Unit 2.

4(1): Behavioural economics (HL)

What you should know by the end of this chapter

• Rational consumer choice

• Assumptions of consumer rationality, utility maximization and perfect information
• Limitations of the assumptions of rational consumer choice
• Biases: rule of thumb, anchoring and framing
• Bounded: rationality, self-control, selfishness
• Imperfect information
• Choice architecture
• Nudge theory

Rational consumer choice

Behavioural economics considers consumer behaviour in a more complex way than classical
economic theory. It introduces human psychology into the buyer decision making process and
considers how factors other than utility maximisation might affect whether someone buys a good or
not. If, for example, you are going to the cinema you might not choose the film you think would give
you the most utility.

Biases

Biases are the factors that influence individuals in decision making situations and take them away
rational judgements. Herbert Simon (1916-2001) was a behavioural economist who believed that
individuals who are confronted by complicated decision-making situations resort to heuristics.

Heuristics
Heuristics simplify decision making when individuals cannot work out the option that will give
them the greatest utility. In buying situations people use mental shortcuts that allow them to
make decisions in the time frame they are normally faced with.

For example, when you are at the cinema you probably will not spend an hour researching all the
films on offer, but spend a few minutes before deciding to watch the ‘crime thriller’ you know you
would normally enjoy.

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Rule of thumb
This approach to decision making in Economics is based on the belief people make quick
judgements (heuristics) based on what they normally consider to be an expected outcome. By
using a rule of thumb individuals are not making decisions based on perfect information so they are
trying to opitimise their utility from consumption rather than maxmised their utility.

Anchoring bias
Anchoring bias is a reference point in an individual’s mind based on past experiences that strongly
influences a decision they make. Anchoring is another aspect of how bias affects decision making in
behavioural Economics. Anchoring is built up over time in the mind of consumers and is based on,
for exmaple, previous buying experiences.

Anchoring bias comes from a series of past

experiences and it can even be formed in the mind
of a consumer from their first experience of buying
a good. For example, if you go to a pizza restaurant
you might have in your mind an anchor price, the
price you would normally expect to pay in this type
of restaurant.

It is possible for businesses to use anchor prices in the mind of consumers to increase sales. For
example, an electrical retailer might promote the normal price for a laptop computer at $500 and
then discount it by 40 percent to a price of $300. It is actually a $300 computer but the anchor in the
mind of the consumer at $500 and this makes them feel like they have got a good deal and they are
more likely to buy the laptop.

Framing bias
Framing bias is the way decisions made by individual are affected by the way choices are
presented to them. The important aspect of framing is way information is presented in terms of the
content of information and the use of language. In a supermarket, for example, you are faced with a
low-fat chocolate mousse. The packaging could highlight, ‘20% fat’ or ‘80% fat-free’. Framing is
another example of behavioural bias. In this case people may well see the benefit of losing 80
percent fat as more attractive than gaining 20 percent from buying the mousse.

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Availability bias
Availability bias considers how individual decision making is affected by information that comes
easily into our minds. This information is often based on our experience of recent events and how
the outcomes of these recent events affect our decision making. In many situations our exposure to
events distorts our view of the world and has too much influence over the decisions we make.

For example, you are thinking of buying a train ticket and the probability of being delayed is 20
percent. You have made several train journeys over the last year and you have not been delayed
once so expect a good journey so you are more likely to book a train ticket. If, on the other hand,
you have experienced several trips where delays have occurred then you might expect a delay on
your next trip and be less likely to buy a ticket. In both cases the probability of a delay is 20 percent
but your decision to travel by train is likely to influenced by your recent experience.

Rationality

Rational behaviour by individuals in underpins much of traditional economic theory. Behavioural

economists see this assumption as too simplistic, so they have developed alternative theories of
rationality.

Bounded rationality
Bounded rationality is based on the theory that individuals make a decision that offers them a
‘good enough’ outcome rather than an ‘optimal’ or utility maximising outcome. The theory sees
people as satisfiers, people who seek a satisfactory or acceptable outcome.

For example, buyers in a fast food restaurant like Macdonald’s do not research their choice by asking
other buyers in the restaurant or by reading numerous online reviews, they might make a quick
choice on what looks appealing and what they have eaten before.

