Behavioural Economic Theory (AQA A-Level Economics): Revision Notes
Behavioural Economic Theory
Introduction to behavioural economics
Behavioural economics is an approach to studying the economy that combines insights from psychology with traditional economic analysis. Rather than assuming people always make perfectly rational decisions, behavioural economics recognises that human behaviour is often influenced by emotions, social pressures, and mental shortcuts.
This field has gained significant attention since the early 2000s. In 2008, economist Richard Thaler and legal scholar Cass Sunstein published an influential book called Nudge: Improving Decisions about Health, Wealth and Happiness, which made behavioural economics accessible to a wide audience. Their work demonstrated how understanding human psychology could help design better policies.
The UK government recognised the value of this approach by establishing the Behavioural Insights Team (BIT) in 2010. Based in the Cabinet Office, the BIT uses insights from behavioural economics, psychology, and social anthropology to understand how people make decisions and how they respond to different options. The team's goal is to design policies that help people make better choices for themselves and society.
According to the BIT, behavioural insights help us understand "how individuals take decisions in practice and how they are likely to respond to options." These insights enable policy-makers to create interventions that encourage and support people to make better decisions.
Traditional economic theory vs behavioural economics
Traditional economics is built on the concept of homo economicus or "economic man." This theoretical model assumes that individuals are perfectly rational, fully informed, and always act in their own self-interest. According to this model, people know exactly what they want and consistently make decisions to maximise their economic benefit.
This simplified model has proven useful for understanding markets and consumer behaviour at a large scale. However, the behavioural economics approach highlights several problems with this assumption:
First, humans display anomalies in behaviour. People often act in ways that contradict what traditional theory predicts. For example:
- We tend to be altruistic, caring about others' wellbeing even when it costs us
- We generally lack self-control, finding it difficult to resist immediate temptation
- We dislike change and prefer to stick with the status quo, even when change might benefit us
Second, cognitive psychology reveals thinking limitations. Research shows that humans frequently make decisions using simple rules of thumb (called heuristics) rather than careful analysis. This leads to predictable errors such as:
- Overconfidence in our own judgements
- Confirmation bias (seeking information that supports what we already believe)
- Recency bias (weighting recent information more heavily than older information)
Emotions also play a fundamental role in decision-making, including feelings like anger, regret, guilt, shame, and disappointment.
Third, humans face computational and reasoning limitations. This is particularly important in complex environments. For instance, when choosing a mortgage, individuals must consider numerous factors and predict how their competitors (other buyers) will behave. In markets with few competitors (oligopolies), firms face similar challenges when setting prices.
Bounded rationality
In reality, people rarely make perfectly rational decisions. Instead, they operate under conditions of bounded rationality. This concept recognises that when making decisions, individuals face three unavoidable constraints:
- Limited information - People never have complete information about all possible alternatives and their consequences
- Limited mental processing ability - Our minds have finite capacity to analyse complex situations
- Limited time - Decisions must often be made quickly, without the luxury of extensive deliberation
These constraints mean that in complex situations, people tend to make satisficing choices rather than maximising choices. Satisficing means accepting outcomes that are "good enough" or sub-optimal, rather than spending excessive time and effort searching for the absolute best option. It represents a practical compromise between the ideal and the achievable.
Worked Example: Laptop Purchase Decision
When buying a laptop, a perfectly rational decision would involve:
- Researching every available model
- Comparing all specifications and prices
- Calculating the optimal choice
In reality, most people:
- Look at a few options
- Find one that meets their basic requirements
- Stop searching once they've found something satisfactory
This demonstrates satisficing behaviour - accepting a "good enough" solution rather than pursuing the theoretically optimal choice.
Bounded self-control
Closely related to bounded rationality is the concept of bounded self-control. Traditional economic theory assumes people have complete self-control when making choices. Behavioural economists recognise this isn't realistic.
Many individuals have limited or bounded self-control. They may set out with good intentions to act rationally, but find themselves slipping into less rational behaviour when more appealing alternatives appear.
For example, someone committed to a healthy eating regime may succumb to fast food after maintaining their diet for several days. The immediate pleasure of unhealthy food overcomes their long-term commitment to health.
