behavioural-economics

An introduction to Behavioural Economics

• Behavioural economists question the assumption of traditional economic theory that individuals are rational decision-makers who endeavour to maximise their utility

  • It argues that many economic decisions made by an individual are biassed

• Behavioural economics is a field of study that combines elements of psychology and economics to understand how people make decisions and behave in economic contexts

Diagram: Traditional Versus Behavioural Economics

• Behavioural economics recognises that human decision-making is influenced by cognitive biases, emotions, social, and other psychological factors that can lead to deviations from rational behaviour
   

• The assumptions of traditional economics regarding decision-making do not hold
   

• The following limitations mean individuals are unlikely to always make rational decisions

  • Bounded rationality 

  • Bounded self-control 

  • Biases
     

Bounded Rationality & Self Control

Bounded Rationality Theory

• This theory argues that people make decisions without gathering all the necessary information to make a rational decision within a given time period

  •  Individuals may not understand the technical jargon linked to selecting insurance or pensions 

• The theory assumes rational decision-making is limited because of

  • An individual’s thinking capacity

  • Availability of information

  • Lack of time available to gather all of the information and make a judgement

• Too much choice can also cause people to make irrational decisions

  • E.g. When making choices about purchasing particular products in the supermarket, there may be too much choice, making it difficult to make a decision 

Bounded Self-Control

• The theory of bounded self-control suggests that individuals have a limited capacity to regulate their behaviour and make decisions in the face of conflicting desires or impulses

  • It recognises that self-control is not an unlimited resource that can be exercised endlessly without consequences 

• Humans are social beings influenced by family, friends, and social settings. This often results in decision-making which conforms to social norms but does not result in the maximisation of consumer utility

•  Bounded self-control leads to decision-making based on emotions, which may not yield the best outcome 

  • E.g People may indulge in impulsive spending, purchasing goods they did not originally intend to buy

• Businesses use marketing to capitalise on the lack of bounded self-control of individuals when appealing to their target audience to maximise sales

  • E.g. Supermarkets place a range of items at the checkout register to encourage impulse purchases

The Influence of Biases on Decision Making

• Biases influence how we process information when making decisions and these influence the process of rational decision-making

  • Examples of bias include common sense, intuition, emotions and personal and social norms 

Types of Bias

Type of Bias	Explanation
Rule of thumb	This is when individuals make choices based on their default choice based on experience E.g. Individuals may also order the same pizza anytime they order from Pizza Hut, However, the best choice may be to buy the new tasty option, which is available at 50% discount
Anchoring and framing	Anchoring bias occurs when individuals rely too heavily on an initial piece of information (the “anchor”) when making subsequent judgements or decisions E.g. When buying a used car, the seller may initially suggest a price of $10,000. Even if you know the market value is lower, the anchor of $10,000 might still influence your perception and as a result, the consumer ends up paying a higher price than intended Framing refers to how the presentation or wording of information can significantly influence people’s choices or judgements The same information can be framed in different ways, leading to different outcomes E.g Consumers are more likely to purchase a product that states ‘80% fat free’ than ‘20% fat’
Availability bias	Occurs when people rely on immediate examples or information that comes to mind easily when making judgments or decisions It leads individuals to overestimate the likelihood or importance of events or situations based on how readily available they are in their memory   Availability bias is influenced by personal experiences, vividness of the information, media exposure, and emotional impact E.g. People use alternative modes of transport when there is a plane crash, even though the probability of a crash happening is very low
Social norms	These are the informal rules that govern behaviour in groups and societies E.g Consumers buy expensive goods to display wealth or social status rather than for practical reasons The perception is that owning luxury goods equates to success and status

The Influence of Altruism & Perception on Rational Choice

• Traditional economics assumes that people always act in their own self interest

  • Yet many charitable economic decisions have no economic benefit for the decision-maker

  • Altruism and perception can be major drivers in the non-rational decision-making process 

• Altruism is the idea that behaviour benefits a group at the expense of the person performing it

  • E.g. Giving charitable donations or volunteering 

• This explains why individuals make decisions that do not always align with maximising their own personal benefits and is in contrast to what rational self-interest theory would suggest

• Altruistic decision-making can be influenced by

  • The pressure to conform to social norms

    • E.g Following ethical and conscious shopping trends may nudge consumers towards sustainable options 

• The perception of fairness and what individuals and societies deem to be right or wrong

  • Individuals may be more concerned with more equitable outcomes for society than their own self-interest

  • E.g Some people buy the Big Issue even though they never read it, as they choose to support the individuals selling the Big Issue