Behavioural economics and nudge 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.

Nudge theory

Nudge 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 nudge 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. Nudge theory suggest that behaviour can be changed without the use of traditional economic incentives, such as subsidies and taxation.

Nudge 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.

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.

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.

Complex decision making

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.

Choice architecture

Choice architecture relates to the symbols and signals that are present at the time that individuals make choices. For example, in deciding to purchase a financial product an individual is likely to be influence by physical surroundings, promotional materials, posters and what the 'choice architect' is saying or suggesting. It may be that the environment in which economic decisions are taken is weighted heavily in favour of the seller, who may lead the buyer towards the decision that is most favourable to them. If policy makers consider this to lead to a sub-optimal decision, such as taking out a loan when the individual really cant afford it, then interventions can be made to prevent this decision making bias. For example, policy makers may pass legislation to insist that there is a time-delay between discussing the product with the salesperson, and being able to sign the contract, or having a 'cooling off' period after the signing of the contract.

Decision framing

Decision framing is structuring an environment so that individuals arrive at a decision that yields the seller the best result. For example, websites selling subscription packages will typically have three prices reflecting different levels of service provision. Option one is usually 'basic' with fewer options, but is the cheapest; options three is the highest level of services, with, often, an excessively high price (which few will choose), and option two is the mid-range and mid priced option, which seems 'good value' compared with the very high price.  Decisions are being framed in such a way that option two is the favoured option, and - crucially - more people are likely to make a decision to purchase when they feel they have a choice. So, offering just the single price (option two) would lead to fewer sales overall.

Decision making bias

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

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 chose 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.

There are several other biases that can influence decision making.

Policy applications

Behavioral economists suggest that policy makers can adapt some of the theories developed to nudge individuals towards making rational choices.

Mandated choices and delays

With mandated choices, individuals (or firms) are provided with a default choice in favour of a beneficial outcome. Force example, individuals may be forced to save for retirement when they might have elected to defer such saving. Individuals investing in stocks could be forced to complete a questionnaire explaining the risks before they are allowed to complete their investment, and cooling off periods to allow individuals to reflect on their decision.

Many of these suggestions have been incorporated in legislation, especially relating to financial services and complex financial products.

[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