Class 1 Curtain Raiser Behavioural Economics PDF

Class 1 Curtain Raiser Behavioural Economics S Subramanian Seeking… State your initial thoughts and expectations (wright or rong) – no judgement attached Go to www.menti.com Enter the code 6610 3888 Join Google Classroom: huarslr  Snippet: The way with the course...

Class 1 Curtain Raiser Behavioural Economics S Subramanian Seeking… State your initial thoughts and expectations (wright or rong) – no judgement attached Go to www.menti.com Enter the code 6610 3888 Join Google Classroom: huarslr  Snippet: The way with the course ∙ The class is divided into three major ideas 1. Principles 2. Methods 3. Applications ∙ We will understand the basic principles of behavioural economics ∙ What is rationality? Or Conversely what is irrationality ∙ How do human beings make decisions ∙ What do we think about time, money ∙ Choice architecture, nudging, behaviour changing techniques ∙ We will look into behavioural labs, experiments, data analysis using appropriate statistical techniques to understand and decompose human preferences ∙ Learn from scholars through videos and multimedia channels  Welcome to this course on the critique of rational consumer behavior CO1: Gain familiarity with the most important contributions in terms of theories and concepts in the field of Behavioural Economics CO2: Critically assess the differences in assumptions and methodologies in understanding economic behaviour between standard economic models and behavioural economics models. CO3: Ability to read and understand journal articles and research reports that use behavioural insights in explaining economic decision making Unit 1 - Introduction to Behavioral Economics Nature of Behavioral economics -Methodological approach: Theory and evidence -Origins of behavioral economics- Neo-classical and behavioral approaches to studying economics- Relationship with other disciplines- Application: Case studies on Loss aversion, Money Illusion, Altruism. Unit 2 - Foundations of Behavioral Economics Values, Preferences and Choices: The standard model- Axioms, assumptions and definitions- Decision making under risk and uncertainty: Prospect theory- Reference points- Loss Aversion- Shape of utility function- Decision weighting- Heuristics and Biases-Application: Case studies on Endowment Effect and Loss Aversion. Mental accounting: Nature and components of mental accounting- Framing and editing- Budgeting and fungibility- Choice bracketing and dynamics-Policy implications- Libertarian paternalism and choice architecture- Nudges- Application Introduction to Neuroeconomics Unit 3 - Intertemporal Choice The Discounted Utility Model: Origin and features of Discounted Utility Model (DUM)- Methodology- Anomalies in DUM; Alternative Intertemporal Choice Models: Time preference- Time inconsistent preferences- Hyperbolic discounting. Unit 4 -Behavioral Game Theory Nature of behavioral game theory- Mixed strategies- Bargaining- Iterated games- Signaling- Learning- Application: Case studies on Market entry in Monopoly and Impasses in bargaining and self-serving bias. References Main Texts Nick Wilkinson and Matthias Klaes, An Introduction to Behavioural Economics, 3rd Edition, Palgrave Macmillan, 2018. Edward Cartwright, Behavioral Economics, Routledge 2011. Other Texts Thaler, R. H., & Sunstein, C. R., Nudge: Improving decisions about health, wealth, and happiness. Thaler, R. H., & Ganser, L. J., Misbehaving: The making of behavioral economics, 2015. Baddeley, M., Behavioural economics: a very short introduction (Vol. 505). Oxford University Press, 2017. What is Behavioural Economics? Perhaps the best way to illustrate the difference between traditional economics and behavioral economics is to borrow a phrase from Thaler and Sunstein book, Nudge. Thaler and Sunstein (2008), Nudge: Improving Decisions about Health, Wealth, and Happiness. USA: Penguin Books. Authors talk about two kinds of species-- Humans and Econs. Econs are mythical creatures that live on the pages of economics textbooks. They're very smart, they can look forward infinitely, they can compute something called utility of objects, and they make perfectly rational choices. Econs don't care about emotions because they don't have any. Econs have the ability of a supercomputer to make fairly complex computations in the snap of a finger.  Human beings are people like you and me-- very different. We're different because we're emotional, we fall in love, we sometimes do silly things, regret our choices. Human beings are impulsive: Human beings tend to make decisions on the spur of the moment. Human beings sometimes do things because other people would like them to do things. Human beings donate to charity. Human beings are also very forward-looking at some points in time, but often care only about the present. Human beings typically form judgments or make choices based on the context around them, as opposed to Econs, who don't care about context. ECONS Humans Are rational Have bounded rationality Have perfect information Have incomplete information Are extremely intelligent and are Are not as intelligent as Econs able to perform complex Have limited ability to carry out calculations quickly complex calculations Seeks to maximise their own utility Are social beings and make Make decisions based on their own decisions in a social context self interest Change