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Introduction to Behavioural Economics

What is behavioural economics (BE)?

After World War II, human rationality became the core hypothesis of neo-classical economics. Even though “rationality” can have different meanings, it is very precisely defined for the economists – an assumption that we all maximise our utility functions. To this end, we take into account all the available information, think about everything that may happen in the future and make rational expectations about it. Moreover, our preferences are stable and no emotions influence our decision-making process.

But do we actually behave in this way? If you feel like you do not fit the description above, you’re not alone. It turns out that people systematically deviate from the rational agent model. We all certainly let our emotions be a part of our decision process; we do not think about all the possibilities and all the future periods. We tend to prefer different things in different moments. Does this make us irrational though?

No. It just proves that the assumptions of neo-classical economics are a bit too strong. However, the simplifying assumptions made by economists are very useful when one wants to create economic models. But when one wants to understand people´s real behaviour and induce them to make better choices, imposing too many assumptions does not seem like the best strategy. This is basically why behavioural economics comes into picture. Unlike other economists, behavioural economists do not assume that people are fully rational. Instead, they take into account their biases and ways of making decisions when trying to model and change their behaviour.

How was BE born?

How a new field like BE develop? If there is a generally accepted theory, how does a new one come into picture and how do people change their view?

First, there must be doubts. There must be someone that does not think that the given theory is perfect and come up with a new one. Then, the toughest part – the new theory must be accepted by the experts in the field in order to survive.

One of the most famous challengers of the rational agent theory was Maurice Allais, who came up with the famous “Allais paradox”. He showed that people’s choices over lotteries were influenced by the addition of the same independent event across lotteries, something that a rational thinker would not take into account (check out http://mathworld.wolfram.com/AllaisParadox.html).

However, by far the most important work was done by two psychologists – Daniel Kahneman and Amos Tversky (for an overall review of their ideas, try reading Kahneman’s book “Thinking Fast and Slow”). In the 1960s and 1970s, they started to run experiments and proved that not only do people deviate from rationality, but that they do so in a systematic way.

But this does not mean that all the economists changed their beliefs immediately and rewrote the theories. In fact, BE is still not a part of classical economics textbooks. After Kahneman and Tversky’s discoveries, it took a lot of time for at least some economists to take up their ideas and try to incorporate them into economic theory.

One of the pioneers in this was Richard Thaler. He applied their work mostly into finance and contributed a lot in the development of the field. Thanks to him, the term “nudging” is now used to denote the use of behavioural economics to change choice structures and thus people’s behaviour (reading suggestion: Nudge by Thaler and Sunstein).

Behavioural economics thus brings psychology into economics and serves to create improved economic models, which incorporate the ways in which people really decide. It is a fast growing field that has wide ranging applications – from the marketing and public policy to understanding people’s financial decisions. Considering that it is still in the nascent stage, there is still a lot more work to be done. So let’s dig deeper into this fascinating field… for who knows, the next big breakthrough may come from one of us!

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