Behavioural Economics: Basic Insights and Introduction to Economic Instruction

Abstract

Behavioral Economics, the topic of this essay, is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complication. Bounded willpower captures the fact that people sometimes make choices that are not in their long-run interest. Bounded self-interest incorporates the comforting fact that humans are often willing to sacrifice their interest to help others. Behavioural economics comprises of consumer behaviour and behaviour on financial markets but a preeminent focus is on contemporary behavioural economics.

Behavioural economics is also concerned with theories of production, theories of the firm, household behaviour, and institutions. Findings of behavioural economists tend to refute the notion that individuals behave neoclassically, giving rise to a literature and debate as to which heuristics and sociological and institutional priors are rational, which yield optimal economic results, and which tend to improve socio-economic welfare.

Under the behavioural economic, the Decision making theory integrates mathematics and statistics to better understand how decisions such as choices between incommensurable commodities, choice under uncertainty, intertemporal choice and how social choice are made.

Introduction

Behavioural economics and economic psychology have advanced dramatically in public profile and academic publications over the past two decades. This has been fuelled to a large extent by the research paradigm advanced by psychologists Daniel Kahneman and the late Amos Tversky. The focus of their approach to behavioural economics, referred to as the biases and heuristics paradigm (or biases and cognitive illusions), is rooted in a particular worldview in cognitive psychology and evidenced by experiments in economic psychology and behavioural economics.

This paradigm is not the only one afforded by behavioural economics, but it is clearly the dominant and most well-known one, finding that individuals incur systematic errors and biases in their decisions.

Therefore, individuals are said to be persistently irrational in their decision-making. They are irrational because their choice behaviours deviate from neoclassical norms of rationality. Because they are irrational, inducing rational cum neoclassical behaviour becomes an issue of critical importance from the perspective of this paradigm.

In the early 1980s, a small group of economists began to argue that the rational expectations revolution had gone too far, and that to understand many important economic phenomena, it was critical to develop new models that made assumptions about human behaviour that were psychologically more realistic and in particular allowed for less than fully rational thinking. This message was roundly dismissed at first but it gradually gained traction. Today, “behavioural economics” – the effort to improve our understanding of the economy through psychologically-realistic models is firmly established. Hundreds of papers in this tradition, many of them highly cited, have appeared in the top economics and finance journals. Dozens of specialists in the area have been hired and tenured at leading universities and conferences on this topic attract large and growing crowds. Moreover, this approach to economics has generated significant interest beyond academia, among non-academic economists, policy makers, and the public at large.

Economic psychology has been largely the playing field of psychologists interested in applying psychological insights to explain economic phenomenon at both a micro and macro level. Much focus has been on describing and explaining micro-level behaviour. Contemporary behavioural economics (as mentioned in the abstract) has been most concerned with applying such insights in engaging and modifying economic theory, although describing choice behaviour in the experimental domain has dominated contemporary mainstream behavioural economics, just as it has dominated economic psychology.

Behavioural economics has always been concerned about psychological as well as sociological and institutional variables as determinants of choice, which together lend themselves to a better understanding choice behaviour in the realm of consumption and production. This has important implications for micro and macroeconomic outcomes. Thus making the field of Behavioural economics very forthcoming and imminent.

Behavioural economics, however, broadly defined, has had little impact of the teaching of economics, especially in terms of basic undergraduate training. At best behavioural economics can be an add-on, a possible special topics section or chapter to the core or foundations of what is taught. The focus of this essay is to articulate some of the basic insights of behavioural economics and to illustrate how behavioural economics might be introduced into the core principles of economic instruction.

Literature Review

From the 18th century to the first half of the 20th century, the leading economic figures such as Adam Smith, John Maynard Keynes, and Irving Fisher were known to bring aspects of human psychology into their analysis of the economy. By the middle of the 20th century, however, this practice was less common, and with the advent of the rational expectations revolution in the 1960s, economists began to focus almost exclusively on models with the same, tightly-specified assumptions about individual psychology hat people have rational beliefs, and that they make decisions according to Expected Utility.

The growth of behavioural economics over the decades is the result of a collective effort by many researchers. But if there is one person who was central to the rise of behavioural economics, particularly in its early years, it would be Richard Thaler, the 2017 Nobel Laureate in economics. To appreciate how central he was, consider the four factors that have driven the growth of the field. First, researchers documented numerous “anomalies” – empirical facts that are hard to square with the traditional, rational model of economic behaviour. Second, they developed a new generation of models based on more psychologically realistic assumptions. Third, they found ways of helping people to make better economic decisions. And fourth, the behavioural economics movement attracted talented young researchers who accelerated the development of the field.

Behavioural economics is a small and growing field within economics that seeks to incorporate more realism and insights from psychology about individual behaviour into economic models. The goal of this movement is not to refute economic principles, but rather to help improve our understanding of behaviour in ways that allow economists to make better predictions and suggest better economic policies. While many economists continue to be hesitant, the past decade has revealed a growing interest in understanding how relaxing certain assumptions about behaviour and incorporating new elements about information processing or individual preferences might impact economic models and analyses. The behavioural economics movement has shown that it is often possible to incorporate slightly richer assumptions about individual behaviour into economic models without losing the fundamental tractability and purpose of those models.

