Behavioural Economics

A-Level Economics · Microeconomics

Behavioural Economics

Behavioural economics challenges the neoclassical assumption of rational economic agents by incorporating insights from psychology into economic models. It examines how real people make decisions, often deviating systematically from rational behaviour.

Rational Economic Man

Traditional economics assumes Homo economicus — a perfectly rational agent who:

Has complete information about all options
Can process all available information instantly
Maximises utility (consumers) or profit (firms)
Has stable, consistent preferences
Responds to incentives predictably
Is self-interested

This model provides powerful predictions but often fails to describe actual behaviour.

Bounded Rationality

Herbert Simon (1955, Nobel Prize 1978) argued that humans have cognitive limitations:

We lack complete information
Processing capacity is limited
Time and attention are scarce

Instead of optimising (finding the best option), people satisfice — they search until they find an option that is "good enough" and stop there.

Example: when choosing a restaurant, people rarely compare every restaurant in a city — they pick one that seems acceptable based on limited search.

Implications for economics:

Firms may not truly maximise profit — managers satisfice
Consumers do not compare all available products
Decision quality depends on the choice architecture (how options are presented)

Cognitive Biases and Heuristics

Heuristics are mental shortcuts that simplify decision-making. They are efficient but lead to systematic biases:

1. Anchoring Bias

People rely too heavily on the first piece of information encountered (the "anchor").

Estate agents show an overpriced house first to make the next seem reasonable
"Was £100, now £60" — the £100 anchor makes £60 feel like a bargain even if it is not
Salary negotiations: the first number stated often anchors the final outcome

2. Availability Bias

People overweight information that is easily recalled (recent, vivid, emotional).

After a plane crash, people overestimate the risk of flying (despite cars being statistically more dangerous)
Extensive media coverage of rare events (terrorism, shark attacks) distorts risk perception
Influences insurance purchases, voting behaviour, and health decisions

3. Present Bias and Hyperbolic Discounting

People disproportionately prefer immediate rewards over future ones, even when waiting would yield a better outcome.

Choosing £50 today over £60 in a month (even though the implied return is enormous)
Overeating now despite knowing future health consequences
Under-saving for retirement — the future feels "distant" and less real

Contrast with rational discounting: standard economics assumes exponential discounting (consistent discount rate over time). Behavioural evidence shows hyperbolic discounting — the discount rate is much steeper for near-term trade-offs, leading to time-inconsistent preferences.

4. Loss Aversion (Kahneman & Tversky)

Prospect Theory (Kahneman & Tversky, 1979, Nobel Prize 2002) shows that losses are felt approximately twice as strongly as equivalent gains.

Losing £50 causes more pain than gaining £50 causes pleasure
This explains why people:
Hold onto losing investments too long (reluctance to "realise" a loss)
Demand a higher price to sell something they own than they would pay to buy it (endowment effect)
Prefer the status quo even when change would be beneficial (status quo bias)

5. Framing Effects

The way information is presented affects decisions, even when the underlying facts are identical.

"90% survival rate" vs "10% mortality rate" — same information, different responses
"Buy 3 for the price of 2" vs "33% off" — perceived differently
Opt-in vs opt-out framing dramatically changes participation rates (organ donation, pensions)

6. Herd Behaviour and Social Norms

People follow the behaviour of others, especially under uncertainty:

Stock market bubbles (investors buy because others are buying)
Bank runs (depositors withdraw because others are withdrawing)
Fashion and consumption trends
Tax compliance ("9 out of 10 people in your area pay their tax on time")

7. Default Bias

People tend to accept pre-set options rather than actively choosing an alternative.

Auto-enrolment in workplace pensions (UK, 2012): participation jumped from ~55% to ~90% simply by changing the default from opt-in to opt-out
Organ donation: opt-out countries have much higher donor rates than opt-in countries

Nudge Theory

Richard Thaler and Cass Sunstein (2008, Nudge) proposed libertarian paternalism: structuring choices to guide people towards better decisions without restricting freedom.

A nudge alters the choice architecture (how options are presented) to exploit known biases for beneficial outcomes.

Key Principles

Default options: set the beneficial choice as the default (pension auto-enrolment)
Simplification: reduce complexity to overcome bounded rationality (simplified benefit application forms)
Social norms: show what others do ("most people in your neighbourhood recycle")
Salience: make important information prominent (calorie counts on menus, graphic cigarette warnings)
Timing: prompt decisions at moments when people are most receptive

UK Behavioural Insights Team ("Nudge Unit")

Established in 2010, it applies behavioural science to policy:

Tax collection: personalised letters telling late payers that most neighbours have paid → increased compliance by 15%
Energy efficiency: social comparison on energy bills ("You used more than your neighbours")
Organ donation: opt-out system implemented in England (2020), Wales (2015)
Healthy eating: placing fruit at eye level in school canteens

Evaluation of Nudging

Strengths:

Low cost compared to regulation or taxation
Preserves freedom of choice (people can still opt out)
Evidence-based and testable (RCTs)
Addresses real cognitive biases
Avoids the heavy-handedness of bans or mandates

Weaknesses:

Still paternalistic — who decides what is "better"?
May be seen as manipulation — people are unaware their choices are being shaped
Effectiveness may be small and temporary — nudges cannot solve deep structural problems (poverty, addiction)
Risk of "sludge" — firms using the same techniques to manipulate consumers (subscription traps, dark patterns)
Does not address the root causes of market failure (externalities, monopoly power)
Ethical concerns: transparency, consent, and the boundary between guidance and coercion