L10: Intermediate Microeconomics
Intermediate Microeconomics ECB002 Lecture 10: Behavioural Economics II
Aims of the Lecture
Establish a deeper understanding of the standard (‘neoclassical’) model of consumer choice and its limitations. This involves examining the core assumptions of traditional economics, such as perfect rationality and utility maximization, and understanding where they might fall short in explaining real-world behavior.
Explore how the standard model's assumptions may be too strong and fail to predict actual human behavior. For instance, while classical economics assumes people always make optimal choices, behavioural economics reveals systematic deviations from this ideal due to psychological factors.
Expand on the class experiment from the previous lecture regarding experiments in economics and behavioural economics. This aims to connect theoretical concepts with practical observations from controlled settings.
Material relevance: Essential for the Semester 1 exam and Semester 1 presentations. Understanding these concepts is crucial for academic success in the course.
Continued concepts from last week covering developments in microeconomics and behavioural economics. This lecture builds upon introductory ideas, delving deeper into specific anomalies and their implications.
Outline of Topics
The Standard Neo-Classical Model of Consumer Choice
Results of The Class Experiment
Behavioural Economics
Some Example Anomalies within Consumer Choice
Reading Assignments for Lectures 9 and 10
Required Reading:
Perloff, Section 3.5 (2nd-4th editions)
Varian, Chapter 31
Alternative Suggestion:
Frank, ‘Microeconomics and Behavior’, Chapter 8 on Consumer Behaviour (2010 or earlier)
Popular References in Behavioural Economics
Horizon TV Programme: About Nobel Laureate Daniel Kahneman, a pioneer in behavioural economics.
Notable books in behavioural economics: These books provide accessible introductions and deeper dives into the field, often combining academic insights with real-world applications.
Freakonomics by Levitt and Dubner (2005)
Super Freakonomics by Levitt and Dubner (2009)
The Economic Naturalist by Frank (2007)
The Undercover Economist by Harford (2006)
The Logic of Life by Harford (2008)
Predictably Irrational by Ariely (2009)
Nudge by Thaler and Sunstein (2009)
Upside of Irrationality by Ariely (2011)
Thinking, Fast and Slow by Kahneman (2012)
Behavioural Economics Saved my Dog by Ariely (2015)
Misbehaving by Thaler (2015)
The Standard Neo-Classical Model of Consumer Choice
The model is based on implicit assumptions about human behavior, forming the bedrock of traditional economic theory. In simple terms, it assumes people are like super-rational calculators.
Well-defined and Stable Preferences: This means individuals know exactly what they want, and their desires don’t change easily or inconsistently. For example, if you prefer apples over bananas, and bananas over oranges, then you must prefer apples over oranges (this is called transitivity). They don't switch preferences based on minor changes in context.
Perfect Information Processing: It's assumed individuals can effortlessly gather, understand, and use all relevant information to make decisions. They are not influenced by how information is presented or by cognitive biases; they simply 'know' all the facts.
Utility Maximization: This is the idea that individuals will always choose the option that gives them the most satisfaction or 'utility' possible, given their budget and the available choices. They always pick the 'best' option for themselves every single time.
This model provides a robust framework for analyzing consumer behavior and offers valuable policy insights. Despite its strong assumptions, it's a powerful tool for predicting general trends and designing policies when people act largely rationally.
Limitations and Choice Anomalies
In the 1980s and 1990s, evidence emerged showing behaviors deviating from theoretical predictions, termed choice anomalies, often observed in controlled lab experiments. These are situations where people make choices that don't make sense according to the standard rational model. Think of them as 'quirks' or 'bugs' in human decision-making.
Evidence robust but subject to dispute from some economists. While many studies confirm these anomalies, some traditional economists argue they might be artifacts of lab settings, not common in high-stakes real-world decisions, or that they disappear with learning.
Situations where anomalies are likely: These are conditions that stress our cognitive abilities, making us more prone to 'irrational' choices.
First-time decisions: When we haven't encountered a situation before, we lack experience to guide a rational choice.
Complex options: Too many factors to consider or understand can overwhelm us.
Numerous options: A vast array of choices can lead to 'choice overload' (as discussed later), where we either pick randomly or don't pick at all.
Low-stakes incentives: If the decision doesn't matter much (e.g., choosing a free pen), people might not put in the cognitive effort to be perfectly rational.
Time pressure: Rushing a decision reduces the ability to process information thoroughly.