their tastes over time Have consistent preference over May have self control issues time Have no self control problems Are unbiased where economics meets psychology…. Behavioural economics combines elements of economics and psychology to understand how and why people behave the way they do in the real world. Challenges the assumptions that we as humans act in “economically rational” manner when given choices in the market place branch of economics that “incorporates the insights of psychology and recognizes that the choices consumers make are governed by many factors that are not consistent with the assumptions behind the neoclassical models”  The Economic Way of Thinking Economics: concerned with developing theories; describe and explain relationships; on the basis of a number of assumptions or premises. People are purely rational actors consumers will always maximize utility producers will always maximize profits They have perfect self-control They never lose sight of their long-term goals. They occasionally make random errors that cancel out in the long run They will always work in their self-interest They have access to all of the relevant information they need – perfect information so... – “when faced with choices, it is assumed that homo economicus will make intelligent, logical and well-considered decisions that give them the most utility”  Here decision making assume that people make those decisions in what is often called a rational manner—they weigh the costs and benefits of different outcomes, evaluate the future with patience and foresight, and acquire the appropriate information to make a good decision. These models have been extraordinarily powerful for predicting large-scale economic phenomena in a wide range of settings: how consumers respond to price changes, how voters react to new information, and many others. Last three decades the standard model of economic rationality, based largely on the assumption of expected utility maximization, has come under increasing criticism from both outside and inside the economics profession.  The global financial crisis of 2008–2010 exacerbated this situation. It prominently drew attention to a large number of empirical anomalies that the standard/traditional model failed to explain. However, the political events of 2016, specifically the Trump victory in the USA and Brexit in the UK, or the Pandemic or the Russia Ukraine war may offer us an even greater source of anomalies than the financial crisis. Certainly the majority of experts found themselves left footed by either political event, showing a significant misunderstanding of voters’ behavior in terms of their values  At the heart of all this lies a fundamental question which mainstream economics struggles to answer: Why did voters behave the way they did in both the US and the UK, seeming to vote against their own interests? For some decades there was an uneasy tension in the economics discipline, with behavioral economics being regarded as an unruly offshoot from the mainstream, consisting of a number of often conflicting and ad hoc hypotheses, with no coherent body of theory. However, post 2008 crisis, economists and policy  Behavioral Economics Behavioral economics is a relatively new school of thought. Behavioural economics examines the differences between what people “should” do and what they actually do and the consequences of those actions. Behavioural economics is grounded in empirical observations of human behaviour, which have demonstrated that people do not always make what neoclassical economists consider the “rational” or “optimal” decision, even if they have the information and the tools available to do so.  Why Study Behavioral Economics? The objective is to modify, supplement, and enrich economic theory by adding insights from psychology Suggesting that people care about things standard theory typically ignores, like fairness or status Allowing for the possibility of mistakes It is important to emphasize that the behavioral economics approach extends rational choice and equilibrium models; it does not advocate abandoning these models entirely. (Ho, Lim and Camerer, 2006, p. 308). Behavioral economics grew out of research in psychology Loss aversion, present bias, mental accounting, inattention, … [Kahneman and Tversky 1979, Thaler 1980, Rabin 1998, DellaVigna 2009] As Camerer and Loewenstein (2004, p. 3) succinctly put it: “Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations.” Behavioral economics has grown very rapidly as a subfield, but neoclassical  Behavioural economics is also interesting because of the pluralism and diversity in its underlying principles. Behavioural economists bring economics together with insights from a wide range of other disciplines, for example psychology (especially social psychology), sociology, neuroscience, and evolutionary biology. Using this multidisciplinary blend of ideas, behavioural economists enrich our understanding of economic and Financial behaviour, without necessarily abandoning the analytical power often associated with conventional economics. Most economists start with the presumption that economic problems emerge, not because people as individuals are fallible, but because of failures in markets and their  Behavioral Economics Applications Household: savings, credit cards, insurance, gambling Finance: bubbles, overtrading, asset price volatility, inattention Public Finance: taxation, charitable giving, retirement, voting Health: health care, exercise, diet, tobacco addiction, organ donations Education: homework, college persistence, peer pressure Labor: work effort, job search, unemployment, wage setting, bonuses Industrial Organization: pricing strategies Business: mergers, investments, stock options, entrepreneurship Development: agricultural productivity and insurance, poverty, savings Energy & Environment: energy conservation, recycling, climate change Sports: athletic performance, betting Macroeconomics: business cycles, monetary policy 18  Psychological Realism Economic theory often aims to build models of behavior with the following features: 1. Generality: the model can be applied across many settings. 