UNIT-1

CHAPTER 1- BUSINESS ECONOMICS: AN INTRODUCTION

1.1 ECONOMICS- MEANING

Economics is a social science concerned with the production, distribution, and consumption
of goods and services. It studies how individuals, businesses, governments, and nations make
choices about how to allocate resources.

The philosopher Adam Smith (1776) defines the subject as "an inquiry into the nature and
causes of the wealth of nations”.

Lionel Robbins defined economics as “the science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses” (Robbins, 1935)
In order to meet the needs of its people, every society must answer three basic economic
questions:

 What should we produce?

 How should we produce it?
 For whom should we produce it?

A society (or country) might decide to produce cars, computers or combat boots. The goods
might be produced by unskilled workers in privately owned factories or by technical experts
in government-funded laboratories. Once they are made, the goods might be given out for
free to the poor or sold at high prices that only the rich can afford. The possibilities are
endless.

Although every society answers the three basic economic questions differently, in doing so,
each confronts the same fundamental problems: resource allocation and scarcity.

Resources are the ingredients needed for production, including physical materials (such as
land, coal, or timber), labour (workers), technology (not just computers but, in a broader
sense, all the technical ability and knowledge that is necessary to produce a given
commodity), and capital (the machinery and tools of production). Scarcity refers to the
essential fact that people’s wants or desires are always going to be greater than the resources
available to fulfil those wants.

Simply put, scarcity means that resources are limited. No country can produce everything, no
matter how rich its mines, how massive its forests, or how advanced its technology. Because
of the constraints of scarcity, then, decisions must be made about resource allocation (that is,
how best to allocate, or distribute, resources for the maximum benefit of the society).

Economics deals with various matters of decision making: Production, exchange and
consumption of goods and services are among the basic economic activities of life. During
these basic economic activities, every society has to face scarcity of resources and it is the
scarcity of resources that gives rise to the problem of choice. The scarce resources of an
economy have competing usages. In other words, every society has to decide on how to use
its scarce resources
1.2 MICRO ECONOMICS AND MACRO ECONOMICS

Traditionally, the subject matter of economics has been studied under two broad branches:
Microeconomics and Macroeconomics. In microeconomics, we study the behaviour of
individual economic agents in the markets for different goods and services and try to figure
out how prices and quantities of goods and services are determined through the interaction of
individuals in these markets. In macroeconomics, on the other hand, we try to get an
understanding of the economy by focusing our attention on aggregate measures such as total
output, employment and aggregate price level. Here, we are interested in finding out how the
levels of these aggregate measures are determined and how the levels of these aggregate
measures change over time. Some of the important questions that are studied in
macroeconomics are as follows: What is the level of total output in the economy? How is the
total output determined? How does the total output grow over time? Are the resources of the
economy (eg labour) fully employed? What are the reasons behind the unemployment of
resources? Why do prices rise? Thus, instead of studying the different markets as is done in
microeconomics, in macroeconomics, we try to study the behaviour of aggregates or macro
measures of the performance of the economy.

For example, microeconomics examines how a company could maximize its production and
capacity so that it could lower prices and better compete. A lot of microeconomic information
can be gleaned from company financial statements.

Microeconomics involves several key principles, including (but not limited to):

 Demand, Supply and Equilibrium: Prices are determined by the law of supply and
demand. This creates economic equilibrium.
 Production Theory: This is the study of how goods and services are created or
manufactured.
 Costs of Production: According to this, the price of goods or services is determined
by the cost of the resources used during production.
 Labour Economics: This branch of economics looks at workers and employers, and
tries to understand patterns of wages, employment, and income.

Macroeconomics:

Macroeconomics, on the other hand, studies the behavior of a country and how its policies
impact the economy as a whole. It analyzes entire industries and economies, rather than
individuals or specific companies, which is why it is a top-down approach. It tries to answer
questions such as, "What should the rate of inflation be?" or "What stimulates economic
growth?"