This lack of self-control helps explain why people often struggle with:
- Saving money for the future
- Maintaining diet and exercise plans
- Avoiding impulse purchases
- Sticking to work schedules
Thinking fast and thinking slow
Nobel Prize-winning psychologist Daniel Kahneman has made groundbreaking contributions to behavioural economics. His research introduced the idea that human thinking operates through two distinct systems:
System 1: Thinking fast This is our intuitive and instinctive thinking mode. Decisions are made quickly with little conscious effort. This is automatic thinking that happens almost unconsciously. System 1 is efficient and allows us to navigate daily life without becoming overwhelmed.
System 2: Thinking slow This is our reflective thinking mode. It requires concentration and deliberate mental effort to work through problems systematically. Decision-making is relatively slow, involving careful and logical thought about each step.
Worked Example: Learning to Skateboard
Initially (System 2 thinking): Beginners must think slowly about every movement:
- Where to place their feet
- How to shift their weight
- How to maintain balance
With practice (System 1 thinking): Experienced skateboarders can:
- Perform complex tricks quickly and instinctively
- Respond to situations promptly and effectively
- Execute movements automatically
However, even experts can suffer if they stop thinking carefully. In high-pressure situations, they may need to switch back to System 2, over-thinking the situation. Paradoxically, this can lead to poor decisions when quick, instinctive responses would be more effective.
Many everyday economic decisions rely on our automatic system - buying coffee at a train station, picking up groceries at the supermarket, or grabbing a sandwich from a café are often quick, intuitive choices. Larger and more important decisions, such as buying a car or house, or choosing an insurance policy, typically require reflective, System 2 thinking.
Cognitive biases in decision making
Behavioural economics demonstrates that quick decisions made using System 1 thinking are often heavily biased. A cognitive bias is a systematic error in thinking that affects the judgements and decisions people make. These biases occur because decisions are made based on our own preferences, beliefs, and dislikes, often without considering contrary information.
Many types of cognitive bias exist, including confirmation bias (seeking only information that supports existing beliefs) and recency bias (overweighting recent experiences). Psychologists use the term cognitive bias to describe this broad category of thinking errors.
Rules of thumb
To cope with limited information, mental capacity, and time, humans rely on rules of thumb - simple thinking shortcuts or informed guesses that help us make decisions quickly. While these heuristics save time and mental effort, they frequently lead to cognitive biases.
The two most common rules of thumb that create biases are availability and anchoring.
The availability bias
The availability bias occurs when individuals place excessive weight on the probability of an event happening because they can easily recall vivid examples of similar events. If something is easy to remember, we tend to think it's more likely to happen.
For example, after hearing several news reports about car thefts, someone might judge vehicle theft to be much more common than it actually is in their local area. The vivid media stories make these events seem more probable than statistical evidence would suggest.
The availability bias often leads to decisions not based on logical reasoning. Media stories that capture our attention affect our reasoning process. We often believe that extreme weather events, such as hurricanes or severe flooding, are more likely than empirical statistical analysis would support.
Research by Ipsos, a market research company, revealed how the general public in 14 countries held significantly distorted perceptions about their societies. In the UK, for instance:
- Many citizens believed 24% of the population were immigrants (the actual figure was 13%)
- People thought 24% of the working-age population was unemployed (the actual figure was less than 7%)
These misperceptions demonstrate how easily recalled information (often from news headlines) distorts our understanding of reality.
Anchoring
Anchoring is a cognitive bias where people rely too heavily on the first piece of information they encounter (the "anchor"). This initial information then influences all subsequent judgements and decisions.
Worked Example: Restaurant Menu Pricing
Menus sometimes feature very expensive main courses alongside more moderately priced alternatives:
- The expensive items serve as anchors
- Even though their prices are quite high, customers are drawn to choosing cheaper items from the menu
- These "cheaper" options seem reasonable compared to the anchor price
- In reality, even these options may still be expensive
When given a choice, we often pick the middle option, believing it's neither too expensive nor too cheap. This anchoring effect shapes countless purchasing decisions without us realising it.