2. Tractability: the model is sufficiently simple in the sense that it can be worked with using standard tools of mathematics and does not rely on large-scale computations to generate insights. 3. Realism: the model is grounded in the psychological reality of human behavior. These can be in tension Behavioral economics places more weight on #3: psychological realism 19  THE EVOLUTION OF BEHAVIOURAL ECONOMICS S Subramanian Why History of BE Behavioral economics as we know it today may not have been around much before the 1970s, but the issues it tackles have been around for a very long time. This is relatively new discipline but steeped in the past of economic thinking. It is for this reason that viewing behavioural economics against the larger historical and conceptual backdrop is crucial not only for understanding the past but also the present – importantly, it exposes some long- standing concerns that are fundamental to both mainstream and behavioural economics. Current day mainstream economics remains heavily influenced by past theorizing. Behavioural economics has an interesting and checkered history.  If judging purely from the advances and writing of the book Misbehaving by Richard Thaler (2015), one would believe that it was Thaler who invented behavioural economics. However, such claims contrast sharply with survey of psychological perspectives on choice that goes back to eighteenth-century contributions by David Hume and Adam Smith. Researhers calls this as ‘old behavioural economics’—that is, behavioural economics pre-Thaler. Many behavioral economic principles are, in fact, a rediscovery of ideas that were first formulated in the work of classical economic thinkers, notably Adam Smith What is important for behavioral economics is how these early theorists shaped classical and, then, neoclassical economics, and how the assumptions they held still inform economic thinking today.  Less well known to most economists is a book that Smith first published in 1759, called ‘The Theory of Moral Sentiments’. Smith explains that people are not motivated solely by self- interest, but also feel a natural sympathy with others, and have a natural sense of virtue. In the Theory of Moral Sentiments, Smith talks about many things that in the last 30 years or so have become major issues in behavioral economics. As Thaler noted in 2015: “The famous Chicago economist George Stigler was fond of saying that there was nothing new in economics; Adam Smith had said it all”.  Adam Smith(1723–1790) He introduced the notion of the ‘imaginary machine’ that entails the coordination of all economic activities in cause and effect relationships: the economic system. Smith was enlightened, and although he is most known for his principles of the free market – he believed this to be a means to an end, not an end in itself. His view was that the greatest happiness in life comes not from the accumulation of money (or, more generally, ‘ materialism’) but from the companionship of fellow men and women. His social views of economics were contained in his important 1759 book, The Theory Of Moral Sentiments The book placed feelings, emotions, virtues as center-stage in economic life. Such psychological notions were rediscovered by behavioral economists, but they were there all along in Smith’s classical work. SMITH’S SENTIMENTS Smith argued that social psychology tells us more about moral action than reason alone, let alone pure logic. Smith identifies the rules of ‘prudence’ (a natural tendency to look after themselves) and ‘justice’ (to deter wrong- doing and to punish those who violate social rules) and explains how these are required for society to survive and thrive. According to Smith, this moral impulse stems from our social nature. This social view is a central idea today in behavioral economics. 19th Century: The Classical Economic Tradition Classical economics dominated economic thought throughout the 19th century, with economists such as David Ricardo and John Stuart Mill expanding upon Smith's ideas. However, philosophers like Jeremy Bentham and John Stuart Mill began to introduce concepts of utilitarianism and the idea that human behavior is driven by more than just rational self-interest. It is fascinating that within a relatively short period of time, moral, philosophical, political, and economic ideas were developed to such an extent that they sustain the intellectual life of society even today. Psychology did go hand in hand with economics for a long time after Adam Smith.  