Macroeconomics examines economy-wide phenomena such as gross domestic product (GDP)

and how it is affected by changes in unemployment, national income, rates of growth and
price levels.
Macroeconomics focuses on aggregates, which is why governments and their agencies rely
on macroeconomics to formulate economic and fiscal policy. For instance, investors who buy
interest-rate sensitive securities should keep a close eye on monetary and fiscal policy.

BUSINESS ECONOMICS

Business economics is a field of applied economics that studies the financial, organizational,
market-related, and environmental issues faced by corporations. It encompasses subjects such
as the concept of scarcity, product factors, distribution, and consumption.

Business Economics, also called Managerial Economics, is the application of economic

theory and methodology to business. Business involves decision-making. Decision making
means the process of selecting one out of two or more alternative courses of action. The
question of choice arises because the basic resources such as capital, land, labour and
management are limited and can be employed in alternative uses. The decision-making
function thus becomes one of making choice and taking decisions that will provide the most
efficient means of attaining a desired end, say, profit maximation

Thus, it is clear from the above discussion that managerial or business economics helps
managers of firms, administrators of non-profit and profit-making hospitals, schools, colleges
and universities to recognise how economic forces affect organisations. It applies economic
theory and methods to business and administrative decision-making in both profit and non-
profit sector.

Business economics links economic concepts with quantitative methods to develop tools for
managerial decision-making. Business economics, thus, intends to bridge the gap that exists
between economics and business management theory. This process is illustrated in Fig. 1.1.
1.4 NATURE OF BUSINESS ECONOMICS:

Traditional economic theory has developed along two lines; viz., normative, and positive.
Normative focuses on prescriptive statements, and help establish rules aimed at attaining the
specified goals of business. Positive, on the other hand, focuses on describing the way the
economic system operates. The emphasis in business economics is on normative theory.
Business economics seeks to establish rules which help business firms attain their goals,
which indeed is also the essence of the word normative. However, if the firms are to establish
valid decision rules, they must thoroughly understand their environment. This requires the
study of positive or descriptive theory. Thus, Business economics combines the essentials of
the normative and positive economic theory, the emphasis being more on the former than the
latter. Following are the features of Business economics:

 Micro-economics in nature
 Aligns more with Normative economics
 Takes the help of macro economics to analyse external conditions
 Making economic theory more application oriented
 Both conceptual and practical
 Aimed at achieving organizational objectives

1.3 SIGNIFICANCE OF BUSINESS ECONOMICS

The significance of business economics can be discussed as under :
1. Business economics is concerned with those aspects of traditional economics
which are relevant for business decision making in real life. These are adapted or
modified with a view to enable the manager take better decisions. Thus, business
economics accomplishes the objective of building a suitable tool kit from
traditional economics.
2. It also incorporates useful ideas from other disciplines such as psychology,
sociology, etc. if they are found relevant to decision making. In fact, business
economics takes the help of other disciplines having a bearing on the business
decisions given various explicit and implicit constraints subject to which resource
allocation is to be optimized.
3. Business economics helps in reaching a variety of business decisions in a
dynamic environment. Certain examples are : (i) What products and services
should be produced? (ii) What input and production technique should be used?
(iii) How much output should be produced and at what prices it should be sold?
(iv) What are the best sizes and locations of new plants? (v) When should
equipment be replaced? (vi) How should the available capital be allocated?
4. Business economics makes a manager a more competent model builder. It helps
him appreciate the essential relationships characterising a given situation.
5. At the level of the firm, where its operations are conducted though known
functional areas, such as finance, marketing, personnel and production, business
economics serves as an integrating agent by coordinating the activities in these
different areas.
 6. Business economics takes cognizance of the interaction between the firm and
society, and accomplishes the key role of an agent in achieving the its social and
economic welfare goals. It has come to realise that a business, apart from its
obligations to shareholders, has certain social obligations. Business economics
focuses attention on these social obligations. It serves as an instrument in
furthering the economic welfare of the society through socially oriented business
decisions.

1.4 SCOPE OF BUSINESS ECONOMICS

As regards the scope of business economics, no uniformity of views exists among various
authors. However, the following aspects are said to generally fall under business economics.

