Behavioural economics and real choices
People do not always behave like the calculating consumers in textbook models. Behavioural economics combines psychology and economics to explain real decisions.
Bounded rationality
Herbert Simon argued people have limited time, information, and brainpower, so they 'satisfice', choosing options that are good enough rather than optimal. Rules of thumb (heuristics) save effort but can lead to predictable mistakes.
Loss aversion
Daniel Kahneman and Amos Tversky found that losses feel roughly twice as painful as equivalent gains feel good. Loss aversion explains why people hold losing investments too long, resist changing default options, and dislike price rises more than they like equivalent price cuts.
The endowment effect
People tend to value things more once they own them. In experiments, people given a mug demand much more to sell it than others are willing to pay to buy it. This makes trades less frequent than standard theory predicts.
Framing and anchoring
How choices are framed changes decisions: '90% survival' sounds better than '10% mortality' though they are identical. Anchoring means initial numbers influence later judgements: a high 'original price' makes a sale price look like a bargain.
Present bias
People often value immediate rewards far more than future ones, more than a consistent discount rate would suggest. This explains procrastination, under-saving for retirement, and difficulty sticking to diets and exercise plans, even when people plan to do better.
Mental accounting
People treat money differently depending on its source or intended use, putting it in mental 'accounts'. Someone might spend a tax refund freely while carrying expensive credit card debt, although money is interchangeable.
Nudges
Richard Thaler and Cass Sunstein proposed 'nudges': changes to how choices are presented that steer behaviour without restricting options. Making pension saving the default (with the option to opt out) has greatly increased participation in several countries. Placing healthy food at eye level in cafeterias is another example.
Worked example
A company changes its pension plan from opt-in to automatic enrolment with an opt-out. Participation jumps from about 50% to over 90%, though nobody's options changed. Standard theory predicts no difference; behavioural economics explains it through inertia, present bias, and the power of defaults.
Key takeaways
People have bounded rationality and use heuristics. Losses loom larger than gains; ownership raises valuation. Framing and anchors shape choices. Present bias undermines long-term plans. Mental accounting treats money inconsistently. Nudges such as default enrolment change behaviour without removing choices.
Flashcard
Limited information and attention
Check your understanding
Why does automatic enrolment raise pension participation so much?