Question

Economists have known for many decades that individuals experience the
emotions of dread and anticipation, but why is it necessary to incorporate
these into economic models?

Answer 1

The Classical economic models make assumptions that all humans are rational, reacts to different scenarios in a particular fashion and divergence between their thinking process is very less. However, as common experience dictates, this is not the case. Most of the humans, if not all, are heavily carried away by emotions, rather than rationality. So, emotions and psychological aspects are important tools to account that why humans diverge away from the rational decisions.

Two types of emotions are distinguished, expected and immediate. Expected emotions have been widely documented and researched. But, practical experience shows that immediate emotions highly influence the decision making process. Sometimes, immediate and expected emotions are contradictory. For example, if someome is in a positive mood, then he/she can become more inclined to take risks, but it may also happen that someone else in a positive mood do not take risks so as to preserve the positive state of mind (Isen, Nygren, & Ashby, 1988;Kahn & Isen, 1993).

People take into account, how they will feel about potential consequences of alternative course of action. Also, fears causes many a times to take a decision which is not in terms of material benefit of a person. Personal Bias dictates over rational decision. If someone finds a product cheaper, is it necessary that he/she will purchase it? No, many personal biases comes into factor when making a decision like maybe the shop which is selling the product at higher cost is more hygenic, more attractive or maybe that shop is one of your friends or relatives. These personal biases dicates our choices and most of the time rational and logical mind is overshadowed by emotional bias in many events of day-to-day life. Peer group influence. Many a times, our decision is based on suggestions by peer group or affected by their decisions. This sometimes may lead to a chain event, completely falsifying classical economic models. Like if you buy groceries at online marketplace for the first time, and it turns out to be spoiled, then you will again revert back to store. But, it may also affect decision making of your parents, your friends etc.

Like Law of Demand suggests that as the price of a good increases, demand decreases and vice-versa (all other conditions being equal). But we often find example of vebler good, in which demand increases and the price increases. There are also many other contradictory examples which violates this law. Reason? Emotions have a role to play here which are not guided by the law of economics.

A recent example of bitcoin is also a good case study. We can see that how the price of bitcoin rose to all time high in december when there was so much buzz about it. But, once the eminent personalities and other people started sharing their views that it may be a bubble, price dropped heavily and halfed in almost a month. The decisions of purchasing bitcoins were largely guided by emotions, considering profit/loss, suggestions by peer groups, seeing someone gaining quick cash etc.