2.1.3 Aspects of Behavioural Economic Theory

Question 1

Summary

Answer 1

1. Emergence of Behavioural Economics
2. Bounded Rationality / Self Control
3. Thinking Fast / Thinking Slow
4. Biases in Decision Making
5. Altruism and Fairness

Question 2

1. Emergence of Behavioural Economics

Answer 2

• Behavioural Economics: applies psychological insights into human behaviour to explain how individuals make choices.
• Built on the psychological understanding of consumer preference that dates back to L.L. Thurstone and Israeli psychologists Tversky and Kahneman.
• Richard Thaler and Cass Sunstein: published ‘Nudge’ in 2008 which is an overview of behavioural economics
• After reading this book, David Cameron set up the UK’s Behavioural Insights Team (BIT)

Question 3

2. Bounded Rationality / Self-Control

Answer 3

1. Bounded Rationality: when making decisions, an individual’s rationality is limited by three unavoidable constraints…
   - Imperfect information, limited mental processing ability and a time constraint.
2. Bounded Self-Control: limited self-control in which individuals lack the self-control to act in what they see as their self-interest.

Question 4

3. Thinking Fast and Thinking Slow

Answer 4

• Kahneman: humans think in two different ways: System 1 and System 2
• System 1 (Thinking fast): instinctive, decisions are made quickly and little effort is used to analyse the situation (Automatic thinking)
• System 2 (Thinking slow): when reflective thinking, concentration and mental effort are required to work through a problem.

Question 5

4. Biases in Decision Making

Answer 5

• Behavioural economics argues that decisions people make when exercising choice are often heavily biased.
• Decisions made on the basis of one’s own likes, dislikes and past experiences
• Psychologists use ‘cognitive bias’ to describe this.
• Cognitive Bias: a mistake in reasoning occurring as a result of holding onto one’s preference regardless of contrary information.

Question 6

4. Types of Bias in Decision Making (Part Two)

Answer 6

Availability Bias:

• Individuals make judgements about the likelihood of future events according to how easy it is to recall examples of similar events.
• E.g. numerous reports of shark attacks may cause an individual to fear this more.
• Ipsos MORI: found that in the UK, the average citizen believed that 24% of the population were immigrant (actually 13%)
• Ipsos MORI: in the UK, the average citizen believed that the unemployment figure was 24% (actually 7%)

Anchoring:

• Cognitive bias describing the human tendency to rely too heavily on the first piece of information offered.
• At an expensive restaurant, we tend to go for less expensive mains despite them also being expensive.

Biases based on Social Norms:

• Social Norms: patterns of behaviour considered acceptable by society.
• Negative Social Norms: young adults often drink heavily because they think it is what people of their age are expected to do.
• Positive Social Norms: in the last 30 years, people’s attitudes towards smoking changed