Thorstein Veblen, in his book "The Theory of the Leisure Class" (1899), introduced the concept of conspicuous consumption and criticized the idea of purely rational economic behavior. Early economists gave much weight to emotions, impulses, stimulus, morals, and the like. For example, the law of diminishing marginal utility, one of the most fundamental principles of the standard economic model, was based on psychological ideas At the beginning of the twentieth century, however, economics turned away from psychology, and behavioral economics. Why?  This shift was initiated by Vilfredo Pareto. In a letter dated 1897 Pareto writes: ‘Pure political economy has therefore a great interest in relying as little as possible on the domain of psychology.’ This is presumably why, when he published a paper in 1900 outlining a new approach to the theory of choice, he claims as one of its main achievements that ‘every psychological analysis is eliminated’ (these quotes taken from Bruni and Sugden 2007). Why would we want to rid economics of psychology,  Psychology can be taken out of economics by focusing on choice rather than desire. Instead of trying to work out why people do things, we can make inferences based solely on what they do. To quote again from Pareto: ‘I am not interested in the reason why man is indifferent between; I notice the pure and naked fact.’ This approach makes a lot of sense, because it allowed Pareto, and subsequent economists, to abstract away from difficult psychological questions and develop a mathematical theory of rational choice. If people are rational then they will reveal their desires  Marshall and Evolutionary Analysis Marshall’s thinking was greatly influenced by evolutionary biology. Most economists think of him as a key player in the development of the marginalist, supply and demand framework of mainstream equilibrium economics, not as a pioneer of evolutionary economics. Marshall’s way of thinking was resurfaced from the late 1930s onwards in the work of members of the Oxford Economists’ Research Group (OERG). It was clear to the Oxford, the post-Marshallians, that competition was much on the minds of managers: ever-fearful of the possibility of cross-entry by firms diversifying from other sectors. This led them to focus on developing long-term goodwill relationships with customers and not to be greedy with profit margins, in order to deter potential entrants. The work of the OERG led to a book on A Behavioural Theory of the Firm (1963). This book was a logical economics descendant of Simon’s (1945) management classic Administrative Behaviour.  Confidence and uncertainty Keynes (1936, 1937) had earlier suggested that when faced with situations in which ‘we simply do not know’ about the future, people tend to use simplifying procedures, such as copying the behaviour of those believed to have better capacities for choosing, or simply extrapolating the past into the future, or making leaps into the unknown on the basis of ‘animal spirits’. Keynes’s emphasis on the psychological underpinnings of investment and business cycles has carried into modern-day behavioural economics far better than the ‘old behavioural’ analyses.  Bounded rationality and the behavioural theory of the firm In the 1940s and 1950s, Herbert Simon, a cognitive psychologist and economist, challenged the notion of perfect rationality in economic decision-making. He introduced the concept of bounded rationality, suggesting that individuals make decisions based on limited information and cognitive constraints. Simon had provided a more formal ground and argued that the human mind lacks the cognitive capacity to do the kinds of computations that would be required for optimal decision-making, especially in the face of organisational deadlines. Simon’s bounded rationality/satisficing approach is a constructive contribution to mainstream economics, but it was impossible to incorporate it into the increasingly tightly defined core of microeconomic theory.  Carnegie School did little to extend their behavioural analysis of decision-making to the realm of consumer behaviour. Most of the works post Oxford post-Marshallians or Carnegie School were used by business school scholars in corporate growth and industrial organisation; management and organisational behaviour etc and not much in economics. It is important to note that the behavioural economics of the 1950s and 1960s was not given enough room to expand.  The ‘New’ Behavioural Economics In the ‘new’ behavioural economics the dawning of more sophisticated ideas in psychology in the twentieth century, and the work of Tversky and Kahneman in particular, contributed greatly to the synthesis of psychology and economics in the emerging field of behavioral economics. Daniel Kahneman and Amos Tversky, in the 1970s and 1980s, conducted groundbreaking research on cognitive biases and heuristics that influence decision-making. Their work laid the foundation for prospect theory, which challenged traditional economic assumptions and introduced the idea of loss aversion and framing effects. Richard Thaler, in the late 20th century, conducted extensive research on behavioral economics, popularizing the field and introducing concepts like mental accounting, anchoring, and nudges. His work demonstrated that individuals often deviate from rational behavior and exhibit systematic biases in their economic decisions. 