neoclassical model assumptions + cognitive biases

homo economicus assumption

consumers behave rationally

do not exist according to Richard Thaler

• consider all options and work out which one gives the most satisfaction and utility

• consumers will always seek to maximise their utility

• consumers act in their own self-interest

• consumers have perfect information

homo economicus

• rational

• have perfect info

• extremely intelligent, and are able to perform complex calculations quickly

• seeks to maximised their own utility

• decisions based on self-interest

• consistent preferences over time

• no self-control problems

• unbiased

homo sapiens

• bounded rationality

• incomplete information

• not as intelligent as homo economicus

• limited ability to perform complex calculations

• social beings and make decisions based on a social context

• changes in taste over time

• may have self-control issues

perfect information

assumption

• all economic agents have access to the same information at the same time

• perfect information on price and quality of all products

issues

• in the real world, there are information asymmetries where different levels of information are available

• limitations to the amount of information that homo sapiens can process → information overload (due to internet)

bounded rationality

the notion that the rationality of consumers is limited by the information they have access to

also they do not have the time nor the cognitive abilities to process and evaluate all the options

self-interest vs bounded selfishness

assumption is that homo economicus’ only act in their own self-interest

however homo sapiens have bounded selfishness

• humans do not always act in their own self-interest

• they volunteer, give to charities, purchase Fairtrade products because of concerns about farmer’s well-being

self-will

assumption that consumer’s have perfect willpower

however homo sapiens have bounded self-control: the natural tendency to give in to temptations sometimes

dual system model

created by psychologists Daniel Kahneman and Amos Tversky

according to this model, individuals have two different systems of thinking

• system 1: fast thinking

• system 2: slow thinking

Richard Thaler’s dual system

refers to system 1 as the automatic system and system 2 as the reflective system

Automatic system

involves fast decisions that are subconscious (gut instinct, impulsive)

leads to poor decision making (making short term decisions without considering long term effects)

Reflective System

involves slow decisions that are much more controlled (deliberate, logical)

Heuristics

mental rule of thumb/shortcut that allows people to make decisions and solve problems quickly and effectively

cognitive biases → can be problematic and result in poor decisions due to automatic thinking

list the cognitive biases

availability bias, anchoring bias, framing bias, social conformity/herd behaviour, status quo/inertia bias, loss aversion bias, hyperbolic discounting

availability bias

• the availability of recent information and examples tend to over-influence people’s decision making

• consumers are poor at assessing risk and probabilities, relying on recent examples rather than carefully examined data

anchoring bias

• when we are given the value of something, and then use this value as a reference point to influence future choices/ decisions

  • overreliance

framing bias

the way information is presented to us influences our choices

• 90% fat free rather than containing 10% fat

social conformity/herd behaviour

natural tendency to want to fit in → others behaviour can exert a powerful influence on our choices

• bandwagon effect: the behaviour of people when they join a perceived majority of people doing something, even if its against their best interests

status quo/inertia bias

consumers when faced with a bewildering set of choices, would prefer to maintain their status quo by doing nothing

loss aversion bias

human feel losses far more significantly than gains

hyperbolic discounting

tendency of humans to prefer short-term rewards over larger returns later

• effect is more powerful when the reward is much further in the future

choice architecture

theory that the decisions that we make are heavily influenced by the ways in the choices are presented to us

• items at cash register

• default choice

• mandated choice

nudge theory

developed by Richard Thaler

suggests that the choice architecture offered to people can be carefully designed to gently encourage (nudge) people to voluntarily choose the better option

• key: maintain consumer sovereignty (their right to choose) but are encouraged to make better decisions

• real world example: Save More Tomorrow → nudge to save money for pensions