Therefore in broader terms, the need for a behavioural approach in economics arises whenever what is ‘rationally’ expected of a utility maximising agent is not borne out in observed behaviour. Faced with this not uncommon situation, behavioural economists seek to employ behavioural theories (typically derived from psychology) to explain such discrepancies: often by highlighting how and why certain factors seem to limit or bound rationality.

The current literature within the academic community is extremely broad. A potential problem with identifying literature of relevance is the embryonic state of research, accompanied the lack of any unifying theory of reference. ‘Behavioural Economics’ has become something of an umbrella term which is sometimes used interchangeably with ‘experimental economics’.

Strong connections between behavioural and experimental economics can be seen in behavioural economists’ reliance on experimental data to test assumptions and motivate new theoretical models. There nevertheless remains a distinction to be made. Some experimental economists do not identify with behavioural economics at all but rather place their work firmly within the rational choice category, studying, for example, the performance of different market institutions and factors that enhance the predictions of neoclassical theory. Experimental economics is defined by the method of experimentation, whereas behavioural economics is methodologically eclectic. The two sub-fields have subtly different standards about proper technique for conducting lab experiments and very different interests about the kinds of data that are most interesting to collect. Therefore, it is incorrect to automatically place experimental work under the heading of behavioural economics. In the other direction, there are many behavioural economists working on theoretical problems or using nonexperimental data. Thus, although behavioural and experimental economists frequently work complementarily on related sets of issues, there are strong networks of researchers working in the disjoint subsets of these subfields as well.

It is important to recognise that much work within the field of behavioural economics lies in the cross-disciplinary intersection zone of Economic Psychology a discipline which is in itself well established and has its own dedicated journal (Journal Economic Psychology). In a detailed review entitled Psychology and Economics Rabin (1998) argued that ‘While standard economics assumes that each person maximizes stable and coherent preferences given rationally-formed probabilistic beliefs, psychological research teaches us about ways to describe preferences more realistically, about biases in belief-formation, and about ways it is misleading to conceptualize people as attempting to maximize stable, coherent, and accurately perceived preferences’

Rabin highlights three themes which are seen as being of particular relevance:

• The dislike of losses outweighs the liking of gains.
• That departure from pure self-interest can arise due to issues of fairness, reciprocal altruism (mutual benefit) and even revenge.
• That under uncertainty, biases in judgement (including those created by too much or too little information) can lead to errors.

A vital distinguishing feature of behavioural economics, often lost in the discourse of the biases and heuristics approach, is that the realism of assumptions matter for the accuracy of analytical predictions and causal analysis. This is in stark contrast to a critical assumption (often an implicit one) of contemporary economics that assumptions, be they behavioural, sociological, and institutional, do not matter in the construction of economic theory. What counts is the accuracy of the analytical predictions generated by the theory.

Thus, these are some of the key points, critical to behavioural economics are:

• Assumptions matter substantively for causal and predictive analysis, be they of a psychological, sociological, or institutional type. It is important to understand why people behave the way they do, with regard to both their cognitive abilities and their environmental constraints.
• It is important to understand how cognitive capacities, information flows, culture, learning, and institutions affect intelligent decision-making.
• A critical component of behavioural economics is building models that better reflect actual behaviour. Such behaviour can be both rational and intelligent without being neoclassical.
• Behavioural economists and economic psychologists run experiments and engage in empirical exercises to determine the choices people make and how these choices are made, and to ascertain to what extent these deviate from the conventional mainstream economic wisdom.
• Individuals tend to behave quite differently from what is predicted by the conventional wisdom.
• Economic theory needs modification from a causal and/or normative perspective.
• Some important concepts to be discussed are: the survival principle, multiple equilibria, bounded rationality, satisficing, fast and frugal heuristics, x-inefficiency, efficiency wages, prospect theory, framing effects, efficient market hypothesis, social and personal capital, capabilities, and, soft or benevolent paternalism.
• Modification of economic theory does not suggest that relative prices, opportunity costs, and incomes play no role in affected behaviour—material incentives matter.
• Supply and demand analysis is enriched by the findings and methodology of behavioural economics.
• Introducing non-material variables into ones analytical framework, such as altruism and reciprocity, social and personal capital, relative positioning, capabilities and framing, enriches consumer theory.
• Introducing effort variability, non-material variables, organizational slack, capabilities and relative positioning enriches production theory.

Well, talking about Biasness in econometrics, it is defined as the difference between the expected value of an estimator and the true value of the number(s) being estimated. In econometrics as well as in everyday usage, asserting that there is a “bias” implies having made an unambiguous commitment to what the true or correct value is. The term bias is ubiquitous in behavioural economics, and much of its empirical and theoretical work concerns deviations from normative benchmarks that implicitly assert how people ought to behave. Given the observation that people deviate from a benchmark (typically an axiomatic definition of rationality or formal logic), there are at least two distinct reactions to consider.