1. Demand Analysis and Forecasting

2. Cost and production Analysis.

3. Pricing Decisions, policies and practices.

4. Profit Management.

5. Capital Management.

These various aspects are also considered to be comprising the subject matter of business
economics.

1. Demand Analysis and Forecasting: A business firm is an economic organisation which

transform productive resources into goods and services to be sold in the market. A major part
of business decision making depends on accurate estimates of demand. A demand forecast
can serve as a guide to management for maintaining and strengthening market position and
enlarging profits. Demands analysis helps identify the various factors influencing the product
demand and thus provides guidelines for managing demand. Demand analysis and forecasting
provided the essential basis for business planning and occupies a strategic place in
managerial economics. The main topics covered are: Demand Determinants, Demand
Distinctions and Demand Forecasting.

2. Cost and Production Analysis: A study of economic costs, combined with the data drawn
from the firm’s accounting records, can yield significant cost estimates which are useful for
management decisions. An element of cost uncertainty exists because all the factors
determining costs are not known and controllable. Discovering economic costs and the ability
to measure them are the necessary steps for effective profit planning, cost control and sound
pricing practices. Production analysis is narrower, in scope than cost analysis. Production
analysis is frequently measured in physical terms while cost analysis is measured in monetary
terms. The main topics covered under cost and production analysis are: Cost concepts and
classification, Cost-output Relationships, Economies and Diseconomies of scale, Production
function and Cost control.
3. Pricing Decisions, Policies and Practices: Pricing is an important area of business
economics. In fact, price is the genesis of a firms’ revenue and its success largely depends on
how correctly the pricing decisions are taken. The important aspects that are dealt under
pricing include: Price Determination in Various Market Forms, Pricing Method, Differential
Pricing, Product-line Pricing and Price Forecasting.

4. Profit Management: Business firms are generally organised for the purpose of making
profits and in the long run profits earned are taken as an important measure of the firms’
success. If knowledge about the future were perfect, profit analysis would have been a very
easy task. However, in a world of uncertainty, expectations are not always realised so that
profit planning and its measurement constitute a difficult area of business economics. The
important aspects covered under this area are: Nature and Measurement of profit, Profit
distribution policies and Technique of Profit Planning like Break-Even Analysis etc.

5. Capital Management : Among the various types business problems, the most complex and
troublesome for the business manager are those relating to a firm’s capital investments.
Relatively large sums are involved and the problems are so complex that their solution
requires considerable time and labour. Often the decision involving capital management are
taken by the top management. Capital management implies planning and control of capital
expenditure. The main topics dealt with are: Cost of capital, Rate of Return and Selection of
Projects.

1.6 DIFFERENCE BETWEEN ECONOMICS AND BUSINESS ECONOMICS

Economics is a traditional subject that has prevailed Business economics is a modern concept and is
from a long time. still developing.

Economics mainly covers theoretical aspects. Business economics covers practical aspects.

In economics, the problems of individuals and In Business economics, the main area of study is
societies are studied. the problems of organisations.

In economics, only economic factors are In business economic, both economic and no-
considered. economic factors are considered.

Both microeconomics and macroeconomics fall Only microeconomics falls under the scope of
under the scope of economics. business economics.

Economics has a wider scope and covers the Business economics is a part of economics and is
economic issues of nations. limited to the economic problems of organisations
1.5 CONTRIBUTION AND APPLICATION OF BUSINESS ECONOMICS TO
BUSINESS

The basic function of a management executive in a business organization is decision making

and forward planning. Decision Making means the process of selecting one action from two
or more alternative courses of action whereas forward planning means making plans for the
future. The question of choice arises because resources such as capital, land, labor and
management are limited and can be employed in alternative uses. Predicting relevant
economic quantities - profit, demand, production, costs, pricing, capital, etc., in numerical
terms together with their probabilities. As the business manager must work in an environment
of uncertainty, future is to be predicted in the light of the predicted estimates, which makes
decision making and forward planning possible.

The nature of economic forecasting is such that it indicates the degree of probability of
various possible outcomes i.e. losses or gains as a result of following each one of the
strategies available. Hence, before a business manager there exists a quantified picture
indicating the number of courses open, their possible outcomes and the quantified probability
of each outcome. Keeping this picture in view, he decides about the strategy to be chosen.