Consumers face three challenges when they are trying to make rational decisions in buying
situations:

• Consumers might have limited time to assess all the possible options when the are
choosing a good. For example, when someone is rushing to buy a drink in a coffee shop in
their break.
• If there are too many choices on offer for the consumer they might opt for the most familiar
option such as choosing a certain brand of biscuits in a supermarket.
• A lack of information may also lead consumers to buy a product they know about rather
than spending time researching alternatives. For example, when someone is choosing a
novel to read they might choose the author they are familiar with rather than finding about
a book of an author they do not know.

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Bounded self-control
Bounded self-control is where individuals consume beyond the point where they maximise their
utility when consuming a good. Utility theory predicts consumers will consume a good to a point
where their total utility is maximised. There is, however, lots of evidence to show that consumers
might not stop consuming a good even if it makes sense to do so. People, for example, might binge
eat fast food beyond the point where they are still enjoying it.

Bounded self-control can be important to governments when

they are trying to regulate the consumption of certain goods.
For example, a government policy to try and reduce the
consumption of 'fatty' food may need to account for
bounded self-control.

Bounded selfishness
Bounded selfishness means individuals make decisions that benefit other people as well as
themselves. Classical economic theory considers individuals to be concerned with their own welfare
and satisfaction and not others. If people make choices to achieve the highest utility for themselves,
their is approach is a selfish one.

For example, when a group of people are deciding on a restaurant for the evening, some individuals
within the group may well accept the choice of others to make the whole group happy with the
choice. Bounded selfishness is important in for charitable organisations who rely on people acting in
the interests of others rather than themselves. This is can also be true when consumers buy fair
trade products and pay a higher price for a good knowing it will benefit a fair trade producer.

Imperfect information
When individuals make decisions, traditional economic theory assumes their decisions are made
using perfect information. This means people buy goods and services and know what they are
buying, and they can make an informed buying decision based on this.

Imperfect information is where buyers are in situations where they do not understand or know
enough about the product they are buying and are therefore unable to put an informed
judgement on the good or service they are buying .

This is particularly the case in markets where products are very technical and difficult for uninformed
consumers to understand. Computer virus software, for example, is difficult for buyers with a basic
knowledge of computers to make an informed buying decision.

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 Behavioural economics in action

Choice architecture
Choice architecture is where a business sets the layout, sequence and range of choices available to
a consumer in a particular way to encourage them to make a buying decision. In their book
‘Nudge’, behavioural economists, Richard Thaler and Cass Sunstein, researched how decision making
by individuals is influenced by the environment where a decision is taken. This environment is
known as choice architecture and the person who designs the environment is known as a choice
architect.

Supermarkets, for example, are laid out to affect your buying decisions. Milk, for example, is often
put at the back of the shop to make you walk through the store where you might make impulse
purchases of other goods.

Nudge theory
Nudge Theory means using choice architecture
(the way choices are presented to individuals)
to encourage people to make decisions that
will improve their own welfare and society’s
welfare.

A ‘nudge’ means changing any part of the choice environment an individual faces to affect their
behaviour by making small alternations to the factors that affect their decisions.

Nudge theory is an area of behavioural economics developed by the Economists, Richard Thaler and
Cass Sunstien in their book ‘Nudge’.

Examples of the application of Nudge Theory:

The obesity problem

Obesity is a major health problem in many countries. A major cause of this is how much people eat.
The Nudge Theory approach to obesity and losing weight would be for people to buy smaller plates,
reduce the quantity of food they buy and ‘keep less in the fridge’. This approach might be a useful
guide for government looking to promote weight loss in society.

Saving money

Saving for retirement is an important decision for individuals and for governments. People need to
have enough money to live on when they finish work so they can enjoy a certain standard of living.
Nudge Theory advocates an opt-out scheme rather than an opt-in scheme for pension contributions.
In the opt-out scheme someone who gets a job are automatically enrolled in the pension scheme
and have to choose to not make payments.

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Reducing carbon emissions

Climate change is one of the world’s most significant problems. A nudge theory approach to
reducing carbon emissions would be a method that uses small changes to the choice environment
that create incentives for firms and households to make decisions that encouraged them to cut their
carbon emissions.

A government could apply ‘nudge’ by making firms sign up to a Greenhouse Gas Inventory where
businesses have to report the amount of carbon they emit into the atmosphere. If this information is
widely available to the public then companies that are the largest emitters would have an incentive
to act and reduce their emissions because of the poor publicity associated with being a major
emitter of carbon.

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