: Cooperative and Predatory Trading’, Journal of Finance, vol.62, PP. 2235-2274.

Gallese, V, Keysers, C, & Rizzolatti, G 2004, ‘A unifying view of the basis of social cognition’, Trends in Cognitive Science, vol. 8, pp.396–403.

Greenspan, A 2008, The Age of Turbulence. With a new Chapter on the Current Credit Crisis, Penguin Books, London.

Gul, CF, & Pesendorfer W 2004, ‘Temptation and Self-Control’, Econometrica, vol.69 no.6, pp. 1403-1436.

Gul, F, & Pesendorfer, W 2005, ‘The Revealed Preference Theory of Changing Tastes’, Review of Economic Studies, p. 66-95.

Editorial, 2004, ‘The Lancet neurology: neuromarketing, beyond branding’, Lancet, vol.3, pp.71-75.

Thaler, R 1980, ‘Towards a positive theory of consumer choice’, Journal of Economic Behaviour and Organization, vol.1, pp.39—60.

Rabin M 1998, ‘Psychology and Economics’, Journal of Economic Literature, 36, pp. 11-46.

Rustichini, A 2005, ‘Neuroeconomics: present and future’, Games Economic Behaviour, vol.52, pp. 201–212.

Zink, C F, Pagnoni, G, Martin-Skurski, M E, Chappelow, J C, & Berns, G S 2004, Human Striatal Response to Monetary Reward Depends on Saliency, Neuron vol. 42, pp. 509–517.

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