One of the most important contribution of Business economics is reconciling traditional

theoretical concepts of economics in relation to the actual business behavior and conditions.
In economic theory, the technique of analysis is one of model building whereby certain
assumptions are made and on that basis, conclusions as to the behavior of the firms are
drawn. The assumptions, however, make the theory of the firm unrealistic since it fails to
provide a satisfactory explanation of that what the firms actually do. Hence, the need to
reconcile the theoretical principles based on simplified assumptions with actual business
practices and develops appropriate extensions and reformulation of economic theory, if
necessary.

Estimating economic relationships, viz., measurement of various types of elasticities of

demand such as price elasticity, income elasticity, cross-elasticity, promotional elasticity,
cost-output relationships, etc. The estimates of these economic relationships are to be used
for purposes of forecasting.

Understanding significant external forces constituting the environment in which the business
is operating and to which it must adjust, e.g., business cycles, fluctuations in national income
and government policies pertaining to public finance, fiscal policy and taxation, international
economics and foreign trade, monetary economics, labor relations, anti-monopoly measures,
industrial licensing, price controls, etc. The business manager has to appraise the relevance
and impact of these external forces in relation to the particular business unit and its business
policies.

Role of business economist is seen in:

1. Specific decisions: relating to demand forecasting, market research, economic

analysis of industry, investment appraisal, security and management analysis, advice
on foreign exchange management etc.
 2. General decisions: based on two factors i.e. internal and external

CONCLUSION

In firms, business economics plays a very important role .The usefulness of business
economics lies in adopting the tools from economic theory, incorporating relevant ideas from
other fields to take better business decisions. Business economics serve as a catalytic agent in
the process of decision making by different functional departments at the firm level. For the
organization’s appropriate direction one should follow the rules of business economics,
which will be helpful in organization’s long-term success.

CHAPTER 2- FUNDAMENTAL CONCEPTS

Decision making is the core of Managerial Economics. Some fundamental concepts and
techniques help the management to take correct decisions.

2.1 OPPORTUNITY COST

Every scarce goods or activity has an opportunity cost. Opportunity cost of anything is
the cost of the next best alternative which is given up. It refers to the cost of foregoing or
giving up an opportunity. It is the earnings that would be realised if the available
resources were put to some other use. It implies the income or benefit foregone because a
certain course of action has been taken. Thus opportunity costs are measured by the
sacrifices made in the decision. If there is no sacrifice involved by a decision there will be
no opportunity cost.

It is also called alternative cost or transfer cost. The opportunity cost of using a machine
to produce one product is the income forgone which would have been earned from the
production of other products. If the machine has only one use, it has no opportunity cost.
Similarly, the opportunity costs of funds invested in one's own business is the amount of
interest earned if the amount had been used in other projects. If an old building is
proposed to be used for a business, likely rent of the building is the opportunity cost.
These are called opportunity costs because they represent the opportunities which are
foregone. The concept of opportunity cost plays an important role in managerial
decisions. This concept helps in selecting the best possible alternative from among
various alternatives available to solve a particular problem. This concept helps in the best
allocation of available resources.

2.2 INCREMENTALISM AND MARGINALISM

Incrementalism- The Concept

Incremental reasoning involves estimating the impact of decision alternatives.

Two important incremental concepts used in Business Economics are incremental cost
and incremental revenue. Incremental cost is a change in total cost resulting from a
decision. Incremental revenue means the change in total revenue resulting from a
decision.
 Incremental cost: change in total cost as result of change in the level of output, investment
etc.

Incremental revenue: change in total revenue resulting from a change in level of output
sold, price, etc

A decision is profitable only if

(i) It increases revenue more than costs,

(ii) It decreases some costs more than it increases others,
(iii) It increases some revenue more than it decreases others,
(iv) It reduces costs more than revenue.

Incremental principle can be used in the theories of consumption, production, pricing

and distribution. Incremental concept is closely related to marginal cost and marginal
revenue in the theory of pricing.