Most behavioural economists have interpreted observed deviations from the assumptions of neoclassical economics as bias, implicitly asserting that neoclassical assumptions are undisputed statements defining what good, or smart, economic behaviour ought to be. According to this view, people who deviate from the neoclassical benchmarks are making mistakes, which is equivalent to saying they are biased. This, in turn, motivates some authors to recommend prescriptive policy changes aimed at de-biasing the choices we make, inducing us to more closely conform to the axioms of economic rationality. Alternative interpretations of observed deviations from neoclassical norms have been put forward by those who question whether the neoclassical model provides sound guidance for how we ought to behave and by those who fear the paternalistic implications of policies aimed at de-biasing choice. One alternative interpretation takes its point of departure from the observation that people who systematically violate neoclassical assumptions are also surviving quite successfully in their respective economic environments. They are going to college, holding down jobs, having children and grandchildren, and so on. If this is the case, then social scientists should abandon neoclassical benchmarks as normative guideposts in favour of more meaningful measures of economic performance, happiness, health, longevity, and new measures of adaptive success that have yet to be proposed.

There is an active debate going on between behavioural and non-behavioural about the extent to which empirical realism is being achieved by the behavioural economics research program. These two distinct layers of debate need to be untangled to appreciate the different issues at play and how behavioural economics is likely to influence public policy as how in 2009, Obama administration recruited among its top advisers, a number of behavioural economists including Richard Thaler, Cass Sunstein, and Daniel Kahneman.

When trying to convince neoclassical economists who are sceptical about the need for behavioural economics, behavioural economists point to the improved ability of their psychology-inspired models to fit data collected from a variety of sources, including experimental, macroeconomic, and financial market data. Sceptics from outside, behavioural economics have questioned whether the deviations from neoclassical assumptions have any important consequences for the economy as a whole, suggesting that they might perhaps “average out” in the aggregate. Scepticism about the relevance of experimental data remains strong, with many doubts expressed about whether the college students who participate in economic experiments can be relied upon to teach us anything new about economics and whether anything learned in one laboratory experiment can be generalized to broader populations in the economy, the so called problem of external validity. 

Another theme in behavioural economics derives from its willingness to borrow from psychology and other disciplines such as sociology, biology, and neuroscience. To appreciate why methodological pluralism is characteristic of behavioural economics, one should recall that in neoclassical economics, there is a singular behavioural model applied to all problems as well as a number of prominent efforts in economic history to expunge influence from other social sciences such as psychology and sociology. Although the structure of choice sets and the objective functions change depending on the application, contemporary economists typically apply the maximization principle to virtually every decision problem they consider. Consumer choice is modelled as utility maximization, firm behaviour is modelled as profit maximization, and the evaluation of public policy is analysed via a social welfare function whose maximized value depends systematically on parameters representing policy tools. In contrast, commitment to improved empirical description and its normative application to policy problems motivates behavioural economists, in many cases, to draw on a wider set of methodological tools, although the breadth of this pluralism is a matter of debate.

Now within behavioural economics, a different debate takes place. Among behavioural economists, despite a shared commitment to borrowing from psychology and other disciplines, there remains tension over how far to move away from constrained optimization as the singular organizing framework of neoclassical theory and in much of behavioural economics, too. An alternative approach, advocated by a minority of more psychology and less economics inspired behavioural economists, seeks to break more substantially with neoclassical economics, dispensing with optimization theory as a necessary step in deriving equations that describe behaviour. Constrained optimization, whether in behavioural or neoclassical economics, assumes that decision makers see a well-defined choice set, exhaustively scan this set, plugging each possible action into a scalar-valued objective function, which might include parameters intended to capture psychological phenomena, weigh the costs and benefits associated with each action, which includes psychic costs and benefits and finally choose the element in the choice set with the highest value according to the objective function.

But due to these debates, we can observe that there seem to be genuine cause for optimism regarding behavioural economists’ widely shared goal of improving the predictive accuracy and descriptive realism of economic models that tie economics more closely to observational data, while undertaking bolder normative analysis using broader sets of criteria that measure how smart, or rational, behaviour is.

Conclusion

One of the reasons for the growth of behavioural economics over the past few decades is the accumulation of empirical facts that are hard to square with the rational paradigm and with some notable economists and behavioural scientists publishing books revealing the mysteries of seemingly ‘irrational’ economic behaviour in a manner accessible to the interested ‘person in the street’. While their intent is dissemination amongst the general populous the studies and the scientific thinking on which they are based as well as the work of the scholars themselves deserves to be taken seriously. Indeed, the everyday behaviours to which the theories have been applied have in some instances provided an excellent means to collate otherwise disparate knowledge and apply it coherently.

However, if behavioural economics was to move more forward, and become an independent economic subject, it had to come up with an alternative paradigm – with a new generation of models that allowed for departures from full rationality, captured the puzzling facts in a parsimonious way, and made new predictions that could be brought to the data.

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