21st Century: Behavioral economics has gained significant traction in the 21st century, with its principles being applied in various fields such as finance, public policy, marketing, and healthcare. Governments and organizations have started using behavioral insights to design interventions that align with actual human decision-making patterns, aiming to nudge individuals towards better choices. Ongoing research continues to expand the understanding of human behavior, incorporating insights from psychology, neuroscience, and other related fields. In 2002, Daniel Kahneman became the first behavioral economist to win the Nobel Prize in Economic Sciences for his pioneering work in prospect theory. In 2017, Richard Thaler also received the Nobel Prize, further solidifying the importance of behavioral economics.  Limitations of Behavioural Economics Lack of Consistency in Findings: Critics highlight inconsistencies in experimental findings within behavioral economics. The replication crisis, wherein many studies fail to reproduce their results, has raised concerns about the reliability of certain behavioral findings. This has led to debates about the generalizability and robustness of behavioral insights. Neglect of Structural Factors: Some critics argue that behavioral economics tends to overlook larger structural factors that shape economic behavior. By focusing primarily on individual biases and heuristics, it may downplay the role of socioeconomic, cultural, and institutional influences. This limits its ability to address systemic issues and propose comprehensive solutions. Lack of Unifying Theory: Behavioral economics has been criticized for lacking a cohesive and unified theoretical framework. While it has identified numerous biases and heuristics, there is ongoing debate about how these  Oversimplified Assumptions: Critics argue that behavioral economics, like traditional economics, relies on oversimplified assumptions about human behavior. While it recognizes deviations from strict rationality, it often assumes that individuals are generally biased and make consistent errors. This approach may overlook the complexity and diversity of human decision-making. Lack of Predictive Power: Some critics contend that behavioral economics has limited predictive power. They argue that while it identifies biases and heuristics, it falls short in accurately predicting individual behavior and market outcomes. The multitude of cognitive biases and contextual factors make it challenging to create robust predictive models.  As behavioral economist Richard Thaler, writing while behavioral economics was still in its relative infancy (1990: 203), says The problem seems to be that while economists have gotten increasingly sophisticated and clever, consumers have remained decidedly human. This leaves open the question of whose behavior we are trying to model. Along these lines, at an NBER [National Bureau of Economic Research] conference a couple of years ago I explained the difference between my models and Robert Barro’s by saying that he assumes the agents in his model are as smart as he is, while I portray people as being as dumb as I am.  Behavioral economists attempt to identify systematic “biases” All of us have innate psychological biases that can lead to predictable “errors” in how we make important (financial/non financial) decisions. Behavioral economics catalogues these errors and helps us to anticipate, and hopefully avoid, these decision-making “traps.” In some situations, people make decisions that seem to violate the foundational assumptions of rational choice models. Over the past half-century, decision scientists have identified anomalies, or biases, in people’s behavior that can’t readily be explained with traditional economic models. It will explore a remarkable range of counterintuitive and sometimes even paradoxical aspects of human behavior, often revealing that our decisions are based on completely unexpected factors. Undeniably, economics is a critically important subject because it is all about our welfare—at an individual level, nationally and internationally, and for our children and future generations.  200+ cognitive bias https://upload.wikimedia.org/wikipedia/commons/6/65/Cognitive_bias_codex_en.svg We behave unpredictably at times Unpredictable nature emanate from our innate anomalies or biases  Example: Coffee (Hong Kong Experiment) Most coffee shops all over the world will sell you coffee in one of three sizes--small, medium, large. The most popular size of coffee anywhere in the world is the medium size of coffee. But here's where it gets interesting. It doesn't matter how much coffee is in that medium cup of coffee. The larger one has too much, the little one has too If welittle, remove the in the one largest size, and the middle has replaced the right that with an even smaller size? amount It turns outof coffee. now the new medium cup of coffee will be the most popular cup of coffee. In the experiment Dr Dilip Soman actually increased the size of every cup of coffee by two ounces– they found that the new medium now became the most popular size.  