Marginalism- The Concept

It includes two basic concepts:

Marginal cost: addition made to total cost as a result of a unit change in output

Marginal revenue: addition made to total revenue as a result of unit change in output sold

Marginal principle is a special case of incremental principle.

Business rules:

Rule1: A course of action should be pursued up to the point where its MR=MC

Rule 2: Different courses of action should be pursued up to the point where all courses
provide equal marginal benefit per unit of cost. It is called equi-marginal principle.

Equi-marginal principle is one of the widely used concepts in managerial economics. This
principle is also known the principle of maximum satisfaction. According to this principle, an
input should be allocated in such a manner that the value added by the last unit of input is
same in all uses. In this way, this principle provides a base for maximum exploitation of all
the inputs of a firm so as to maximise the profitability.

The equi-marginal principle can be applied in different areas of management. It is used in

budgeting. The objective is to allocate resources where they are most productive. It can be
used for eliminating waste from activities. The management can accept investments with high
rates of return so as to ensure optimum allocation of capital resources. A multi product firm
will reach equilibrium when the marginal revenue obtained from a product is equal to that of
another product or products.

When more than one input is used:

MP X MPY
PX
= PY

2.3 TIME PERSPECTIVE

Another principle is the principle of time perspective which is useful in decision-making

related to output, prices, expansion of business etc.

Short run: time period where atleast one factor is fixed in supply

Long run: time period where all factors are variable in supply

Economists distinguish between the short run and the long run in discussing the
determination of price in a given market form because in the long run a firm must cover its
full cost. On the contrary, in the short-run it can afford to ignore some of its (fixed) costs. The
principle of time perspective can be stated as under : A decision should taken into account
both the short run and the long run effects on revenues and costs and maintain a right balance
between the long run and the short run perspectives.

2.4 TIME VALUE OF MONEY- DISCOUNTING PRINCIPLE

Generally people consider a rupee tomorrow to be worth less than a rupee today. This is
also implied by the common saying that a bird in hand is worth than two in the bush.
Anybody will prefer Rs. 1000 today to Rs. 1000 next year.

There are two main reasons for this :

(1) the future is uncertain and it is preferable to get Rs. 1000 today rather than a year
after ;

(2) even if one is sure to receive the Rs. 1000 next year, one would do well to receive Rs.
1000 now and invest it for a year and earn a rate of interest on Rs. 100 for one year.

What is the present value (PV) of Rs. 1000 obtainable after one year ?

The relevant formula for finding this out is

100
PV = (1+i)n

Where, i is the rate of interest.

We find that PV of Rs. 100 = 100 ÷ (1 + 8%) = 100 ÷ 1.08 = Rs. 92.59.

The same reasoning applies to longer periods. A sum of Rs. 100 two years after will have
a present value :

100 100 100

PV = 2 = 2 = = Rs. 85.73
(1+i) (1.08) 1.1664
 The principle of economics used in the calculations given above is called the discounting
principle. It can be explained as "If a decision affects costs and revenues at future dates, it
is necessary to discount those costs and revenues to obtain the present values of both
before a valid comparison of alternatives can be made"present values of both before a
comparison of alternatives can be made’’

2.5 RISK, RETURN AND PROFIT

Profit simply means a positive gain generated from business operations or investment after
subtracting all expenses or costs.

Profit (π) = TR-TC

In economic terms profit is defined as a reward received by an entrepreneur by combining all

the factors of production to serve the need of individuals in the economy faced with
uncertainties. In a layman language, profit refers to an income that flow to investor. In
accountancy, profit implies excess of revenue over all paid-out costs. Profit in economics is
termed as a pure profit or economic profit or just profit.

Accounting Profit:

Refers to the total earnings of an organization. It is a return that is calculated as a difference

between revenue and costs, including both manufacturing and overhead expenses. The costs
are generally explicit costs, which refer to cash payments made by the organization to
outsiders for its goods and services. In other words, explicit costs can be defined as payments
incurred by an organization in return for labor, material, plant, advertisements, and
machinery.