Bounded Rationality: This concept, introduced by Herbert Simon, suggests that human rationality is limited by the amount of information available, the cognitive limitations of the mind, and the finite amount of time we have to make a decision. Instead of perfectly optimizing, people often use 'heuristics' (mental shortcuts or rules of thumb) to make good enough decisions, even if not perfectly optimal. For example, choosing a familiar brand rather than researching all options.
Results of the Class Experiment
Experiment Structure: The experiment was designed to observe how different levels of cognitive load (how much brainpower is required) affect performance and decision-making, mimicking real-world scenarios where people face varying degrees of complexity.
Participants completed questions grouped into different types:
Simple 4: Four simple calculations. This task requires minimal effort and serves as a baseline for performance under low cognitive load.
Simple 8: Eight simple calculations. Doubling the number of simple tasks tests how increased quantity, even of easy tasks, impacts sustained attention and accuracy.
Complex 4: Four more difficult calculations. This task assesses performance when the quality of the task (its difficulty) increases, demanding more processing power per question.
Each round contained one question of each type. This allows for a within-subject comparison, observing how each individual's performance changes across different conditions.
Typical results for such experiments often show that as tasks become more numerous or complex, accuracy can decrease, and completion times may increase. Individuals might also exhibit a preference for simpler tasks or demonstrate signs of cognitive fatigue when faced with more demanding ones.
Behavioural Economics: A New Framework
Behavioural Economics: This field combines insights from psychology with economic theory to better understand human decision-making. It acknowledges that people are not always perfectly rational and are influenced by emotions, biases, and context. It aims to make economic models more realistic.
Aims to create new behavioural models that better incorporate psychological factors. Instead of assuming ideal rationality, these models integrate realistic human traits, like how we perceive risk or react to losses.
Recognizes that individuals may have non-stable preferences (what they want can change based on context or 'framing'), imperfect information processing (we have biases and shortcuts), and challenges in maximizing utility (we often struggle to pick the absolute best option).
It retains the analytical strength of standard economic models while expanding their assumptions for greater applicability. Behavioural economics largely uses the same mathematical tools as traditional economics but modifies underlying assumptions about human psychology to create more accurate predictions.
Impact of Behavioural Economics: This relatively new field has profoundly influenced various areas.
Gradual shift in economics understanding across domains including competition, environmental factors, labor, and monetary policy. For instance, understanding why people might not save enough for retirement or why they react strongly to price increases but less so to stagnant wages.
Offers new policy guidance to governments by unraveling how agents react to policymaking. This has led to the development of 'nudge' units in governments, using subtle interventions to guide citizens towards better choices (e.g., automatically enrolling people in pension plans).
Provides businesses insights into marketing strategies based on consumer behavior. Companies use behavioural insights to design products, pricing strategies, and advertising campaigns that effectively appeal to human psychology, such as offering a slightly more expensive 'premium' option to make the middle option seem more attractive.
Example Anomalies in Consumer Choice
A series of anomalies illustrated to showcase systematic deviations from the standard consumer choice model. These are specific examples where human behavior consistently breaks the rules of perfect rationality.
3a. Top Position (or Primacy) Effects
Individuals tend to favor options at the start of a sequence, contrary to the standard theory which assumes every option can be evaluated equally regardless of its position. This is like remembering the first thing you read on a list better than things in the middle.
Why it happens: This effect is often attributed to attention and memory. Early items receive more cognitive processing, and people may get fatigued or less attentive as they progress through a list.
Evidence from Eurovision Contest:
Early or last performances get disproportionately more votes, impacting even expert judges. Viewers and judges may form initial impressions that anchor their subsequent evaluations, or they might simply remember the first few acts more vividly.
In a retail context, this means items placed at the beginning of a display or website list might get more attention or sales.
3b. Choice Overload
An increase in the number of alternatives often leads individuals to avoid making a choice altogether, or to make less optimal choices, rather than carefully evaluating each option. People become so overwhelmed by too many options that they just give up.
Terminology: Also known as ‘deferred choice’ (delaying a decision), ‘choice avoidance’ (not choosing at all), and ‘the paradox of choice’ (more options can make us less happy or decisive).
Why it happens: Evaluating many options requires significant cognitive effort and can lead to 'regret aversion' – the fear of making the wrong choice when so many alternatives exist. This can paralyze decision-making.