Coffee experiment is a classic example of what we call a context/compromise effect (an aspect of cognitive psychology). This effect was first made popular by Itamar Simonson, who is a professor at Stanford. His argument: In situations where people do not have a good idea of how to value objects, they use information from the context to help them make that judgment and compromise. We have situations where the context now informs consumers about what the right choice is. Debate: Is irrationality truly damaging to welfare and well-being? Rational Choice Traditional approaches to economic decision making invoke the so-called rational choice model, which is a framework for understanding and often formally modeling social and economic behavior. But what does it mean? Suppose a friend of yours comes to you and says, Dilip, how much should I save for a diamond? How would you advise that person to proceed? Well, it turns out that economics has a very handy model to describe how this person should go about making that decision. That model is called the life cycle hypothesis. The hypothesis essentially says is, you want to look at the net present value of your future income stream and then set your savings decision. You need to know the expenditure patterns. Current economic conditions etc. I could go on and on, listing the kinds of information you would need to know to answer that question. Essentially, this is the difference between an irrational human being, and what is an economically rational person. So what does it mean to be rational? When we describe someone as rational, we often want to imply that they are dispassionate,  Behavioral perspectives on economic rationality Baumeister (2001): ‘A rational being should pursue enlightened self-interest.’ This definition draws attention to three crucial concepts: ‘enlightened’, ‘pursue’ and ‘self-interest’. ‘enlightened’ implies that an individual has perfect knowledge, something that is obviously not realistic. Many instances of conflicts between short-run and long-run considerations. The Four C's of Rationality Completeness of information, Cognition, The Ability To Think Through Problems, Computational ability, which is the ability to process information and make fairly complex calculations, and finally, Consistency in decision making, both internal and external. Completeness Having complete knowledge of all the information. There might be some decisions where you have completeness, but in most decisions, you don’t. Even when you go to a store to buy a product, there are always issues like safety, and warranty, and after sale service that you don't have information about.  Cognition The ability of human beings to make completely unemotional decisions. If you're a rational agent, what you want to do is to look at only elements of the decision-making that adds something called utility to your choice, and look at those, and only those. Example: Regret is the emotion of wishing that you had chosen something that you did not choose. Regret can actually affect decision-making in a number of different ways. I should have bought a stock that's going up for $10 but don't, because I could have bought it for $7. These emotional responses to decision-making in a number of different spectrums.  Computational ability The decision-making for deciding on the buying a house certainly involves obviously addition, multiplication, subtraction, discounting etc. Even if you had perfect information on all the numbers, the sheer act of computing the outcome is problematic and difficult. You're essentially trying to solve a complex problem can best be handled by a supercomputer, but now you're giving it to your laptop to process. What happens there is the laptop, at some point in time, simply freezes, cannot handle the data, and gives up. Human beings tend to do is, they tend to try and find short cuts so that they can actually make decisions, given their limited cognitive abilities. Consistency When you think about the mathematical modelling of rationality, there's a fairly complex set of algorithms and theorems that actually describe what rational choice looks like. You have a set of variables determining the choice combined with an importance weighting, conspire to form something called utility, which is the measure of how valuable that product is to you, the consumer. This is can be understood using the Axioms of Rational Choice  Rationality Does rationality relate just to decision-making, involving choice and actions, or does it relate to attitudes and beliefs? In general, economists have tended to concentrate on decision-making and actions While psychologists have often taken the view that, while decision-making involves deliberate choice, the formation of attitudes and beliefs may be beyond our conscious control, and therefore outside a discussion of rationality for economists. Rational decision: 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. Irrational Decision: Behavioural economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going  What we need is not a model that is able to explain moves along the best-response strategy path but along the actual-response strategy path which in many instances could be bettered. In this sense, individuals appear to act irrationally to the extent that they deviate from the best-response path. But what do we mean by ‘rational’ here? The terms ‘rationality’, and its opposite, ‘irrationality’, are used extensively in economics, and particularly in connection with behavioral economics. Indeed many people think of behavioral economics as being an approach to understanding why people act  Many behavioral economists take the view that if we misjudge what is in our self-interest then this is not a failure of rationality. We may have incomplete knowledge or we may have cognitive failures in terms of the processing of information within given time constraints. These failures are often ascribed to ‘bounded rationality’, and behavior that fails to achieve self-interest because of bounded rationality is therefore not irrational according to this criterion. Bounded rationality describes the way that humans make decisions that departs from perfect economic rationality, because our rationality is limited by our thinking capacity, the information that is available to us, and time. Instead of making the 'best' choices, we often make choices that are satisfactory.  