Introduction to Behavioural Economics: Microeconomics Study Notes

Introduction to Behavioural Economics

Overview

Behavioural Economics (BE) is a field within microeconomics that examines how psychological factors influence economic decision-making, often challenging the predictions of traditional neoclassical models. This topic covers the differences between neoclassical and behavioural approaches, key phenomena such as framing effects, uncertainty, time, strategic behaviour, and the assessment of BE's impact on economic theory and policy.

• Neoclassical model & Behavioural Economics: Comparison of perfect vs. bounded rationality.

• Framing effects: How presentation of choices affects decisions.

• Uncertainty: Decision-making under risk and ambiguity.

• Time: Intertemporal choices and self-control.

• Strategic behaviour & social norms: Interactions and fairness.

• Assessment of BE: Evaluation of behavioural economics' contributions.

Neoclassical Model vs Behavioural Economics

Neoclassical (n/c) Model

The neoclassical model in microeconomics assumes that consumers are perfectly rational, always seeking to maximize utility given constraints. It relies on mathematical modelling and constrained optimization, but may not accurately reflect real-world behaviour.

• Assumptions: Perfect rationality, complete information, and consistent preferences.

• Consumer Choice: Decisions are made to maximize utility subject to budget constraints.

• General Equilibrium: Markets reach equilibrium through rational actions of agents.

Behavioural Economics (BE)

Behavioural economics studies how consumers actually make choices, incorporating insights from psychology to explain and predict behaviour that deviates from the neoclassical model.

• Empirical Realism: Focuses on observed behaviour rather than theoretical assumptions.

• Psychological Factors: Includes biases, heuristics, and social preferences.

• Modification of Theory: Adjusts models based on experimental and real-world data.

Perfect vs. Bounded Rationality

Perfect Rationality

Traditional economics assumes agents are perfectly rational, described as homo economicus:

• Infinitely self-interested

• Infinitely capable of processing information and solving optimization problems

• Infinitely self-disciplined and consistent in executing plans

This assumption, rooted in 19th-century economics (Walras, Jevons), enabled mathematical modelling but was not based on observed behaviour.

Bounded Rationality

Herbert Simon introduced the concept of bounded rationality, recognizing limitations in human decision-making:

• Bounded self-interest: Social preferences affect choices.

• Bounded information processing: Cognitive limitations restrict decision quality.

• Bounded will-power: Time-inconsistency and self-control issues.

People use heuristics and simplified rules, such as mental accounting (Thaler), to make financial decisions. Empirical realism is central to BE, aiming for more accurate predictions than the homo economicus model.

Heuristics and Satisficing

Heuristics

Humans often rely on simple decision-making rules or heuristics that are context-dependent, rather than strictly rational calculations.

• Pattern recognition and interpretation of ambiguous information.

• Satisficing: Seeking 'good enough' solutions rather than optimal ones (e.g., choosing a cellphone).

• Ecological rationality: Decision-making suited to specific environments.

Framing Effects

Definition and Examples

Framing effects occur when the way choices are presented influences decisions, even if the underlying options are identical.

• Positive vs. Negative Framing: People prefer positively framed choices (e.g., 'saving lives' vs. 'preventing deaths').

• Reference Points: Decisions are influenced by initial anchors or reference values.

• Marketing Applications: Pricing strategies, default options in pension plans, and organ donation uptake.

Example: The disease dilemma (Tversky & Kahneman, 1981) shows that people choose differently when outcomes are framed as gains versus losses, despite identical probabilities.

Uncertainty

Heuristics and Biases

People use mental shortcuts to make judgments under uncertainty, which can lead to systematic errors:

• Anchoring: Relying on initial information to make estimates.

• Availability: Judging frequency by how easily examples come to mind.

• Representativeness: Overvaluing small samples or similarities.

Example: Hospital birth rates—people underestimate fluctuations in small samples.

Risk and Loss Aversion

• Risk Aversion: Preference to avoid losses, even when expected value suggests risk-taking is rational.

• Loss Aversion: Losses are felt more intensely than equivalent gains.

• Endowment Effect: People value items they own more than identical items they do not own.

• Sunk Cost Fallacy: Continuing an activity due to previously invested resources, contrary to rational choice theory.

Example: Coffee mug experiment—average selling price is higher than buying price due to endowment effect.

Time and Intertemporal Choice

Discounting the Future

Standard economic theory uses exponential discounting to value future utility:

• Utility today: $u(c)$

• Utility in $t$ years: $\delta^t u(c)$, where $0 < \delta < 1$

• For three periods: $u(c_1) + \delta u(c_2) + \delta^2 u(c_3)$

Marginal rate of substitution (MRS) between periods:

• Between periods 1 & 2: $MRS_{1,2} = \delta \frac{MU(c_2)}{MU(c_1)}$

• Between periods 2 & 3: $MRS_{2,3} = \delta \frac{MU(c_3)}{MU(c_2)}$

Time Inconsistency and Hyperbolic Discounting

Real people often display time-inconsistent preferences, discounting the distant future more heavily than predicted by exponential models. Hyperbolic discounting is represented by:

• Discount factor: $\frac{1}{1 + kt}$, where $k > 0$

This leads to self-control problems, where plans made for the future are not followed when the time arrives.

Self-Control and Commitment Devices

• Planner vs. Doer Self: Long-term goals vs. short-term temptations.

• Commitment Devices: Tools or institutions that help individuals stick to plans (e.g., savings clubs, penalties for early withdrawal).

Example: Announcing fitness goals publicly to increase accountability.

Strategic Behaviour & Social Norms

Game Theory and Social Preferences

Traditional game theory assumes rational players care only about their own payoffs. Behavioural game theory finds that people often care about fairness and others' outcomes.

• Dictator Game: Most people split money equally, contrary to n/c predictions.

• Ultimatum Game: Offers below 30% are frequently rejected; most proposals are close to 50-50.

• Punishment Games: Observers punish unfair behaviour, even at personal cost.

Social norms and fairness are important motivators in economic decisions.

Modelling Social Preferences

Utility functions can be extended to include social preferences:

• Own payoff

• Positive deviation from others' payoffs (pleasure of doing better)

• Negative deviation from others' payoffs (displeasure of doing worse)

• Inequality aversion parameter

Reference-point dependent utility functions can capture these effects.

Assessment of Behavioural Economics

Mainstream Appeal and Criticisms

Behavioural economics has gained prominence in academia and policy, offering insights where neoclassical theory falls short. However, some argue that deviations from n/c theory may be minor or average out, and that markets reward rational behaviour.

• Complementarity: BE and n/c models can be used together.

• Normative vs. Descriptive: BE describes actual behaviour; n/c models provide normative guidance.

• Policy Applications: 'Nudge' units use BE insights to improve choices (e.g., retirement savings, organ donation).

Debates within Behavioural Economics

• Should constrained optimization remain central?

• Is satisficing a better model than optimizing?

• Are heuristics sub-optimal or contextually rational?

Behavioural economics continues to evolve, improving predictive ability and realism in economic models.

Summary Table: Neoclassical vs. Behavioural Economics

Feature	Neoclassical Economics	Behavioural Economics
Rationality	Perfect	Bounded
Decision-making	Optimization	Heuristics, satisficing
Preferences	Stable, consistent	Context-dependent, constructed
Social Preferences	Ignored	Included
Policy Implications	Free markets, efficiency	'Nudges', behavioural interventions

Conclusion

Behavioural economics provides a more realistic account of human decision-making by incorporating psychological insights, bounded rationality, and social preferences. It challenges the assumptions of neoclassical theory and has significant implications for policy and economic modelling.