Notes on Behavioural Economics

Bounded Rationality

Bounded rationality is a concept that describes the limitations humans face when making decisions. It challenges the traditional economic view that humans are perfectly rational beings.

1. Limits to Rationality: Bounded rationality suggests that humans can’t be fully rational due to cognitive and other limitations. This is a departure from classical economics, which assumes perfect rationality[1].
2. Decision-making: The theory posits that individuals often use heuristics or “rules of thumb” for decision-making, rather than optimizing every choice[3].
3. Utility Maximization: While classical economics assumes individuals always maximize utility, bounded rationality introduces the idea of “satisficing,” where people seek satisfactory solutions instead of optimal ones[4].
4. Policy Implications: Understanding bounded rationality can help in designing policies that account for human limitations, making them more effective.

Instead of optimizing, people often “satisfice,” meaning they settle for a good-enough option rather than the best one.

In economics, bounded rationality suggests that people make judgments based on incomplete information.

Nudges

Nudges are subtle interventions designed to guide people’s behavior without restricting their choices. They are rooted in behavioral economics and aim to help individuals make better decisions by accounting for human irrationalities. For example, nudges can help people save for retirement or make healthier food choices. They are informed by a growing body of research and often draw on deep evidence to be effective.

Nudges have both theoretical and practical value. They can dissolve biases and guide people to their best behavior. This approach has been particularly effective in areas like public policy, where nudges have been used to influence consumer behavior and social psychology. There’s overwhelming evidence that society has benefited from the use of nudges, especially in combating issues like poor health choices or financial mismanagement.

However, it’s worth noting that the effectiveness and ethical implications of nudges are still subjects of ongoing research and debate.

Anchoring

Anchoring is a cognitive bias where people give too much weight to the first piece of information they encounter, known as “the anchor.” This initial information then influences their subsequent decisions and judgments. For example, if you first see a shirt priced at $100 and then find a similar one for $60, you’re likely to think the second shirt is a good deal, even if it’s still overpriced.

Anchoring is not just limited to pricing; it can affect various aspects of life, including negotiations and estimations. In finance, anchoring can lead to irrational biases towards arbitrary benchmark figures, affecting investment decisions.

The concept is widely studied in behavioral economics and is considered a form of priming effect. It’s important to be aware of anchoring because relying too heavily on the first piece of information can lead to poor decisions.

Loss Aversion

Loss aversion is a psychological phenomenon where people feel the pain of losing more intensely than the pleasure of gaining. In simpler terms, losing $100 feels worse than gaining $100. This concept is a cornerstone in behavioral economics and helps explain why people make certain financial decisions, like holding onto losing stocks for too long or avoiding risks that could lead to gains. It’s a key factor in various aspects of life, from investing to decision-making in everyday scenarios.

Hyperbolic Discounting

Hyperbolic discounting is a concept in behavioral economics that describes how people tend to value immediate rewards more than future rewards, even if the future rewards are larger. For example, you might choose to eat a cookie now rather than wait for a healthier, more satisfying meal later. This tendency can affect various aspects of life, including financial decisions and lifestyle choices.

The concept is different from exponential discounting, which is more rational and consistent over time. Hyperbolic discounting can lead to inconsistent choices, where what seems valuable now may not align with long-term goals. In practical terms, businesses often use this understanding to offer deals that encourage immediate purchase by delaying payment.

Social Norms

Social norms are unwritten rules that govern behavior within a community or society. They play a critical role in shaping actions and interactions among individuals. These norms can vary based on culture, situation, or personal beliefs and can influence actions ranging from everyday etiquette to moral choices.

One interesting aspect is the “tipping point” for the spread of social norms. Research shows that as low as 25% adoption of a new norm can significantly reshape society.

Community discussions are effective tools for changing harmful social norms. In these settings, group members identify local practices that need change and work collectively to implement new norms.

Social norms also evolve to discourage self-interest and encourage behaviors that benefit the community. They are crucial for sustaining cooperative relationships and coordinating collective action.

Overconfidence

Overconfidence refers to the tendency of individuals to overestimate their abilities, knowledge, or future prospects. In economic terms, overconfidence can affect various aspects like contract choices, market behavior, and consumer decisions.

1. Contract Choices: Overconfidence can influence how people choose contracts in real-effort tasks. People who are overconfident may opt for contracts that are not in their best interest due to a miscalibrated assessment of their capabilities.
2. Market Behavior: Overconfidence can lead to poor investment decisions. For example, an overconfident trader might take on too much risk, believing they can outperform the market.
3. Consumer Choices: Overconfidence can cause consumers to misjudge product quality and price, leading to poor purchasing decisions.

Understanding overconfidence can help A-Level Economics students grasp why individuals and firms make irrational choices, deviating from what traditional economics would predict.

Applications

Behavioral economics integrates insights from psychology to explain economic decision-making. In A-Level Economics, this field has various applications:

1. Consumer Behavior: Behavioral economics helps understand why consumers may not always act rationally. It explores alternative views of consumer behavior, such as bounded rationality and heuristics[4].
2. Policy Making: Insights from behavioral economics can inform public policies. For example, “nudges” can encourage better health or financial choices.
3. Market Dynamics: Behavioral economics can explain market anomalies that traditional economics can’t, such as bubbles and crashes.

Criticisms

Behavioral economics has faced several criticisms, some of which are:

1. Lack of Predictive Power: Critics argue that behavioral economics doesn’t offer strong predictive models, unlike traditional economics.
2. Limited Realism: Observations made in laboratory settings may not accurately represent real-world behavior. Lab experiments often involve small stakes and may not have lasting consequences.
3. Temporal Resolution: There’s a lack of clarity on when biases actually occur, making it difficult to apply behavioral insights effectively.