Behavioural economics Flashcards
Behavioural economics
- A study of the effects of psychological, social, cognitive and emotional factors on economic decision-making
- An alternative to neoclassical assumptions of rationality and optimisation
- Behavioural economics tries to mic insights from Psychology with Econ, and looks at problems through the eye of a “human” rather than an “Econ”
- It uses insight from psychology to explain why people make apparently irrational decisions such as why people eat too much, take too little exercise or do not save enough for retirement
Rational economic decision making
Rational choice theory
- An economic principle that states that individuals always make logical decisions that provide them with the greatest benefit or satisfaction - given the choices available - and are also in their highest self interest
Rational behaviour
- When individuals (acting in self interest) attempt to maximise their welfare, satisfaction or utility gained from the goods/ services consumed
This will differ dependent on the economic agent:
- Households or consumers wish to maximise their utility or personal satisfaction
- Firms wish to maximise their profits
- Government wish to maximise the welfare of the population
Social factors affecting demand
- Social awareness
- Social norms
- Social pressure
Emotional factors influencing demand
- Emotional arousal can affect the demand for health insurance after major incidents
- Binge drinking and eating at times of personal insecurity
- Demand for products such as football season tickets and antiques also has a strong emotional attachment
Utility theory
- Utility theory is concerned with the satisfaction that an individual derives from consuming a good or service
- The unit of measurement for utility is called utils
- Total utility is the aggregate amount of satisfaction an individual services from consuming a good or service
- Marginal utility is the amount of satisfaction an individual derives from consuming one extra unit of a good or service.
Change in total utility/ change in number of units consumed
Imperfect information
- Traditional economic theory assumed that individuals have perfect knowledge when it come to rational decision making
- However because consumers have imperfect information - individuals make the ‘wrong decision’ - even though it was a ‘rational decision’
Moral hazard
A situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost
Imperfect information impacts decision making
- Difficult for economic agents to make rational decisions and is a potential source of market failure
- Economic agents can be faced with too little information, too much information or find themselves knowing more or less information that other parties to a transaction
- Information can also be presented in such away to exclude some people and be meaningful to others
- Costs involved in acquiring information that deter people from doing so, e.g. house surveys, mechanical checks on cars, thorough checks/ references on new employees
- Misallocation of resources in the case of merit goods and demerits goods
Two cognitive systems
System 1
- Fast
- Unconscious
- Automatic
- Everyday decisions
- Error prone
System 2
- Slow
- Conscious
- Effortful
- Complex decisions
- Reliable
Bounded rationality
Suggests that when people make decisions they are limited by
- The information available to them
- Their intellectual limitations
- The time available to make decisions
Heuristics (rule of thumb)
- Heuristics are best described as mental shortcuts or rules of thumb for decision making to help people make a quick satisfactory, but perhaps not perfect answer to a complex question
- The economist Gerd Gigerenzer argues that heuristics can be an optimal way to respond in occasions where we lack information or time. People learn from experience and develop many different heuristics over time
Bounded self control
- It suggest that individuals have limited control over their decision-making and therefore make decisions that are not in their best interest
- By recognising that people have limited control when making decisions we can adopt strategies that can help individuals improve their own welfare and therefore the welfare of society as a whole
Cognitive bias
- Decision making which deviates from rationality in judgment, whereby inferences about other people and situations may be drawn from preferences and beliefs, regardless of contrary information
- Individuals create their own “subjective social reality” from their perception of the input
Default bias in choices (Habitual behaviour)
- People prefer to carry on behaving as they have always done
- Repeat choices/ purchases often become automatic because default choices don’t involve any mental (cognitive effort)
Examples
- Your choice of daily breakfast
- Choosing food at a restaurant
- Political preferences in election
Anchoring
- Value is often set by anchors or imprints in our minds which we use as mental reference points
- Some anchors establish in our minds a low price, other help to establish a higher basic price that we should be prepared to pay
Examples
- “Big price drop” campaigns by supermarkets
- Refereeing decisions might be anchored by the size of home crowd
Availability bias/ Availability Heuristic
- Biases affect how people process complex information
- The availability bias happens we people often judge the likelihood of an event, or frequency of its occurrence by the ease with which examples and instances come easily to mind
- Most consumers are poor at risk assessments - for example they over-estimate the likelihood of attacks by sharks or list accidents
- Smokers may see one elderly heavy smoker and exaggerate the likely health life expectancy of this group
- Periods of very warm weather affect beliefs about causes of climate change
- People buy more lottery tickets if a big winner has lived locally
Availability bias
- The availability bias happens when people often judge the likelihood of an event, or frequency of its occurrence by the ease with which examples and instances come to mind. (Automatic thinking)
- Can lead to overly cautious decision making
