BEHAVIOURAL ECONOMICS

An introduction

Scan this QR code to see just how irrational we can be!

Optical illusions are just one way our brains are fooled, and vision is something we have evolved to
rely on for millennia.
Imagine what would happen if we asked our brains to do something more complex and unfamiliar
at the same time as it is bombarded with other information and requests.

Behavioural economics crosses psychology and economics to study situations

where economic agents might be predictably irrational.
Irrational means when people make choices and decisions that go against the
assumption of rational utility-maximising behaviour.
Traditional Economics assumes: Traditional Economics assumes:
• Economic agents have well defined • Economic agents have limits to their
preferences cognitive ability
• They are super-smart • They are flawed and are social animals,
• They act solely to maximise their self- influenced by people around them and
interest circumstances
• They can handle vast amounts of • They are not driven purely by the need to
information maximise their welfare
• They can and do use this information to • They lack self-control in certain situations
make unbiased decisions such as overeating, overspending or even
over-working
• Rational decisions can be wrong, but they
are not systematically wrong. • Their decisions can be biased
Some economists call these super-beings Some economists call these irrational
“Econs”. economic agents “Humans”.

For more detail on the links between behavioural

and neoclassical economics, use this QR code:
BEHAVIOURAL ECONOMICS

Real world examples

of irrationality Consider these two scenarios
How rational are you?
Take 30 seconds to A B
decide your answer to A massive flood somewhere An earthquake in california
the question on the right. in North America next year, sometime next year, causing
in which more than 1,000 a flood in which more than
people drown 1,000 people drown
Which is the more likely?

The answer is A. Most people choose B because we are drawn to information that is
familiar – earthquakes in California. But look again at A and you will see that there is a
much smaller list of criteria than B.
People are particularly irrational when they are dealing with:
• Large amounts of information or too little information or unreliable information
• Complex informatioAn or where the consequences are complex
• Information economic agents are unfamiliar with
• Decisions taken infrequently
• Limited time
Real world examples where people are likely to be predictably irrational are:
Climate Change COVID Pandemic
• Large amounts of complex information • Large amounts of information of varying reliability
• Complex consequences • Complex consequences
• Decisions taken infrequently
Financial decisions such as pensions
• Large amounts of complex information Bounded self-control occurs when
• Decisions taken infrequently economic agents may be aware it is
Food choices – Obesity
irrational for them to consume or continue
• Some information is contradictory
consuming something, but they are
• Bounded self-control unable to stop.

Some good books to read on this topic include:

BEHAVIOURAL ECONOMICS

Bounded rationality
and heuristics

When economic agents experience more information than they have the
cognitive ability to deal with, they will experience bounded rationality.
Economic agents are still attempting to be rational but there are limits or “boundaries” to
how successful they can be. Rationality will be more or less bounded depending on the
circumstances – it can vary. It isn’t only people who experience bounded rationality but
businesses and governments.
Economic agents will reduce the cognitive load by adopting “heuristics” or simple rules
of thumb. These are mental short cuts.
Inertia and habitual choices Availability bias Anchoring
Making the same choice as Using easily recalled information to The use of (sometimes irrelevant)
before. This is closely linked to inform a decision e.g. earthquakes information as a reference point
loss-aversion, where economic in California or assessing the for an estimate e.g. seeing an
agents value losses more than probability of a plane crash based “original price” for a good that is
the equivalent gain. on stories in the news. now “on sale” and thinking you
have a good deal.

Economic agents who experience bounded rationality and use heuristics are adopting utility
satisficing behaviour rather than utility maximising.
To experience some of these You can find out more about Some good books
effects for yourself, try heuristics by following to read on this
these experiments: this QR code: topic include:
BEHAVIOURAL ECONOMICS

Behavioural biases
Certain …means ..and adopt
situations such that economic heuristics ..so their
as too much agents experience (mental shortcuts) decisions are
or too complex bounded to lighten the biased and
information… rationality... load... irrational.

Behavioural biases exist when economic agents make decisions that are deviating
from rational choices in a systematic way. Importantly for economists, biases are
often predictable, so we can still model behaviour and outcomes.

Default bias (status quo bias) Optimism bias Recency bias

This is where consumers avoid This exists when economic agents This is where most recent data is
making an active choice. For example, believe they are less likely (perhaps weighted more heavily than older data
they accept the default choice that than others) to experience a negative e.g. speculators might think recent
is offered e.g. if premium delivery event. This can be closely linked to trends will continue and especially
on online shopping is the default then the availability heuristic e.g. recalling combined with herd mentality (the
consumers will not “un-choose” it. a person living to 100 who smoked belief that something must be right
This is closely linked to loss aversion. heavily. if others are doing it).

Outcome bias Salience Confirmation bias

This exists where a decision is based This is the tendency to focus on the This exists where greater weight is
solely on the outcome e.g. winning the most easily recognisable features of given to information that fits with
lottery does not mean that gambling a concept or event rather than the our existing beliefs e.g. our choice
is a wise decision. whole thing. of media sources to find news that
reflects our already-held beliefs.

Stereotyping Survivor bias Ostrich effect

This is where certain groups or This exists where errors in judgement This is where economic agents ignore
people are expected or assumed to are made by focussing only on negative information. Research
be associated with certain survivors or successes e.g. trying to suggests investors check the value
characteristics. replicate features of successful of their assets less frequently during
companies. bad markets.

