Revsison Notes 2 Behavioural Economics.docx

**Introduction to Behavioural Economics** Behavioural economics is an interdisciplinary field that combines insights from psychology, economics, and cognitive science to better understand how individuals make decisions. Unlike traditional economic models, which assume that individuals are rational...

**Introduction to Behavioural Economics** Behavioural economics is an interdisciplinary field that combines insights from psychology, economics, and cognitive science to better understand how individuals make decisions. Unlike traditional economic models, which assume that individuals are rational agents who seek to maximize utility, behavioural economics acknowledges that humans often deviate from rationality due to cognitive biases, emotions, and social influences. **Key Principles of Behavioural Economics** 1. **Bounded Rationality:** Decision-making is limited by cognitive abilities, time constraints, and the information available. 2. **Heuristics and Biases:** Individuals rely on mental shortcuts that can lead to systematic errors in judgment. 3. **Behavioural Insights in Policy:** Recognizing irrational behaviour allows for the design of policies (e.g., nudges) that guide individuals toward better decisions. 4. **Social Preferences:** Decisions are influenced by fairness, reciprocity, and altruism, not just self-interest. Behavioural economics has practical implications in diverse areas such as marketing, finance, public policy, and organizational management. **1. Bounded Rationality** **Bounded rationality** is a concept introduced by Herbert A. Simon to describe the limitations of human decision-making. It challenges the traditional assumption of full rationality in economics. **Key Features** 1. **Cognitive Constraints:** - Human brains have limited processing power, which restricts the ability to analyse all available options. 2. **Incomplete Information:** - Decisions are made based on the information at hand, which may be incomplete or imperfect. 3. **Satisficing Behaviour:** - Instead of optimizing, individuals often settle for a \"good enough\" solution due to limited resources. 4. **Dynamic and Adaptive:** - Bounded rationality emphasizes that individuals adapt their decision-making strategies based on the environment and past experiences. **Examples in Decision-Making** - A consumer choosing a product based on brand reputation rather than conducting extensive research. - A manager making a strategic decision with limited data under time pressure. **Criticism** - Critics argue that bounded rationality lacks predictive precision and that its reliance on context-specific behaviours makes generalization difficult. **2. Heuristics** Heuristics are mental shortcuts or rules of thumb that simplify decision-making. While they are efficient, they can lead to biases and errors. **Types of Heuristics** 1. **Availability Heuristic:** - Decisions are influenced by how easily examples come to mind. - Example: Overestimating the probability of plane crashes due to extensive media coverage. 2. **Representativeness Heuristic:** - Judgments are based on how similar something is to a stereotype. - Example: Assuming a person who enjoys poetry is more likely to be a literature professor than a truck driver, ignoring base rates. 3. **Anchoring and Adjustment Heuristic:** - Initial information (anchor) influences subsequent judgments. - Example: A high starting price in negotiations biases the final agreement. **Pros and Cons** - **Pros:** Heuristics save time and effort, making them effective in routine decisions. - **Cons:** They can lead to systematic biases, such as overconfidence or stereotyping. **3. Framing, Anchoring, and Self-Interest** **Framing** Framing refers to how the presentation of information influences decision-making. - **Positive vs. Negative Framing:** - Example: A surgery with a \"90% survival rate\" is perceived more favourably than one with a \"10% mortality rate,\" even though both convey the same information. - **Loss Aversion:** - People are more sensitive to potential losses than equivalent gains, leading to risk-averse behaviour. **Anchoring** Anchoring is the tendency to rely heavily on the first piece of information encountered (the \"anchor\") when making decisions. - **Example in Pricing:** - A product priced at \$100 with a \"50% discount\" seems like a better deal than the same product priced directly at \$50. - **Applications:** - Used in marketing, negotiations, and behavioural nudges to influence decisions. **Self-Interest** Traditional economics assumes individuals act purely out of self-interest to maximize personal utility. Behavioural economics challenges this by recognizing: - **Social Comparisons:** Individuals care about fairness and relative gains, not just absolute outcomes. - **Reputation and Reciprocity:** Acts of self-interest are often tempered by the desire to maintain social relationships. **4. Altruism and the Common Good** Behavioural economics acknowledges that individuals often act in ways that benefit others or the community, even at a personal cost. **Altruism** - **Definition:** The willingness to act in the interest of others, even at a cost to oneself. - **Examples:** - Donating to charity, volunteering, or helping a stranger. - **Motivations:** - Empathy, moral obligations, or social rewards (e.g., recognition or gratitude). **The Common Good** - **Definition:** Actions that benefit society as a whole, often requiring cooperation and shared sacrifices. - **Public Goods Dilemma:** - People may free-ride, enjoying the benefits of a public good without contributing (e.g., clean air, national defence). - Behavioural economics explores strategies like social norms and nudges to encourage contributions. **Reciprocity and Fairness** - Many decisions are influenced by perceptions of fairness and a willingness to reciprocate kind actions. - Example: Employees are more motivated by fair treatment and recognition than monetary rewards alone. **Applications of Behavioural Economics** 1. **Policy Design:** - Nudges, such as opt-out systems for organ donation, increase participation without limiting choice. 2. **Marketing:** - Framing discounts or product benefits influences consumer behaviour. 3. **Organizational Management:** - Understanding bounded rationality and heuristics helps in better decision-making and leadership. Behavioural economics provides a richer and more realistic understanding of human behaviour, bridging the gap between theoretical models and real-world complexities