Economics, Microeconomics 2.4 Behavioral economics

Classical/Neoclassical Economic Theory

Consumers are rational and make intelligent, good decisions in the marketplace

Rational behavior of consumers

They consider the possible options (it is assumed they have the necessary information [perfect information/knowledge])

Decide which of these options will give them the most utility/satisfaction

Act in their own self-interest

The “invisible hand” will drive the economy efficiently

Behavioral Economic Theory

Consumers are not perfectly rational and sometimes make poor economic decisions

why are humans not perfectly rational?

Humans have bounded (limited) rationality: The rationality they have is limited by the information they have, which is imperfect--no human can have all of the information about a market (perfect vs. imperfect information)

Humans have bounded self-control: Not everyone has perfect willpower, and people often give into temptation

Humans have bounded selfishness: It is generally assumed that people act selfishly, but this is not always true 

Rule of thumb bias

Easy way for the brain to make a decision when presented with imperfect information; usually a reference to “common” knowledge (also known as a heuristic)

Anchoring bias

Consumers use the given value of something to make future choices

E.g., “Maple syrup costs P700, but it is on sale for P400. I should buy a bunch of maple syrup!”

Framing bias

The presentation of information influences choices

E.g., Which are you more likely to buy, a yogurt that says it is “90% fat free” or one that says “Contains 10% fat”? 

Availability bias

recent/more accessible information tends to over influence decision making 

E.g., People assume homicides are more common than suicides because homicides have greater media coverage, although in reality suicides outnumber homicides.  

Herd behavior/Bandwagon effect

Wanting to be part of the group

E.g., Buying clothes to meet new fashions, even though old clothes are still good; Buying stocks as prices go up because others are making money (e.g., “FOMO”)

Status quo/Inertia buying

 When consumers are faced with too many choices, they may do nothing or stay with the same option 

E.g., There are 87 types of breakfast cereal in the grocery store. You buy corn flakes (because you grew up eating corn flakes) even though there are other cheaper or tastier cereals

Loss aversion bias

Humans feel more pain from losses than pleasure from gains; people make poor choices because they fear loss; OR, people focus more on the bad than the good

Hyperbolic discounting

Preference for immediate satisfaction over larger, long term rewards

E.g., It is Wednesday, and you have a big assignment due Friday. You should start it today, but you put it off until Thursday morning and go out with your friends Wednesday night

Choice architecture

decisions we make are heavily influenced by how choices are presented to us

Checkout line at the grocery store: Candy and other attractive items placed there to encourage you to “impulse buy”, even though it is not in your best interest

Nudge Theory is a

Way to encourage consumers to make better decisions without taking away the right to choose (called “libertarian paternalism”

Better consumer decisions =

more efficient allocation of resources and a more sustainable market 

poor consumer decisions =

inefficient allocation of resources--market failure

Profit maximization

firms seek to maximize profits as much as possible 

Assumed to be the ONLY incentive for firms according to Classical Theory

However, this may adversely affect society and consumers--negative externalities in the form of pollution, wasteful use of resources, public health effects, etc. 

Corporate Social Responsibility

firms incorporate public interests into their business model and production decisions

E.g., A business may choose to use only sustainable energy or ‘green’ packaging, even though this may increase production costs and reduce profit

“Satisficing” (satisfying + sacrificing)

firms/entrepreneurs pursue other goals for their own satisfaction rather than maximizing profits

E.g., A surf shop is closed when the surfing is good; Chick-Fil-A is closed on Sunday, even though profits for restaurants are greater during weekends than weekdays

ncreasing market share

firms prioritize growing their business to increase their consumer base over maximizing profits (long-term strategy)

Just like consumers, producers

do not always behave rationally or produce efficiently