Behavioural Economics- Introductory Lecture

Behavioural Economics a branch of modern microeconomics (and some

macroeconomics!) that attempts to model the workings of the economy by
looking at how individuals actually behave.

Traditional neoclassical economics assumes:

i) Individuals and firms are fully rational i.e. they have infinite processing
power and can see all the consequences of their actions.

ii) Individuals and firms have full information about all their choices.

iii) Uncertainty can be modelled using subjective probability judgments by

firms and individuals.

iv) Firms and individuals converge on equilibrium outcomes in the economy.

v) Firms and individuals are fundamentally self-interested.

This means that individuals and firms (or “agents”) will behave according to the
prescriptions of neoclassical economics.

While these originated in psychological research, they have increasingly been

used as assumptions derived from analysis of the ideally rational being.

Behavioural Economics deviates in terms of assumptions made and the scope of

the analysis.

i) Behavioural Economics does not aim to find a rational model of humans.

ii) Behavioural Economics makes few assumptions about human attitudes and
knowledge.

iii) Behavioural Economics takes Psychology and Cognitive Science as sources

of ideas about human behaviour.

iv) Behavioural Economics uses experiments to validate or refute theories.

There are many branches of behavioural economics depending on the area being
studied. Examples are:

i) Behavioural Finance.

ii) Institutional/ Evolutionary Economics.

iii) Consumer theory.

iv) Individual Choice.

v) Behavioural Game theory.

History of Behavioural Economics

Neoclassical economics originally based around 19th century psychological

ideas.

Notion of introspection as a valid method of acquiring knowledge about

psychology.

Stimuli and Sensations- psychophysics. As stimulus increases so increment of

sensation falls.

dp k
i.e.: =
dS S
where k is constant, S is the stimulus and p is sensation.

(Weber- Fechner law)

This translates into the idea of Diminishing Marginal Utility i.e. that the
increment of utility falls as the quantity of the good increases.

Human behaviour seen as pursuit of pleasure and avoidance of pain- utilitarian

in influence.

This can be seen as weakly “rationalistic”- humans choose actions based on a

comparison of pain and pleasure.

Problem was one of a shift in the underlying psychology- psychology and

economics went off in different directions.

William James (1890)- attacked hedonistic psychology and emphasised non-

rational motives and impulses.

Sigmund Freud- emphasised role of unconscious in human action.

This led to an attack on the “rationalistic” economics and its basis in hedonistic
economics.

Attempts by some economists to accommodate new psychology based on

instincts failed to find favour.

Pareto (1906)- suggested rebuilding economics on the basis of preferences and

choices rather than hedonism and utility.

Utility only used in its ordinal form as indifference curves.

Idea that economics still empirical but based around notion of choice founded in
repeated actions and logical reasoning.

Motives unnecessary
Behaviorism- movement in psychology that resisted any use of concepts relating
to the mind. Focussed exclusively on behaviour.

Radicalisation of Pareto’s ideas:

Integrability problem- cannot retrieve utility from choices.

Hicks & Allen (1934)- Notion of Marginal Utility abandoned in favour of

Marginal Rate of Substitution.

Samuelson P. (1938)– Notion of underlying preferences also abandoned-

“revealed preference theory”. Choices only need to obey consistency
requirements- preferences unnecessary (and unscientific!)

Friedman M. (1953) – Assumptions of theory don’t matter so psychological

ideas are irrelevant.

Reasons for re-emergence of psychology in economics:

i) Shift away from behaviourist psychology in 1970s and emergence of

cognitive psychology. More broadly- emergence of cognitive science.

This shift was helped enormously by Herbert Simon- an economist who pushed
behavioural ideas from the early 1950s but then shifted to computer science and
psychology.

ii) Emergence of game theory as small- scale models that could be tested. (as
opposed to large-scale market models).
iii) Willingness of psychologists to use rational choice as a starting point (or
“null hypothesis”) for testing rather than trying to reconstruct economics from
the bottom up.

iv) Emergence of theoretical problems in economics- multiple Nash Equilibria

in games, the failure of General Equilibrium models, paradoxes with full-
rationality model e.g. public goods.

v) Sen (1993)- Notion of rationality itself an inherently psychological

interpretation.

Crucial paper-Kahneman, D. & Tversky, A. "Prospect Theory: An Analysis of

Decision under Risk,"

This is a theory of individual decision making. However, it was a jumping- off

point for further studies in Behavioural Economics.