Ponder Upon 1. Why do people often avoid or delay investing in big projects or exercising, even if they know that doing those things would benefit them? 2. Why do gamblers often risk more after both winning and losing, even though the odds remain the same, regardless of “streaks”? 3. Why are we inclined to sell the shares in our portfolio that are performing well, and hold onto those that are performing poorly? 4. Why should you always buy auto insurance and never buy electronics insurance? 5. Why do we over-estimate the probability of plane crashes and under-estimate the probability of car crashes? 6. Why is it significant that the recent credit crisis, the worst economic recession that the US has seen since the 1930’s, took  Why incentives matter — even in behavioral economics Incentives do affect people’s decisions. It’s just that, often, incentives aren’t enough to tell a good story about economic phenomena. When behavioral elements are left out of standard models, choices can end up going in the opposite direction of what the standard theory predicts. For example, people sometimes do buy more when the price is high Economists need to enrich the traditional economics toolbox — but we can’t ignore the importance of economic incentives to the decisions people make.  Incentives Using Behavioural Insights Link: https://doi.org/10.1111/ajae.12340  Second Concept: Is pursuing the same as maximizing? The work of Kahneman and Tversky in particular concludes that people tend to take a heuristic approach to decision-making. The term ‘heuristic’ means that people use simple ‘rules-of-thumb’, often unconsciously, in order to make decisions when there is a lot of information involved, much uncertainty, and a realistic time constraint. Thus we may have a personal rule always to pay by cash for purchases of less than Rs100, even if we have a credit/debit/UPI handy. Sometimes this can result in inconsistent or incoherent behavior the heuristics involved in the decision-making processes of bounded rationality are more related to ‘satisficing’. (or doing the best you can with what you have)  Even the most innocuous of economic choices are in principle very complicated. For example, consider a shopper in a grocery store looking at rows of breakfast cereal and deciding which one to buy. Should she buy the cereal she usually buys? Should she try a new cereal the store has just introduced? Should she buy the cereal on special offer? Will the cereal she usually buys be on special offer next week? Will it be cheaper in another store? Should she be tempted by the cereal with the chance to win a holiday in the Caribbean? Clearly, most of us do not spend much time considering all these issues. Indeed, most of us simply buy the cereal that we usually buy. That way we can make a quick decision that will probably keep us happy. This is an example of a heuristic. A heuristic is any ‘rule of thumb’ or simple rule of behavior by which a person solves a problem.  The story of a shopper called Anna in a grocery store deciding what breakfast cereal to buy. There is a large selection of potential choices, all with different characteristics, but we will narrow things down to the four listed in Table The standard way of thinking about this in economics is to assume that Anna has a utility function that says how much utility she gets from particular combinations of money and goods. In this context we would write u(x, TQ, HQ) as the utility she gets from having money x and a cereal with taste quality TQ and health quality HQ. Cereals for sale, and their characteristics, with 1 = low, 2 = medium and 3 = high. The utility of each cereal if initial wealth is $100. Behavioral economists have primarily focused on basic heuristics – i.e. heuristics designed to solve a specific problem.  Maximizing versus satisficing Almost no one maximizes, carefully calculates cost versus benefit, operates with perfect information, or carefully forecasts into the future the implications of current decisions, especially with any degree of certainty. People engage in what behavioral economists refer to as satisficing — they do the best they can to get the best possible results they can, given the psychological, physiological, and environmental constraints they face. If conventional behavior is considered to be rational, then behavioral economists refer to the way in which people actually do behave as boundedly rational. Being boundedly rational often involves decision-making shortcuts, or heuristics. Some behavioral economists argue that using heuristics typically results in errors and biases in decision making. Satisficing decision theory