The accounting profit is calculated as:

Accounting Profit= TR-(W + R + I + M) = TR- Explicit Costs

TR = Total Revenue

W = Wages and Salaries

R = Rent

I = Interest

M = Cost of Materials

The accounting profit is used for determining the taxable income of an organization and
assessing its financial stability. Let us take an example of accounting profit. Suppose that the
total revenue earned by an organization is Rs. 2, 50,000. Its explicit costs are equal to Rs. 10,
000. The accounting profit equals = Rs. 2, 50,000 – Rs. 10,000 = Rs. 2, 40,000. It is to be
noted that the accounting profit is also called gross profit. When depreciation and government
taxes are deducted from the gross profit, we get the net profit.
ii. Economic Profit:

Considers both explicit costs and implicit costs or imputed costs. Implicit that is foregone
which an entrepreneur can gain from the next best alternative use of resources. Thus, implicit
costs are also known as opportunity cost. The examples of implicit costs are rents on own
land, salary of proprietor, and interest on entrepreneur’s own investment.

Let us understand the concept of economic profit. Suppose an individual A is undertaking his
own business manager in an organization. In such a case, he sacrifices his salary as a manager
because of his business. This loss of salary will opportunity cost for him from his own
business.

The economic profit is calculated as:

Economic profit = Total revenue - (Explicit costs + implicit costs)

Alternatively, economic profit can be defined as follows:

Pure profit = Accounting profit - (opportunity cost + unauthorized payments, such as bribes)

Economic profit is not always positive; it can also be negative, which is called economic loss.
Economic profit indicates that resources of a business are efficiently utilized, whereas
economic loss indicates that business resources can be better employed elsewhere.

MARKET FORCES AND EQUILIBRIUM

Consumers and producers react differently to price changes. Higher prices tend to reduce
demand while encouraging supply, and lower prices increase demand while discouraging
supply.

Economic theory suggests that, in a free market there will be a single price which brings
demand and supply into balance, called equilibrium price. Both parties require the scarce
resource that the other has and hence there is a considerable incentive to engage in
an exchange.

Equilibrium price is the price at which quantity demanded is equal to quantity supplied.

Example

The weekly demand and supply schedule for a brand of soft drink at various prices (between
0p and 80p) is shown below.

PRICE QUANTITY
QUANTITY DEMANDED
(p) SUPPLIED
80 2000 0
70 1800 200
60 1600 400
 50 1400 600
40 1200 800
30 1000 1000
20 800 1200
10 600 1400
0 400 1600

Equilibrium

As can be seen, this market will be in equilibrium at a price of 30p per soft drink. At this
price the demand for drinks by students equals the supply, and the market will clear. 1000
drinks will be offered for sale at 30p and 1000 will be bought – there will be no excess
demand or supply at 30p.

How is equilibrium established?

At a price higher than equilibrium, demand will be less than 1000, but supply will be more
than 1000 and there will be an excess of supply in the short run.

Graphically, we say that demand contracts inwards along the curve and supply extends
outwards along the curve. Both of these changes are called movements along the demand or
supply curve in response to a price change.
If the market is working effectively, with information passing quickly between buyer and
seller (in this case, between students and a college canteen), the market will quickly readjust,
and the excess demand and supply will be eliminated.

In the case of excess supply, sellers will be left holding excess stocks, and price will adjust
downwards and supply will be reduced. In the case of excess demand, sellers will quickly run
down their stocks, which will trigger a rise in price and increased supply. The more
efficiently the market works, the quicker it will readjust to create a stable equilibrium price.

Changes in equilibrium
Graphically, changes in the underlying factors that affect demand and supply will
cause shifts in the position of the demand or supply curve at every price.

Whenever this happens, the original equilibrium price will no longer equate demand with
supply, and price will adjust to bring about a return to equilibrium.

Changes in equilibrium

For example, if there is a particularly hot summer, students may prefer to drink more soft
drinks at all prices, as indicated in the new demand schedule, QD1 .

