Behavioural economics

Introduction to behavioural economics

Behavioural economics attempts to understand the effect of individual psychological processes, including emotions, norms, and habits on individual decision-making in a variety of economic contexts.

Homo economicus

All economic behaviour involves decision-making by individuals, and traditional (neo-classical) theories of economic behaviour assume that economic agents apply rational thought to each and every decision to achieve the maximisation of personal benefit (utility) or, in the case of producers, the maximisation of profits. The assumption of the rational individual ('economic man' or homo economicus) is central to most micro-economic theory, and can be seen most clearly in marginal analysis. Marginal analysis suggests that economic agents carefully weigh-up the expected costs and benefits of alternative decisions based on accurate information, and select the option that maximises their personal gain. In other words, individual economic agents are driven by self-interest, and if all agents are driven by self-interest based on all the information they have, each marginal decision will be rational.

This idea underpins the theory of how markets work to allocate scarce resources, and is the basis of micro-economics, yet the real world seems full of examples of where decision making does not seem rational, nor in the individual’s self-interest. The cases of cigarette smoking, over-eating, and failing to save enough for retirement are just a few of the apparently irrational decisions routinely made by individuals across the developed world. Behavioural economics challenges the long held view in mainstream economics that individuals are ‘unemotional’ maximisers who make rational decisions – rational actors being identified as homo economicus. It also offers suggestions as to how individuals can be ‘nudged’ towards more effective decision-making.

Challenging the assumptions of traditional economics

Behavioural economists identify at least three questionable assumptions contained in traditional theory.

  1. That individuals make decisions based on ‘unbounded (unlimited) rationality’ accurately processing all the information at their disposal.

  2. They the use ‘unbounded willpower’ to convert wants into actions and consumption (or production), and have absolute self-control when confronted with choices. In other words, they can resist making ‘poor’ choices.

  3. They are driven by ‘unbound selfishness’ to achieve maximum benefit for themselves.

Go to: Decision Making Systems