Behavioural economics

Behavioural economics examines the psychology behind economic decision making and economic activity. Behavioural economics examines the limitation of the assumption individuals are perfectly rational.

Key people: Gary Becker, Daniel Kahneman, Richard Thaler, Robert J. Shiller,

Concepts in behavioural economics

Bounded rationality – making decisions based on limited information and from a narrow range of heuristics (simple rules)

Choice architecture – The theory of consumer choice is influenced by the ways goods are presented. For example, complementary goods placed together can help sales. Related to the concept of a nudge.

Cognitive bias. when we look at issues with a certain bias, for example, we see the data which confirms our point of view and we filter out data which is inconvenient

Discrimination – when people discriminate on grounds of age/sex.

Dual-system theory – the idea we have two decision making elements. One is impulsive, the other is more rational, cognitive and analytical. Similar to ‘hot-cold’ states.

Endowment effect – when we give greater weighting to what we already have.

Fairness and reciprocity – the importance of fairness and returning favours in economic decisions

Gift-giving – the concept that giving gifts is an important aspect of social life. These transactions do not fit into standard supply and demand analysis.

Herding behaviour – the tendency of individuals to follow the collective perceptions and beliefs of the majority – particularly likely in finance.

Irrational exuberance – when people get carried away by rising asset prices

Mental accounting – how individuals separate their budget into different accounts, limiting spending on particular aspects of expenditure.

Optimism bias – A tendency to wishful thinking and over-confidence in our plans.

Present bias – a tendency to value payoffs in the present moment more than equivalent costs/benefits in the future. Also, we can discount future payoffs in a time-inconsistent way.

Prospect theory – the idea we suffer comparatively more from losses than gains. It also places emphasis on a relative starting point. We judge utility from our loss/gain – rather than our finishing point.

Rational economic man – This is the classical view of individual behaviour. It assumes individuals 1) Are rational and well informed. 2) Seek to maximise their utility. Behavioural economics is based on challenging this conventional wisdom.

Reciprocity – The strong social pressures that we try to reciprocate treatment. If we are treated ‘badly’ we can seek to ‘punish’ the person – even if it leads to loss of our own utility. Similarly, we try to reward good behaviour (e.g. concept of gift-giving)

Salience – when we give a greater weighting to one-off recent events. For example, if we have a bad experience with British Airways, we never want to travel with them again.

The social dimension of creating trust. We may incur losses to give the impression of trust and honesty.

Social Norms – Decisions where social norms outweigh personal decisions of utility, e.g. voting because it is considered social duty – even if we know voting makes no difference anyway.

Status Quo Bias – A preference for the existing situation rather risk change.

Sunk-cost fallacy – Placing too much importance on sunk costs (irretrievable costs) – costs that cannot be got back.

Nudges – Factors which encourage consumers to change behaviour through small suggestions

Main areas of behavioural economics

1. Understanding decision making

How individuals make decisions in the real world – as opposed to economic models.

2. Changing behaviour

Using knowledge of behavioural economics to change behaviour through nudges.

3. Behavioural finance

  • Psychology of bubbles – rapid rises in asset prices
  • Positive feedback loop – when two events positive reinforce each other. For example, rising house prices increases confidence in the housing market, and increased confidence in housing market leads to rising prices.


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