PRICE QUANTITY
QUANTITY SUPPLIED NEW Q DEMANDED
(p) DEMANDED

80 2000 0 400

70 1800 200 600

60 1600 400 800

50 1400 600 1000

 40 1200 800 1200

30 1000 1000 1400

20 800 1200 1600

10 600 1400 1800

0 400 1600 2000

At the higher level of demand, keeping the price at 30p would lead to an excess of demand
over supply, with demand at 1400 and supply at 1000, with an excess of 400. This will act as
an incentive for the seller to raise price, to 40p. Equilibrium will now be re-established at the
higher price.

There are four basic causes of a price change:

An increase in demand shifts the demand curve to the right, and raises price and output.

Demand shifts to the right

Demand shifts to the left

A decrease in demand shifts the demand curve to the left and reduces price and output.
Supply shifts to the right
An increase in supply shifts the supply curve to the right, which reduces price and increases
output.

Supply shifts to the left

A decrease in supply shifts the supply curve to the left, which raises price but reduces output.
Introduction to Behavioural Economics:

Behavioural economics combines elements of economics and psychology to understand how

and why people behave the way they do in the real world. It differs from neoclassical
economics, which assumes that most people have well-defined preferences and make well-
informed, self-interested decisions based on those preferences.

Shaped by the field-defining work of University of Chicago scholar and Nobel laureate
Richard Thaler, behavioural economics examines the differences between what people
“should” do and what they actually do and the consequences of those actions.

Behavioral economics is grounded in empirical observations of human behavior, which have

demonstrated that people do not always make what neoclassical economists consider the
“rational” or “optimal” decision, even if they have the information and the tools available to
do so. For example, why do people often avoid or delay investing in retirement account or
exercising, even if they know that doing those things would benefit them?

By asking questions like these and identifying answers through experiments, the field of
behavioral economics considers people as human beings who are subject to emotion and
impulsivity, and who are influenced by their environments and circumstances.

This characterization draws a contrast to traditional economic models that have treated people
as purely rational actors—who have perfect self-control and never lose sight of their long-
term goals—or as people who occasionally make random errors that cancel out in the long
run.
Several principles have emerged from behavioral economics research that have helped
economists better understand human economic behavior. From these principles, governments
and businesses have developed policy frameworks to encourage people to make particular
choices

What are the origins of behavioral economics research, and who are Tversky and
Kahneman?

Behavioral economics has expanded since the 1980s, but it has a long history: According
to Thaler, some important ideas in the field can be traced back to 18th-century Scottish
economist Adam Smith.

Smith is often remembered for the concept of an “invisible hand” that guides an overall
economy to prosperity if each individual makes their own self-interested decisions—a key
concept in classical and neoclassical economics. But he also recognized that people are often
overconfident in their own abilities, more afraid of losing than they are eager to win and more
likely to pursue short-term than long-term benefits. These ideas (overconfidence, loss
aversion and self-control) are foundational concepts in behavioral economics today.

More recently, behavioral economics has early roots in the work of Israeli psychologists
Amos Tversky and Daniel Kahneman on uncertainty and risk. In the 1970s and ’80s, Tversky
and Kahneman identified several consistent biases in the way people make judgments,
finding that people often rely on easily recalled information, rather than actual data, when
evaluating the likelihood of a particular outcome, a concept known as the “availability
heuristic.” For example, people may think shark or bear attacks are a common cause of death
if they’ve read about one such attack, but the incidents are actually very rare.

What is a “nudge” in behavioral economics?

In behavioral economics, a “nudge” is a way to manipulate people’s choices to lead them to

make specific decisions: For example, putting fruit at eye level or near the cash register at a
high school cafeteria is an example of a “nudge” to get students to choose healthier options.
An essential aspect of nudges is that they are not coercive: Banning junk food is not a nudge,
nor is punishing people for choosing unhealthy options.

For example, automatically enrolling employees in pension plans—and asking them to opt
out rather than offering them the chance to opt in—is an example of a nudge to encourage
better and more consistent saving for retirement.

The formal term Thaler and Sunstein use to describe a situation designed around nudges is
“libertarian paternalism”—libertarian because it preserves choice, but paternalistic because it
encourages certain behavior. In Thaler’s words: “If you want people to do something, make it
easy.”