Noble laureate Herbert Simon was the first one to give alternative thinking to rational decision-making in 1956. He coined the term "satisfice" in alternative to "optimize" and proposed bounded rationality as an alternative basis for the mathematical modelling of decision-making, as used in economics, political science, and related disciplines. Satisficing is a decision-making strategy that aims for a satisfactory or adequate result. Simon believed that decision-makers establish a criterion (their "level of aspiration") that an alternative should meet to be acceptable. People examine possible options in the order that they think of them. Eventually, they accept the first option that meets their criterion. Example To illustrate the above theory in agriculture, a farmer is looking for some pesticides to control a particular type of pest, and while buying the pesticide, he usually ends up buying the narrow spectrum pesticide, which will manage only that particular pesticide. In the process, he ignores the information or may not even get access to the information that the broad spectrum pesticides would be the better option for him, as they could control some other type of pests and weeds also. In this case, buying broad-spectrum pesticides was the optimal solution, but most of the farmers will end up buying narrow-spectrum pesticides, which is a satisficing solution to the problem.  In many different situations, decision-makers look for something good enough and satisfy their prime objective. According to Simon 1957, the personal level of aspirations and demand from the solution can rise or fall over time, depending on the ease or difficulty of finding satisfactory solutions. If the satisfactory results are easily achievable, then the aspiration is expected to rise, and it may lead to a near-optimal solution in the long run. Whereas, if satisfactory solutions are challenging to achieve, it may lead to a fall in the aspiration level of a decision-maker. But decision-maker is assumed to make the best choice despite their inability to optimize.  Example: Organ Donation Why are organ donation consent rates really low in countries like Canada and the United States? Why are they extremely high in other countries, like France and Austria? In Canada, organ donation rates are about 2.5%. In Austria, they're close to 99%, and that's a big difference. Essentially, the default assumption is different in Canada versus Austria, and defaults play a huge role in shaping decision-making. Defaults work because of two reasons. Reason number one--people are extremely lazy: If you put obstructions in their approach to a certain outcome, those obstructions are enough to prevent them from reaching that outcome. So, the simple principle is if you want to engage people in a certain outcome, make that outcome easy. Second reason: Defaults signal something about everybody else: If everybody else is donating organs--if that's the default--perhaps I should  The Compromise Effect: Options tend to get chosen more often when they are the compromise option in a choice set Simonson, I (1989), Journal of Consumer Research. Defaults: A no-action default is the outcome when an individual fails to make a decision Johnson E. and D. Goldstein (2003), Science  Bounded willpower captures the idea that even given an understanding of the optimal choice, people will often still preferentially choose whatever brings the most short-term benefit over incremental progress toward a long-term goal. For example, even if we know that exercising may help us obtain our fitness goals, we may put it off indefinitely, saying we will “start tomorrow.” If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall off of the weight loss bandwagan, showing his lack of self-control. Bounded self-interest is the idea that people are often willing to choose a less-optimal outcome for themselves if it means they can support others. Giving to charity is an example of bounded self-interest, as is volunteering. While these are common activities, they are not captured by traditional economic models, which predict that people act mostly to further their own goals and those of their immediate family and friends, rather than strangers.  The third concept: self-interest Economists have traditionally measured this concept in terms of utility, where utility is a measure of subjective value. (rational choice theory) -- preference orderings. Arguably, actions where no deliberation is involved, sometimes called instinctive, are neither rational nor irrational. These actions tend to occur on the spur of the moment. Such actions are sometimes referred to as arational. (not being caused by any kind of conscious deliberation.)  The avoidance of loss In conventional economics, people are particularly concerned with maximizing income and wealth. But BE recognizes that, on average, people tend to despise losses. For individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Loss aversion refers to an individual’s tendency to prefer avoiding losses to acquiring equivalent gains. Experiments Lisa Kramer: Weather to invest in stocks or bonds! https://www.youtube.com/watch?v=Obbr48YKDM8 Zachary Zong: Why 4 diamonds are better than 400 points https://www.youtube.com/watch?v=913BF3Akwvo&t=1s Nico Lacetera: Driving a few miles can cost hundreds of dollars https://www.youtube.com/watch?v=5QwNSk2JZuM&t=2s