UNIT 1: BEHAVIOURAL ECONOMICS
1. WHAT IS BEHAVIOURAL ECONOMICS?
It is about understanding economic behaviour. Why and how do we make the choices we do?
It is about testing the standard economic model indeed the maximizing the expected utility model. What does it
do well and what not so well? What are the limits?
It is about applying insights from lab experiments, psychology, and other social sciences in which we can see how
the choices of people actually are and how they vary. In this way we could see the determinacies of our
preferences trough backgrounds, level of education, culture, marital status…etc in order to help people make
better decisions.
The behavioural economics is not new, going back to Adam Smith: “The theory of moral sentiment 1759”.
Recognise the important of emotion and social interactions in economics outcomes.
Some economic principals were based on the psychological theory at the time e.g., decreasing marginal utility.
It was needed a unified model that simplifies the state of the world because was complex to introduce this
behavioural dimension. At the end of the 20th century Vilfredo Pareto argued that economics should break from
psychology and the focus should be on choice rather than desire “if people are rational then they will reveal their
desires through their choices, and so we need to focus only on choice. Meaning that if you choose to maximize
certain utility that in a way translates your desire to have that certain utility.
In the second half of the 21st century behavioural economics made a comeback with Herbert Simon that
questioned the purpose of rational models (standard economic model) and proposed the concept of bounded
rationality: Individuals that are not rational have limited rationality. Rationality is bounded because there are
limits to our thinking capacity, available information, and time.
Kahneman and Tversky provided evidence that the assumptions of the standard economic model are limited
because of cognitive bias (depending on the information we received we are cognitively limited) framing
effects (your decision will depend on the context) and reference point (the decision will be different depending
on certain levels (e.g., level of wealth))
• Nobel prize 2017 Richard H. Thaler “for his contributions to behavioural economics”
• Nobel prize 2002 Vernon L. Smith “for having established laboratory experiments as a tool in empirical
economic analysis, especially in the study of alternative market mechanisms “and Daniel Kahneman “for
having integrated insights from psychological research into economic science, especially concerning
human judgment and decision-making under uncertainty”
• Nobel prize 1978 Herbert A. Simon “for his pioneering research into the decision-making process within
economic organizations”.
2. STANDARD ECONOMIC MODEL
The neo-classical economic model is the way most economists think about consumer welfare and consumer
choice. Neoclassical economics provides a unified and simple vision of the economy based on some common
rationality assumptions. So, we need to maximize the satisfaction in which the utility is different from each other
This sets economics apart from other social sciences such as psychology, where ‘theories’ describe empirical
regularities
Agents are generally assumed to maximise their utility (which may, but must not necessarily, coincide with their
profit)
It is generally assumed to have access to complete information, and to be able to process such information. It lies
it in the assumptions that we have complete information in which we try to make a decision we have all the
information available
1. WHAT IS BEHAVIOURAL ECONOMICS?
It is about understanding economic behaviour. Why and how do we make the choices we do?
It is about testing the standard economic model indeed the maximizing the expected utility model. What does it
do well and what not so well? What are the limits?
It is about applying insights from lab experiments, psychology, and other social sciences in which we can see how
the choices of people actually are and how they vary. In this way we could see the determinacies of our
preferences trough backgrounds, level of education, culture, marital status…etc in order to help people make
better decisions.
The behavioural economics is not new, going back to Adam Smith: “The theory of moral sentiment 1759”.
Recognise the important of emotion and social interactions in economics outcomes.
Some economic principals were based on the psychological theory at the time e.g., decreasing marginal utility.
It was needed a unified model that simplifies the state of the world because was complex to introduce this
behavioural dimension. At the end of the 20th century Vilfredo Pareto argued that economics should break from
psychology and the focus should be on choice rather than desire “if people are rational then they will reveal their
desires through their choices, and so we need to focus only on choice. Meaning that if you choose to maximize
certain utility that in a way translates your desire to have that certain utility.
In the second half of the 21st century behavioural economics made a comeback with Herbert Simon that
questioned the purpose of rational models (standard economic model) and proposed the concept of bounded
rationality: Individuals that are not rational have limited rationality. Rationality is bounded because there are
limits to our thinking capacity, available information, and time.
Kahneman and Tversky provided evidence that the assumptions of the standard economic model are limited
because of cognitive bias (depending on the information we received we are cognitively limited) framing
effects (your decision will depend on the context) and reference point (the decision will be different depending
on certain levels (e.g., level of wealth))
• Nobel prize 2017 Richard H. Thaler “for his contributions to behavioural economics”
• Nobel prize 2002 Vernon L. Smith “for having established laboratory experiments as a tool in empirical
economic analysis, especially in the study of alternative market mechanisms “and Daniel Kahneman “for
having integrated insights from psychological research into economic science, especially concerning
human judgment and decision-making under uncertainty”
• Nobel prize 1978 Herbert A. Simon “for his pioneering research into the decision-making process within
economic organizations”.
2. STANDARD ECONOMIC MODEL
The neo-classical economic model is the way most economists think about consumer welfare and consumer
choice. Neoclassical economics provides a unified and simple vision of the economy based on some common
rationality assumptions. So, we need to maximize the satisfaction in which the utility is different from each other
This sets economics apart from other social sciences such as psychology, where ‘theories’ describe empirical
regularities
Agents are generally assumed to maximise their utility (which may, but must not necessarily, coincide with their
profit)
It is generally assumed to have access to complete information, and to be able to process such information. It lies
it in the assumptions that we have complete information in which we try to make a decision we have all the
information available
