Behavioural Economics

Published Apr 6, 2024

Definition of Behavioural Economics

Behavioural economics examines how psychological, social, cognitive, and emotional factors influence the economic decisions of individuals and institutions and the consequences these decisions have on market prices, returns, and the allocation of resources. It challenges the classical economic assumption of rational and well-informed agents, offering a more nuanced understanding of economic activities.

Core Concepts

Behavioural economics introduces several core concepts that explain why people make irrational financial decisions. These include:

– Heuristics: Simple, efficient rules, either hardwired or learned, that help individuals make decisions under uncertainty but can lead to systematic biases.
– Bounded Rationality: The idea that rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.
– Prospect Theory: A theory that describes how people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. Prospect theory shows that people value gains and losses differently, leading to decision-making that deviates from traditional economic rationality.
– Anchoring: The cognitive bias that describes the common human tendency to rely too heavily on the first piece of information offered (the “anchor”) when making decisions.
– Loss Aversion: The tendency to prefer avoiding losses to acquiring equivalent gains; it’s better to not lose $5 than to find $5.

Example

Consider the case of saving for retirement, a scenario where behavioural economics provides significant insights. Despite the evident rational decision to start saving early to benefit from compound interest, many individuals procrastinate or save less than the optimal amount. Behavioural economics explains this through concepts such as present bias, where individuals give stronger weight to payoffs closer to the present time over future benefits. Additionally, the illusion of control might lead individuals to overestimate their ability to start saving at a later date or to recover lost savings, further deterring immediate action.

Why Behavioural Economics Matters

Understanding behavioural economics is crucial because it enhances our comprehension of economic phenomena by incorporating the complexity of human nature. It offers insights into why people sometimes make irrational decisions that can lead to inefficient markets, helping policymakers design better interventions (e.g., nudges towards beneficial economical or social outcomes) and enabling businesses to better understand consumer behaviour.

Frequently Asked Questions (FAQ)

How does behavioural economics impact financial markets?

Behavioural economics demonstrates that financial markets are not always efficient and that prices can deviate from their true value due to human biases. For example, overconfidence can lead investors to trade too aggressively, while herd behaviour can result in asset bubbles or crashes.

Can behavioural economics suggest ways to improve decision-making?

Yes, by understanding the biases and heuristics that lead to poor decision-making, individuals and institutions can implement strategies to counteract these tendencies. For example, setting up automatic savings can help combat procrastination and present bias, nudging people towards better financial health.

How do behavioural economists view the concept of rationality?

Behavioural economists argue that while individuals strive to make rational decisions, their rationality is bounded by cognitive biases, emotions, and social influences. As such, traditional models of rational choice theory need to be expanded to incorporate these factors for a more accurate description of real-world decision-making.

Conclusion

Behavioural economics provides a powerful lens through which to view human behaviour in economic settings, melding insights from psychology with traditional economic models. It acknowledges and explores the imperfections and idiosyncrasies in human decision-making, offering a more realistic framework for understanding how economic decisions are made and how they can be influenced or improved. Understanding its concepts not only helps explain and predict economic behaviours better but also fosters the creation of policies and interventions that can lead to improved outcomes at both the individual and societal levels.