Impacts are profound on decision-making processes for consumers, reflected in the course evaluations. For example, when students are presented with too many options for course modules, they might struggle to decide, potentially picking arbitrarily or sticking with familiar choices. A famous experiment showed that a jam tasting table with 24 varieties attracted more people but resulted in fewer purchases than a table with only 6 varieties.
3c. Leftmost Digit Bias
People often focus excessively on the leftmost digit when processing numbers, which can skew perceptions of value or magnitude, even if the difference is tiny. For example, we see more like than .
Why it happens: Our brains process numbers from left to right. The first digit we encounter heavily influences our initial impression, and subsequent digits might receive less attention. This is a form of 'anchoring effect'.
Commonly explained through retail tactics like pricing at £1.99 instead of £2.00. The difference is only one penny, but £1.99 feels significantly cheaper than £2.00 because our brain anchors onto the '1' instead of the '2'. This small price difference, known as 'charm pricing', can lead to a disproportionately higher number of sales.
3d. Decoy (or Attraction) Effects
Introduction of an irrelevant or clearly inferior option (the 'decoy') can sway choices between other available options, making one of the original options appear more attractive. The decoy is usually similar to one existing option but clearly worse, making that option look comparatively better.
Why it happens: The decoy effect works by providing an easy comparison point. It helps our brain rationalize a choice by making one option clearly superior to the decoy, even if it wasn't the standout choice before.
Illustrative Scenario with Houses:
Imagine you're choosing between House A (modern, great location, expensive) and House B (traditional, slightly worse location, cheaper). It's a tough choice. If a decoy House A- (modern, great location, even more expensive than A) is introduced, House A suddenly looks like a much better deal – it's the modern option without the extreme price of A-. Similarly, if the decoy was a House B- (traditional, worse location, same price as B), House B would look better. This 'irrelevant' third option can help consumers favor a choice by providing a point of comparison that highlights the strengths of one of the original options.
A classic example is the Economist magazine subscription: an online-only option, a print-only option (decoy, same price as online/print combo), and an online+print combo. The print-only option often makes the online+print combo seem like a much better value.
3e. Default Effects
Consumers tend to stick with default options much more than traditional theory would predict. People often go with the pre-selected choice simply because it's easier or implies endorsement, rather than actively making a different selection.
Why it happens: Defaults leverage inertia (it takes effort to change), imply a recommended choice (if it's the default, it must be good), and avoid the cognitive load of making an active decision. Changing a default requires action, and people are often 'status quo biased'.
Example from 401(k): When employees are automatically enrolled in a pension plan () with an opt-out choice (they have to actively decide not to participate), participation rates are significantly higher (often ) than with opt-in systems (where they have to actively decide to participate, resulting in much lower rates, sometimes below ). This demonstrates the powerful influence of defaults on important financial decisions.
3f. Loss Aversion, Framing, and Endowment Effects
These are related concepts explaining how our perception of value is highly subjective and emotional.
Loss Aversion: Individuals usually prefer avoiding losses over acquiring equivalent gains. The psychological pain of losing something (£100) is generally felt to be twice as powerful as the pleasure of gaining the same amount (£100). This means people are more motivated to prevent a loss than to achieve an equivalent gain. For instance, a policy framed as preventing the loss of 100 lives will be more impactful than one framed as saving 100 lives, even if the outcome is identical.
Framing: This refers to how information is presented. The way a choice is 'framed' – for example, as a gain or a loss, or with different wording – can significantly alter people's decisions, even if the underlying choices are objectively the same. For example, a medical treatment described as having a " survival rate" sounds more appealing than one with a " mortality rate," despite conveying identical information.
Valuation of items can shift depending on ownership, termed as the endowment effect. This psychological phenomenon describes how people tend to value an item more highly once they own it, simply because it is theirs. For example, if you are given a coffee mug, you are likely to demand a higher price to sell it than what you would be willing to pay to buy the exact same mug if you didn't already own it. Ownership creates an emotional attachment, increasing its perceived value.
Summary of the Session
Key Learning Outcomes:
Understand pros and cons of the standard neo-classical model. While powerful, it relies on ideal assumptions that don't always reflect human behavior.
Define behavioural economics and its significance. It's a field that enriches standard economics with psychological realism, leading to more accurate predictions and effective policies.
Discuss various consumer choice anomalies and their inconsistency with standard models. We explored specific instances—like top position effects, choice overload, and loss aversion—where people systematically deviate from perfect rationality, demonstrating the need for behavioural insights.