Social influences on behaviour
Social norms
Human beings are social animals, and the behaviour of others significantly influences our own choices. By observing and learning from other people's behaviour, social norms become established. Social norms are patterns or forms of behaviour considered acceptable by society or groups within society.
Negative social norms can encourage harmful behaviour. Many young adults drink heavily because they believe it's expected behaviour for people their age. However, by presenting statistical data showing that most young adults don't engage in regular heavy drinking, behavioural economists can help challenge these perceptions and encourage young drinkers to moderate their behaviour.
Positive social norms can be seen in changing attitudes towards smoking over the past 30 years. In the 1980s, smoking was socially acceptable in almost all public places, including libraries, trains, and the London Underground. Concerted health campaigns provided better information about smoking risks, gradually altering social attitudes. People became much more willing to accept laws restricting smoking rights. Laws banning smoking in public places are economic sanctions (government regulations restricting behaviour) rather than nudges.
The French-American economist Esther Duflo won a Nobel Prize for her work using behavioural economics to reduce poverty and improve economic development. One example from 2003 involved reducing teacher absenteeism in India by encouraging teachers in 120 schools to have their photograph taken with students each day. This reinforced the bond between teachers and learners, using social norms to improve attendance.
Critics of behavioural economics argue that sanctions, such as smoking bans, may be more effective at changing behaviour and improving public health than nudges, which only influence some people's behaviour. Nevertheless, government reports in Ireland show that since smoking in public places was banned, people are also less likely to smoke in other people's houses because it's now considered socially unacceptable.
Nudges
Nudges are factors that encourage people to think and act in particular ways. Unlike sanctions or regulations, nudges try to shift behaviour in ways that align with desirable social norms without restricting freedom of choice.
The key difference between nudges and sanctions:
- Sanctions are economic penalties imposed by regulations or laws that restrict an individual's freedom to behave in certain ways. Breaking a sanction leads to punishment.
- Nudges work by influencing choices without imposing penalties or removing options.
For example, the UK government's consumer empowerment strategy uses behavioural economics principles to influence consumer behaviour. The BIT publication Better Choices: Better Deals recommends ways government policy can nudge people towards beneficial decisions.
Nudges represent an approach that complements traditional policies. They can be particularly effective at addressing market failures, such as presenting meal options in school canteens in ways that promote healthier choices.
Altruism and fairness
Altruism
Altruism means acting to promote someone else's wellbeing, even when it involves personal cost, financial loss, time, or risk. Before behavioural economics emerged, traditional economists assumed individuals only acted in self-interest and weren't altruistic.
However, altruism can be explained within maximising theory by assuming individuals gain pleasure from giving to others. More recently, behavioural economists have highlighted evidence that many people's first impulse is to cooperate with others rather than compete. Young children frequently help other children around them out of genuine concern for their welfare, before they've been taught to do so. Even animals display altruistic behaviour.
Fairness
Altruistic behaviour often stems from people's perceptions of fairness. Fairness is a normative concept involving value judgements about what is right or reasonable. Different people hold different views about what constitutes fair treatment.
A popular view is that fairness involves:
- Treating people equally
- Treating people in ways that are right or reasonable
- Sharing with others
- Giving others respect and time
- Not taking advantage of people
Most individuals believe in fairness and are concerned with the welfare of others. This concern for fairness influences economic decisions, from charitable donations to support for policies that redistribute wealth.
Key Points to Remember:
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Behavioural economics applies psychological insights to understand how individuals actually make decisions, challenging the traditional "homo economicus" model.
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Bounded rationality recognises that people make decisions under three key constraints: limited information, limited mental ability, and limited time. This often leads to satisficing rather than maximising behaviour.
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Humans use two thinking systems: System 1 (fast, automatic, intuitive) for everyday decisions and System 2 (slow, deliberate, analytical) for complex decisions requiring careful thought.
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Cognitive biases are systematic thinking errors that affect decision-making. The two most common rules of thumb that create biases are availability (overweighting easily recalled events) and anchoring (relying too heavily on initial information).
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Social norms and nudges can influence behaviour in positive or negative ways. Nudges encourage desirable behaviour without restricting choice, while sanctions impose penalties for non-compliance. Understanding these concepts helps policy-makers design more effective interventions.