Behavioural Economics

21st century economics: Behavioural economics talks about combined idea of

economics and psychology in real life activities. It has emerged as a critique to
traditional economic theories that are based on rational behaviour of people.
In its current situation, since the second half of 20 th century, behavioural economics
has existed integrating insights from economics and psychology. It is motivated by
the observation that, in practice, individual and collective human behaviour deviates
systematically from normative principles of economic behaviour.
Concept of rational consumer choice
Rational choice theory states that individuals use their self-interests to make
choices that will provide them with the greatest benefit. People weigh their options
and make the choice they think will serve them best.
Rational choice theory in social science is an important concept because it helps
explain how individuals make decisions. According to this idea, every choice that is
made is completed by first considering the costs, risks and benefits of making that
decision. Choices that seem irrational to one person may make perfect sense to
another based on the individual’s desires. Individuals try to maximize their rewards
because they’re worth the cost.
Rational choice theory expresses that individuals are in control of their decisions.
They don’t make choices because of unconscious drives, tradition or environmental
influences; however, they are pushed to make rational considerations to weigh
consequences and potential benefits.
Adam Smith, who proposed the idea of an "invisible hand" moving free-market
economies in the mid-1770s, is usually credited as the father of rational choice
theory. The majority of classical economic theories are based on the assumptions of
rational choice theory: individuals make choices that result in the optimal level of
benefit or utility for them. Further, people would rather take actions that benefit
them versus actions that are neutral or harm them
Examples: Rational investors are those investors who will quickly buy any stocks
that are priced too low and short-sell any stocks that are priced too high. Likewise, a
rational consumer would be a person choosing between two cars—if Car B is
cheaper than Car A, so the consumer purchases Car B.
A rational consumer always looks for maximizing utility at the given costs. Likewise,
a producer always looks for maximizing profit and minimizing the costs, so as to
increase the profit amount.

Rational choice theory helps to explain how leaders, policy makers and other
important decision-makers of organizations and institutions make decisions.
Rational choice theory can also attempt to predict the future actions of these actors.

Assumptions of rational choice theory

In order to fit the criteria for rational choice theory, the following assumptions are
made.

1. All actions are rational and are made due to considering costs and rewards. In
case of consumers, they assess the utility they gain against the cost they have
to bear while consuming the given goods.
2. The reward of a relationship or action must outweigh the cost for the action
to be completed. The consumers have adequate information about the
market.
3. When the value of the reward diminishes below the value of the costs
incurred, the person will stop the action or end the relationship.
4. Individuals will use the resources at their disposal to optimize their rewards.
5. Market/consumers have complete information

Limitations of rational consumer choice

Biases: The theory is based on the rule of thumb (guided by accurate principle).
It is based on limitation of framing and anchoring effect. Framing effect is a
cognitive bias (systematic error in thinking, processing and interpreting
information) that impacts our decision making when said if different ways. In
other words, the degree of influence is based on how related facts are presented.
Similarly, framing leads to the decision making based on the pre-occupied
information.
Bounded rationality: The rationality that an individual think for is limited just to
optimization of resources, which may not be always true in real life. People
attempt to find rationality based on the finite amount of time and resources
when they have to make a decision. For example, when ordering at a restaurant,
 customers will make suboptimal decisions because they feel rushed by the
waiter.
Bounded self-control: Valuing the present much more than the future to make
the decision. For example, people may also look to save more for the after-
retirement life than at present.
Bounded selfishness: People maintain some level of altruism (selflessness), in
which they seek happiness by helping others.
Imperfect information: The simple rational choice model assumes that the
individual has full or perfect information about the situation. But in reality, this is
not the case due to existence of information asymmetry.

Behavioural Economics
Economists have forwarded behavioral economics as a critique for the rational
consumer choice theory. Behavioural economics attempts to explore why people
sometimes make irrational decisions, and why and how their behavior does not
follow the predictions of economic models. Decisions such as how much to pay
for a cup of coffee, whether to go to graduate school, whether to pursue a healthy
lifestyle, how much to contribute towards retirement, etc. are the sorts of
decisions that most people make at some point in their lives. Behavioral
economics seeks to explain why an individual decided to go for choice A, instead
of choice B.
This idea criticized the traditional belief people being rational in economic activities.
Most of the time, people may not take decision rationally as humans are
characterized by bounded rationality, bounded willpower and bounded self-
interest, subjected to the limitations/constrains of human judgment and choice.
People occasionally make choices that are against their own interests and people
are often altruistic.

While rational choice theory doesn’t take into consideration how ethics
and values might influence decisions, Behavioural Economics considers
number of unforeseen factors that could affect the decision making. Another
argument against rational choice theory is that most people follow social
norms, even when they’re not benefitting from adhering to them.
 Also, some critics say that rational choice theory doesn’t account for choices that
are made due to situational factors or that are context-dependent. Factors like
emotional state, social context, environmental factors and the way choices are
posed to the individual may result in decisions that don’t align with rational
choice theory assumptions.
Because humans are emotional and easily distracted beings, they make decisions
that are not in their self-interest. For example, according to the rational choice
theory, if Charles wants to lose weight and is equipped with information about
the number of calories available in each edible product, he will opt only for the
food products with minimal calories. Behavioral economics states that even if
Charles wants to lose weight and sets his mind on eating healthy food going
forward, his end behavior will be subject to cognitive bias, emotions, and
social influences. Temptation can cause an individual distract from self-
interest.

