Behavioural economic theory

'Traditional' microeconomic theory is commonly referred to as rational choice theory to highlight the assumptions that underlie most conventional economic models.

However, not all theories of economic behaviour start with the assumption that consumers and producers are rational in their behaviour, and always try to maximise their utility - as consumers - or to maximise their profits - as producers.

Bounded rationality

American economist Herbert Simon - often regarded as the pioneer of 'alternative' approaches to economic behaviour - coined the phrase 'bounded rationality' to propose that all decision-making is limited (bounded) in some way in terms of cognitive abilities. Individuals rarely, if ever, have sufficient information to make a completely rational choice. Limited time in which to make a decision also constrains rational choice.

For example, individuals might rely on the first comparison website appearing after a Google search, rather than trawling through twenty similar sites, or they might choose one of the first five Amazon products to appear rather than look through two hundred similar products. [1]

Bounded self control

It is a fundamental assumption of the 'traditional' approach to economic decision making that individuals can control what they do, and there is no limit on their ability to exercise this self-control. For example, if an individual has assessed the costs and benefits of eating a healthy diet and have made plans to do so, then traditional theory suggests they will have the self-control to reject alternatives. 

However, insights from behavioural economics suggests that decision making is rarely made with absolute self control, and that it is bounded - limited. Bounded self-control refers to behaviour where individuals lack the cognitive 'strength' (or willpower) to make a rational decision. While it is rational to start saving for the future as soon as possible, many will not save 'today' because they lack the mental strength to do so.

Behavioural economic theory applies the techniques of behavioural psychology to economics understand how actual economic decisions are made when faced with limited information and limited cognitive abilities.

The underlying assumption behind behavioural economics is that economic decisions are not only influenced by economic rationality (driven by the attempt to maximise self interest) but by a range of other factors, including emotional, cultural and social influences.

In applying this analysis to economics, supporters argue that behavioural theory can provide useful insights into how behaviour can be changed, and, as a result, help develop policy tools to 'nudge' individuals to make choices which lead to desirable outcomes. This suggests that behaviour can be changed without the use of traditional economic incentives, such as subsidies and taxation.

Behavioural theory can be used to shape legislation to prevent firms from exploiting their market power, as well as directly influencing the decisions of individuals.

The traditional view of decision making

Behavioural economists question many of the basic assumptions of traditional economic theory, including:


  1. That decisions are made as a result of individuals weighing up all the available information in front of them.
  2. That individuals exercise self control when faced with choices, and can resist making 'spur of the moment' decisions.
  3. That individuals always look to maximise their own personal gain when making economic choices.

These assumptions are challenged by behavioural economists.

How are decisions actually made?

For example, Nobel Prize winner, Daniel Kahneman, proposed that individuals have two decision making systems. System one is fast and automatic, and often derived from 'commonsense' or from previous experience of making similar decisions.

In contrast, system two is slower, more deliberate, and involves more conscious mental processing to weigh up the benefits of a range of alternatives. While it is less automatic, and less prone to bias, it can easily be manipulated.

Decision making bias

Behavioural economists also point to the use of simple rules when faced with very complex decisions. Individuals are not always able to make accurate calculations or risk, or have sufficient time to undertake a detailed and diligent approach to decision making.

Rule of thumb decisions

In the absence of information, individuals often employ 'rule of thumb' guidelines, called heuristics, which are time-saving patterns of thinking used when faced with common choices - such as only purchasing a breakfast cereal when the label says 'special offer'.

The heuristic has saved time, and avoids the need for conscious decision making. However, using common rules of thumb may lead to irrational decision-making - the same good might be cheaper in another store, but not labeled as 'special offer'. These may be convenient methods of making decisions, but can be full of biases and lead to errors of judgment.

According to behavioural economists, decision making can be subject to certain biases which can dictate how decisions are arrived at.

Anchoring

Anchoring is a decision-making bias where the decision maker relies on a single piece of information from which to make a decision.

This may typically be the first piece of information they receive. When consumers are busy and have limited time it may appear to make sense to select a single piece of ‘relevant’ information to assess the benefits (or costs).

For example, goods in stores may be deliberately marked with a high price, so that a few days later they can offer a discount – the high price is the ‘anchor’ to which other prices are judged. The discounted price now appears a ‘good deal’ when perhaps it was not.

If you check the half-time score of your favourite team (say soccer), and the score is Your team 0 – Other team 2, and you then check again at the end of the match, and the score is now Your team 2 – Other team 2, you are relatively happy as the draw seems a good result. However, if the initial half time check showed: Your team 2 – Other team 0, you would be very disappointed at the 2-2 draw. Our judgments and decisions commonly reflect this bias towards the ‘anchored’ piece of information.

The availability bias

The availability bias suggests that individuals commonly make decisions based on the information that is available at the time the decision is made. For example, if an individual has seen positive news about the performance of a particular investment, they are more likely to choose this investment, rather than an alternative (which actually may be a better investment.)

A key factor in the availability bias is the 'ease' with which information or images can be brought to mind. This can alter an individual's perception of risk. For example, if an individual can bring to mind what it is like to be burgled (perhaps because they have been burgled before) they are more likely to insure their property than if they cannot easily bring to mind such images. They are less likely to know or recall statistics on the probability of burglaries in their area.

The status quo bias

The status quo bias relates to the repeated pattern of behaviour where individuals tend to repeat the choice that they have previously made, rather than weigh up the options and make a rational decision. For example, individuals appear to prefer to remain with their existing internet and phone providers, rather than switch providers. This means that firms can manipulate this by raising price for existing customers in comparison with the price for new customers.

Confirmation bias

Another decision-making bias is the confirmation bias, which occurs when decisions are made which support pre-existing beliefs or views. For example, if a individual believes that a particular make of car performs better than another one, they are likely to seek out information that confirms this view, and ignore information that contradicts this, or rank it of lower value.

Influence of social norms

Another important decision-making bias is the tendency to 'follow the pack' and base decisions (at least to some extent) on what others in the social group do or have done. This behaviour is well known, but traditional economic theory does not include social norms as a significant influence on decision making. Clearly, the rise of the social media 'influencer' indicates the power of social norms in helping form opinions and in nudging people towards making a decision. Unlike much tradition media advertising, 'influencing' is more in tune with the theory of behavioural economics, where nudges may be more effective than direct messaging.

This may also be true for governments when attempting to change behaviour - appealing to social norms (such as, '..most people in your age group have had 2 COVID-19 vaccinations..') may be more powerful than simply compelling people to get vaccinated.

Altruism

Traditional economic theory makes the assumption that the individual acts in their own self interest to maximise the net benefit of a decision. The work of behavioural economists suggests that this is not always the case. Indeed, some behaviour can be described as 'pro-social' (or altruistic) including volunteering, helping others when they have emergencies, and giving to charity.

This suggests that, at times, self-interest may give way to the interests of others.

The Dictator Game provides an insight into this behaviour, and suggests that individuals are prepared to give away some of the rewards they earn when they do not have to. It may be that altruism is a social norm, or that individuals do derive personal utility from altruistic behaviour, but whatever the motive is the possibility of altruism certainly extends the economists thinking about how decisions are made.

[1] Behavioural Economics, in Competition and Consumer Policy, Centre for Competition Policy, Economic and Social Research Council Edited by Judith Mehta, University of East Anglia, 2013, viewed August 1, 2021 https://competitionpolicy.ac.uk/documents/8158338/8193541