What is Behavioural Economics?
A simple explanation
Behavioural economics is relatively new field which combines insight from psychology, judgement, and economics to generate more accurate understanding of human behaviour. In an ideal world, people would always make decisions that would provide them with the greatest benefit and satisfaction. Within behavioural economics, there is a theory called rational choice theory. Rational choice theory states assumes that people will make the most rational decisions by weighing the pros and cons of each situation. This person is infinitely rational, has unlimited cognitive ability, can correctly weigh the pros and cons of a situation, knows their preferences, does not switch between contradictory desires; and this person is called homo economicus.
Homo economicus personifies the supposedly sensible way in which humans behave in markets, and dominated economic theory for a substantial period of time starting from the late 1800’s. This is why traditional economics uses this theory to predict behavior: give people numerous options, and they will choose the one best for them.
Homo economicus personifies the supposedly sensible way in which humans behave in markets, and dominated economic theory for a substantial period of time starting from the late 1800’s. This is why traditional economics uses this theory to predict behavior: give people numerous options, and they will choose the one best for them. Psychologists in the 1970s drew on psychological evidence to suggest that the actions of people actually deviate from the rationality of homo economicus. Humans tend to have trouble exercising self control, make choices that bear mixed relationships with their preferences, and submit to impulses. They often choose the option that has the greatest immediate appeal at the expense of long term happiness, like taking drugs or overeating.
This how the field of behavioral economics was born. Unlike classical economics, in which decision-making is based on logic, Behavioural economics explores why people make irrational decisions, and how their behaviour sometimes does not follow economic models. Paying for post-secondary education, how much to contribute to retirement, how much to pay for grocery items are decisions that people take in their lives. Behavioral economics seeks to explain why a person went for a choice A instead of choice B.
Biology, Psychology, and Behavioral Economics
The brain’s prefrontal cortex is considered the center of decision making activities
It is located in the frontal lobe, which control important cognitive skills in humans, such as emotional expression, problem solving, language, judgement, and of course, decision making
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The prefrontal cortex is divided into various regions based on functionality:
The dorsolateral prefrontal cortex is the topmost part of the prefrontal cortex and is involved in functions such as planning, working memory, and cognitive flexibility. It is specialized in problem solving and how to focus while performing tasks
The orbitofrontal cortex is involved in decision making, especially the ability to make decisions based on emotional information. It may help us predict the reactions of others and module our behavior accordingly
The ventromedial prefrontal cortex governs decision making by looking at the bigger picture. It is connected to many areas of the brain such as the amygdala, thalamus, temporal lobe, and olfactory system, and uses information from these parts to assist us in personal and social decision making.
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Behavioral economics mirrors cognitive psychology, which aims to guide individuals towards healthy behavior by correcting emotional or cognitive behaviours.
In 2017, American academic Richard Thaler won the Nobel Prize in Economics for his work on behavioural economics, especially an interesting concept called “nudge theory”. “Nudge theory” explains how small interventions can help people make different or better decisions.
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Examples of nudge theory include:
Countries where people have to opt in to donating organs see up to 15% of the population registering to donate. In nations where people are automatically enrolled in organ donation programs (after death) and they have to actually opt out, only 10% decide to do so, creating a larger pool of donors consisting of 90% of the population.
At restaurants, servers are trained to “up-sell” - to offer extra options along with the meal the customer is purchasing. For example, if you buy a coffee and the barista offers a muffin as well, then you are more likely to buy the muffin because it was suggested to you.
Some schools rearrange the display of items in their cafeterias so that students are encouraged to buy the nutritious options (placing healthy foods at eye level, making it inconvenient to buy junk food like putting vending machines in a distant corner).
Behavioral economics is a fascinating field which suggests that humans can make errors in judgement, and a simple nudge can lead them to make better decisions for themselves.
Featured image is courtesy of The Economist.
Article Authors: Sara Gehlaut, Maria Giroux
Article Editor: Stephanie Sahadeo