2.3 Aspects Of Behavioural Economic Theory

• Behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions
• What is behavioural economics?


  Behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain how individuals make choices and decisions
• Traditional economics is about creating a theory and using it to explain actual behaviour, whereas behavioural economics reverses this process. Behavioural economics is about observing actual behaviour and then coming up with a theory
• Traditional theories are often rejected by behavioural economists on the grounds that the simplifying assumptions on which the theories are built are unrealistic
• Bounded rationality is the idea that individuals' rationality, when making decisions, is limited by the information they have, limited mental processing ability, and the finite time available in which to make decisions
• What is bounded rationality?

  Bounded rationality is the idea that individuals' rationality, when making decisions, is limited by the information they have, limited mental processing ability, and the finite time available in which to make decisions
• In complex choice situations, bounded rationality often results in satisficing rather than maximising choices
• Traditional economic theory assumes that when making choices, individuals have complete self-control. By contrast, behavioural economists believe that individuals have bounded (limited) self control
• Bounded self-control refers to the limited self-control in which individuals lack the self-control to act in what they see as their self interest
• The idea of bounded self-control contradicts the traditional hypothesis of diminishing marginal utility. Diminishing marginal utility states that, as people consume more of a good, each additional unit gives a lower level of utility. However, in cases of bounded self-control, individuals overestimate the value of additional units.
• A cognitive bias refers to the systematic error in thinking that affects the decisions and judgements that people make, and leads to irrationality
• What is cognitive bias?


  A cognitive bias refers to the systematic error in thinking that affects the decisions and judgements that people make, and leads to irrationality
• Examples of cognitive biases include:

  • The availability bias
  • Anchoring
  • Social norms
  • Loss aversion and the endowment effect
  • Herding
• Availability bias occurs when individuals make judgements about the likelihood of future events according to how easy it is to recall similar past events. It often leads to decisions that are not based on logical reasoning
• Anchoring is an example of a predictive bias, and describes the human tendency when making decisions to rely too heavily on the first piece of information (called the 'anchor').

  • Individuals use an initial piece of information when making subsequent judgements
  • When given a choice, individuals often tend to pick the middle option, believing it is not too expensive nor too cheap
• Biases based on social norms refers to the idea that individuals make decisions based on society etiquette and expectations of how to behave given how other people in society act.
• Biases based on social norms refers to the idea that individuals make decisions based on society etiquette and expectations of how to behave given how other people in society act.

  • Actions and behaviour can also be influenced by social norms. Psychological research suggests that the desire to conform to social norms and follow a particular trend overrides more rational decision-making processes in order to associate with a desired group