Behavioural Influences on Individual Economic Decision Making (3.3.1.2)
Welcome to one of the most exciting areas of modern Economics! For years, standard economic theory assumed that people are like perfectly logical super-calculators, known as Homo Economicus (Economic Man), who always make decisions to maximise their satisfaction (utility).
In this chapter, we step into Behavioural Economics, which says: "Wait a minute! People are human. We make mistakes, we get emotional, and we often take shortcuts."
Understanding these human influences is crucial because it shows us why markets sometimes fail and how governments and firms can influence our choices.
Recap: The Traditional View (The Rational Agent)
Before diving into behavioural theory, remember what traditional economics assumes about individual decisions (3.3.1.1):
- Individuals have perfect information (or can easily access it).
- They have stable preferences.
- They are **rational**—they calculate all costs and benefits to achieve **Utility Maximisation** (the greatest possible satisfaction).
Behavioural economics challenges these very assumptions.
1. Bounded Rationality and Bounded Self-Control
1.1 Bounded Rationality
This key concept suggests that while individuals *try* to be rational, their ability to do so is limited by three things:
- Limited Information: We don't have the time or resources to find every piece of data.
- Limited Time: We often need to make quick decisions.
- Limited Brainpower (Computational Problems): We struggle to process massive amounts of complex data.
Because of these bounds, we often don't truly maximise utility. Instead, we **satisfice**—we choose the option that is "good enough," rather than calculating the absolute best choice.
Analogy: Imagine buying a new phone. A perfectly rational person would research every model, compare every specification, and read thousands of reviews. A boundedly rational person will look at three good options, read a few quick summaries, and buy the one that looks reliable and fits their budget quickly.
Key Takeaway: We are rational, but only within limits (the bounds) imposed by our mental capacity and environment.
1.2 Bounded Self-Control
Even if we know what the best choice is (i.e., we are rational), we often lack the willpower to stick to it.
Bounded self-control describes the tendency to choose immediate gratification (short-term pleasure) over long-term benefit, even when we know the long-term benefit is better for us.
- The decision-maker knows the optimal (best) choice but cannot execute it due to lack of willpower.
Example: You know saving money for retirement (long-term gain) is rational, but you spend that money on a new pair of expensive trainers today (short-term pleasure).
Did you know? This phenomenon is sometimes called the "present bias." We tend to overweight benefits received now and discount those received later.
2. Biases in Decision-Making
If we are not perfectly rational, how do we make choices? We rely on mental shortcuts and inherent mistakes, known as biases.
2.1 Computational Problems
As mentioned under bounded rationality, people struggle with complex mathematical tasks, especially probability and calculating future values.
- Example: Few people can quickly calculate the true long-term cost of a loan with variable interest rates, making them susceptible to poor financial deals.
2.2 Inertia (The Power of Default)
Inertia is the tendency to do nothing or to stick with the decision that was made for us (the **default option**).
Economists have found that the way a choice is presented drastically affects the outcome. If the default choice is good, inertia leads to good outcomes; if the default is bad, inertia leads to bad outcomes.
Example: In countries where citizens are automatically enrolled in organ donation schemes (opt-out), donation rates are extremely high. In countries where citizens must actively sign up (opt-in), rates are much lower, even if everyone agrees that organ donation is good. People stick with the default.
2.3 Rules of Thumb (Heuristics)
When faced with limited time and information, we use simple, practical methods to make quick decisions. These mental shortcuts are called Rules of Thumb or Heuristics.
- Why we use them: They save time and effort.
- The risk: They often lead to biased or sub-optimal decisions.
Example: When shopping for a product you know nothing about (like a specific type of electronics), you might use the rule of thumb: "Buy the most expensive one, because expensive means better quality." This saves research time, but you might overpay significantly.
2.4 Anchoring
Anchoring occurs when an individual relies too heavily on an initial piece of information (the "anchor") when making subsequent judgements or decisions.
This initial anchor, even if irrelevant, heavily skews the final decision.
Example: A shop puts an original price tag of \$500 on a jacket, then crosses it out and marks the price as \$250. The initial \$500 (the anchor) makes the consumer feel that \$250 is a huge bargain, even if the jacket's actual value is only \$150.
2.5 Social Norms
Many economic decisions are not made in a vacuum; they are influenced by the behaviour of the people around us.
Social norms are unwritten rules about what is considered normal, acceptable, or expected behaviour in a group or society.
Example: If you see that your neighbours are installing solar panels or using electric cars, you are more likely to do the same because the behaviour has become a "social norm" in your area. This is why public health campaigns often highlight what the majority is doing ("8 out of 10 students recycle").
Quick Review Box: Decision Biases
Inertia
Anchoring
Rules of Thumb
Computational Problems
Social Norms
(A simple trick to remember the main biases: I ARCS)
3. Altruism and Perceptions of Fairness
Traditional economics assumes we are purely self-interested. Behavioural economics reveals that we are often motivated by caring for others and by our sense of justice.
3.1 Altruism
Altruism is acting out of selfless concern for the well-being of others, often involving a personal cost.
In the traditional model, donating to charity makes no sense, as it reduces your personal utility. However, millions of people donate every day because of altruistic motivations, driven by the satisfaction of helping others (a type of non-monetary utility).
3.2 Perceptions of Fairness
Our decisions are strongly affected by whether we perceive a transaction or distribution as fair or unfair. If we think something is unfair, we may reject it, even if accepting it would make us financially better off.
Classic Example: The Ultimatum Game. Person A is given \$100 and must offer a share to Person B. If B accepts, they both keep the money. If B rejects, neither gets anything.
- Rational Prediction: Person A should offer \$1, and Person B should accept (as \$1 is better than \$0).
- Real-world Behaviour: Person B often rejects offers perceived as unfair (e.g., offers below \$20-\$30), punishing Person A for being greedy, even though it costs B money. This shows that the desire for fairness (or the desire to punish unfairness) outweighs monetary gain.
Key Takeaway: Economic decisions are not just about calculating personal gain; they are moderated by ethics, empathy, and social context.
4. Policy Implications: The Use of Nudges
Because behavioural economists understand that people are predictable in their irrationality, governments and firms can use this knowledge to subtly influence behaviour. This is often done through **Nudges**.
A Nudge is a gentle intervention that alters people's behaviour in a predictable way without forbidding any options or significantly changing economic incentives (like price).
- Nudges rely heavily on exploiting biases like Inertia and Rules of Thumb.
Examples of Nudges in Practice
- Using Defaults to Boost Saving: Companies automatically enroll employees into workplace pension schemes (using the power of inertia). Employees can opt-out, but few do, drastically increasing national savings.
- Framing and Health: Placing healthy food options at eye-level in a school cafeteria (using rules of thumb/visual bias) encourages better eating without banning unhealthy options.
- Tax Compliance: Government letters reminding citizens that "9 out of 10 people in your area have already paid their taxes" (using social norms) significantly increases the rate of tax payment.
Why are nudges popular? They are cheap to implement and respect freedom of choice, unlike traditional regulatory tools like taxes or bans.
***
Chapter Summary: Key Takeaways
- Traditional economics assumes perfect **rationality** (Utility Maximisation).
- Behavioural economics argues that individuals exhibit **bounded rationality** (limited by time, data, and computation) and **bounded self-control** (lack of willpower).
- We use **biases** like rules of thumb, anchoring, and inertia to navigate complex choices.
- Non-selfish factors like **altruism** and **perceptions of fairness** play a significant role in market outcomes.
- Governments use this understanding to create **nudges**—subtle changes to the choice environment—to steer people towards better economic decisions without coercion.