Try watching these tutor2u videos on biases to get more detail:

Availability bias Scarcity bias Default bias General overview
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Behavioural Nudges

A nudge is a policy or a strategy used to influence economic agents who are

behaving irrationally. A nudge would not usually affect the decisions of a purely
rational economic agent. Both businesses and governments adopt nudges.
Framing Choice architecture
Framing relates to how information is presented. Choice architecture is a wider concept (but includes
Economic agents are much more likely to respond framing) and refers to changing the whole context in
to information presented positively or to avoid which people make decisions e.g. positioning healthy
a loss e.g. act now to avoid a penalty for late food at the front of a cafeteria, default choices,
payment of tax. decoy options.

Smoking - These images COVID 19 - Clear simple messages

on cigarette packets aim on government press conferences
to provide a strong image and in numerous other locations
to create an availability reduce decision making and appeal
bias against samoking. to altruism. Altruism is where
economic agents act in the
interests of others.
Pensions - Employees are required to opt out of employer provided
pension schemes. This has a powerful effect on numbers in the scheme.
The default choice is to remain. Similar approaches have been used for
organ donation.
Food Labels - Behavioural economics suggests that the key to influencing
irrational behaviour such as over-eating unhealthy foods is providing
information in a simple, consistent, easily understood format.

To find out more about Some good books

nudges, head to this to read on this
tutor2u page topic include:
BEHAVIOURAL ECONOMICS

Altruism

Altruism is where economic agents consider the impact of their actions on others.
This, by definition, means that they are irrational. Rational economic agents by
assumption act to maximise their own self-interest.
Giving to charity Actions to reduce climate COVID vaccinations
While it could be argued that change Although there are examples
people gain utility from helping The atmosphere and the are young people being
others, this is none the less an environment are an example affected by COVID they are at
altruistic act. Research shows of a common pool resource. much lower risk than other
that the majority of people One characteristic is that the groups of the population. This
donate to charity although impacts of any one economic means that part of the reason
they tend to give from time agent is infinitesimally small. for getting vaccinated and
to time rather than regularly. It is therefore altruistic indeed taking any of the COVID
Some services such as the (irrational in an economic protective measures
RNLI are funded entirely sense) to take action to reduce is altruistic.
by donations. climate change.

Business examples of altruism

Some companies encourage Some companies donate to Most private schools have
and enable employees to offer charities and/ or work with out-reach programmes and
their time to charitable causes. start-up companies offering undertake significant voluntary
their expertise to increase work.
the chance of success.

There are other reasons why businesses might Some good books
undertake this type of activity such as recruiting to read on this
topic include:
staff, branding, and attracting customers and
improved access to finance through ethical
investment funds.
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The “Nudge Unit”

the Behavioural Insights Team

The UK based Nudge Unit was set up in 2010 to apply the lessons from behavioural
economics to public policy. It now advises governments and public bodies around
the world on using nudges to persuade people to pay their taxes, make better use
of public services and even Columbia’s peace process. The Nudge Unit has been
closely involved in tackling the spread of COVID.
“Practicalities are the most significant impediment to
people getting a COVID vaccine”. Research showed high Easy
numbers saying they are willing to receive the vaccine Attractive TIMELY
but there is a large intention-action gap. The BIT’s EAST
framework suggests people put off tasks when they social
become too effortful.

“COVID prevention – too much information”. Policy

makers face a delicate balance between sharing enough
information with people but not so much that it becomes
overwhelming. A randomised control trial in Bangladesh
of handwashing found that a step-by-step guide improved
recall but adding too many steps obscured the message.

The Nudge Unit (or the Behavioural Insights Team) A good book to
has worked on prompting people to pay their tax read on this is:
on time, turn up in court, improving organ donation
and improving job centre outcomes. Find out
more here:
BEHAVIOURAL ECONOMICS

Social Norms
and Herd Behaviour

Our day-to-day behaviour is influenced strongly by what we understand to be the prevailing social
norms or social customs. Social norms become accepted by the majority of a given community of
people. Social network effects can amplify different types of behaviour (both good and bad).
Herd behaviour is a type of social norm in which individuals act collectively as part of a group, often making decisions
as a group that they would not make as an individual. Herd behaviour occurs because
• Individuals want to be accepted, and this can mean behaving in the same way as others, even if that behaviour
goes against your natural instincts.
• Individuals find it hard to believe that a large group could be wrong (“2 heads are better than 1”) and follow the
group’s behaviour in the mistaken belief that the group knows something that the individual doesn’t. This is
described as the bandwagon effect or groupthink.
Examples
Observing white lines in car parks Wearing facemasks even when not Wearing seatbelts
legally required

Queueing behaviour e.g. for shops, for Buying a round of drinks when in a Different ways of greeting people
public transport, for entry to events etc bar or pub with friends in different cultures / countries

Asset bubbles e.g. houses, shares etc Making different choices from a menu Commenting and interacting with
when with friends rather than alone social media platforms

Using herd behaviour and social norms to tackle economic problems

Find out more
Hotel bathroom signs suggesting that the Tax bills from tax authorities indicating by taking a look
majority of hotel guests reuse their towels the proportion of taxpayers that pay their at these tutor2u
rather than requesting fresh ones each taxes on time, to encourage citizens to pay videos:
day, helping to reduce water usage their taxes and reduce government
and environmental impact. borrowing.

Providing information to young people on the number of peopleusing alcohol,

drug and nicotine, to correct their over-estimates of usage.