Concept of Dual system model

Behavioural economics considers two concepts –Automatic System and Reflective
System.
Automatic System involves fast decisions that are done even through subconscious
mind. Reflexive System involves slow decisions through controlled and critical
thinking.
Neo-classical economists mainly were on the side that every time people look for
making decisions through Reflexive System while Behavioural Economist Richard
Thaler says this is not the case all the time.

What are the cognitive biases that affect decision-making?

A cognitive bias is a systematic error in thinking that occurs when people are
processing and interpreting information in the world around them and affects the
decisions and judgments that they make. Cognitive biases are often a result of the
human brain's attempt to wrongly interpret the situation while looking to simplify
information processing. Because of this, subtle biases (subconsciously biased or
very small errors that even may remain unnoticed) can creep in and influence the
way you see and think about the world.
1. Availability bias—over influence of recent information and examples
 2. Anchoring bias—Considering the reference value to make future choices,
mind occupied with reference value
3. Framing bias—choice making capacity influenced by the way information
(data, advertisement etc.) presented to an individual
4. Social Conformity/ Herd behavior—Feeling of gratifying and rewarding
through appearing like others, (switching to new fashion outfits)
5. Status Quo/Inertia bias—Feel convenient to buy goods from the same seller
(reluctant to search new options)
6. Loss aversion bias—Fear of facing loss more than receiving pleasure out of
any event/action (like discount offer)
7. Hyperbolic discounting—attracted by the short-term benefit than the long-
term rewards

How can people be encouraged to make better choices?

1. Choice Architecture: It is the idea which explains that the decisions we make are
heavily influenced by the ways in which the choices are presented to us. Change in
default choice and mandated choice are among the main choice architecture.
Although the status quo bias can be very powerful, default options do not always
result in a good outcome. Example: Google search is automatically opened in many
computers/laptops. Consumers find it comfortable to rely on default choice as they
may not have time or resources to research alternatives or they may lack courage to
make changes or they find it obvious and easier options.
Mandated choice is the situation where people are required by law to make a choice
in advance. Eg: making people sign for organ donation which acquiring driving
license.
2. Consumer nudge/Nudge Theory:
It is a part of behavioural economics, which is popularly known as ‘choice
architecture’. Nudge is any aspect that helps change people’s behaviour in a
pradictable way without forbidding any options or significantly changing their
economic incentives.
Nudges are not mandatory provision, but drive the people in a self-motivated form
to make their own decision. It is also a type of indirect government intervention that
is easy to implement and cheaper to avoid.
An individual's behaviour is not always in alignment with their intentions. People
will often do something that is not in their own self-interest, even when they are
aware that their actions are not in their best interest. Unlike classical concept that
used to consider that people always tend to show rational behaviour, nudge theory
says that they are not rational either due to own reasons of an individual or
influence of surrounding or people in network.
Nudge theory suggests consumer behaviour can be influenced by small suggestions
and positive reinforcements. Nudge theory is a flexible and modern concept for:

● Understanding of how people think, make decisions, and behave,

● Helping people improve their thinking and decisions,
● Managing change of all sorts, and
● Identifying and modifying existing unhelpful influences on people.

The nudge is generally applied to influence behaviour. Nudge theory seeks to

improve understanding and management of the 'heuristic' (enabling someone to
discover and learn for themselves), which influences on human behaviour to change
daily practices by themselves and for themselves.

Nudge theory is a radically different and more sophisticated approach to achieving

change in people than traditional methods of direct instruction, enforcement,
punishment, etc.
Nudge theory accepts that people have certain attitudes, knowledge, capabilities,
etc., and allows for these factors (which autocratic methods ignore them). Nudge
theory is based on understanding and allowing for the reality of situations and
human tendencies (unlike traditional forcible instruction, which often ignores or
discounts the reality of situations and people).
Nudge theory seeks to minimize resistance and confrontation, which commonly
arise from more forceful 'directing' and autocratic methods of 'changing'
people/behaviour. It suggests that well-placed ‘nudges’ can reduce market failure,
economise the government expenses, encourage desirable actions and help increase
the efficiency of resource use.
For example:
a. Putting fruits and green vegetables at eye level to make people aware against the
use of junk foods counts as a nudge. But making a law to ban junk foods is not a
nudge.
b. Erecting signs saying 'no littering' and warning of fines (Enforced measure)--
Improving the availability and visibility of litter bins (nudge).
c. Statutory direction for not using tobacco (Enforced measure)—Informative
picture of health hazard by tobacco use on the cover of packets (nudge)
d. Counting calories/dieting (Enforced measure)—Use smaller plate to have lunch
(nudge)
e. “Do not litter in the area or face cash penalty of Rs 1,000 (Enforced measure)”—“I
am a civilized person, not to litter” (nudge)
f. “Send your children school (Enforced measure)”—“An educated person earn more
money and has better life” (nudge)