3.1.2.3 - Behavioural economic theory

Bounded rationality

People may try to make good decisions but lack the time, attention or mental capacity to compare every relevant alternative.

Traditional consumer theory often assumes consistent preferences and the selection of the feasible option that maximises expected utility. Behavioural economics investigates how people actually decide and uses psychological and social influences to explain departures from that benchmark. It questions the universal use of the rational model, rather than claiming that every choice is random or mistaken.

Bounded rationality means that decision making is constrained by limited processing ability, time or attention. A person comparing dozens of energy tariffs may have all the prices available yet struggle to calculate the best option for uncertain future use. They may choose a tariff that is good enough, rather than the best possible one. This is sometimes called satisficing.

Distinguish the constraint from imperfect information. If the supplier hides a compulsory fee, relevant information is missing. If the fee is disclosed among fifty complicated alternatives but the person cannot process them effectively, the difficulty is bounded rationality. Both may operate together. More disclosure can fix a missing-information problem while leaving the processing problem unresolved.

A simple choice aid may reduce the burden by showing total annual cost under the user's stated consumption. However, a comparison tool can be misleading if it assumes the wrong consumption or excludes important conditions. A shortcut can save worthwhile time; it does not follow that exhaustive search is always better once search costs are counted.

Bounded self-control

Knowing which action serves a longer-term goal does not guarantee that a person will carry it out when an immediate temptation arrives.

Bounded self-control is a limitation on implementing intentions, particularly when a short-term reward competes with a longer-term objective. A student plans to save £10 each week for a needed laptop but repeatedly spends it on an immediate treat, later regretting the choice. The relevant pattern is the conflict between the plan and the action, not simply that the student enjoys treats.

Present benefits can feel unusually compelling when they become immediate. Someone may prefer saving next week's allowance when deciding today, then switch to spending when next week arrives. This inconsistent choice over time challenges a model of stable preferences and careful utility maximisation. Postponing a task can similarly avoid an immediate effort cost while creating larger future costs.

By contrast, someone who knowingly revises a saving plan after discovering an urgent need has changed relevant circumstances. That is not sufficient evidence of weak self-control. Nor can an observer infer irrationality merely because they dislike the purchase. The person's own goals, information and later choices matter.

A commitment device makes it easier to follow an earlier plan, for example a voluntary transfer into a savings account that is harder to access. It changes the immediate opportunity or effort involved in deviating. It can help if the earlier goal remains appropriate, but inflexibility has a cost when circumstances change. Behavioural explanations therefore depend on evidence of the mechanism and do not justify treating all consumers as incapable of choice.

Heuristics, anchoring and availability

Rules of thumb can simplify decisions, but they can create predictable errors when the shortcut is poorly matched to the problem.

A heuristic, or rule of thumb, is a practical decision shortcut. “Choose a familiar brand” may reduce search effort and use experience as evidence of reliability. It can work well, yet it may overlook an equally reliable cheaper product. A heuristic is not automatically a bias; a bias is a systematic tendency for decisions or judgements to depart from an appropriate benchmark.

Anchoring occurs when an initial number influences a later estimate or choice, even when that number is weakly relevant or irrelevant. An invented online experiment gives otherwise identical information about a bag to randomly assigned groups:

The difference in medians is £17. Because the bag and its information are the same, the higher initial number is a possible anchor raising valuations. Random assignment makes a difference in participant characteristics less likely, so the evidence is more persuasive than comparing unrelated groups. However, this one experiment does not establish the size of the effect for every product or prove that every participant was influenced. Participants might also treat the suggested number as a signal of quality; an experiment using an explicitly irrelevant number could help separate that explanation.

Availability bias occurs when events that are vivid, recent or easy to recall receive too much weight in judging probability. After seeing dramatic reports of a rare burglary, someone may overestimate the local theft risk and buy unusually expensive security equipment. The reports are memorable; they need not show that the statistical risk increased. Recent information can be useful when it is representative, so the mistake is treating ease of recall as sufficient evidence of likelihood.

Social norms

Choices can depend on what people believe others do or what their community regards as acceptable.

A social norm is a shared expectation about behaviour. A descriptive norm concerns what others commonly do; an approval-based norm concerns what others think people should do. Both can influence economic choices through belonging, approval, reputation or a judgement that the group has useful knowledge.

Suppose a residence honestly tells students that most neighbours switch unused lights off. A student may copy that behaviour because it now seems normal, or because they wish to be a considerate member of the group. Energy use can fall without a change in the electricity price. The mechanism differs from a tax that raises the financial cost of using energy.

Social information can also have unintended effects. Saying “many people waste energy” may make waste appear normal, weakening conservation. A message about a group the student does not identify with may have little influence. Accurate wording and the relevant reference group therefore matter.

Do not assume that a social influence always contradicts rational choice. If a person values others' approval, conforming can raise their utility. Behavioural analysis is useful because it makes those influences explicit and investigates how presentation or beliefs about others alter choices. Evidence should check behaviour, not just whether people remember the message, and should hold prices and other conditions comparable when trying to isolate a norm effect.

Altruism and fairness

Economic decisions can reflect concern for other people's welfare and for how gains and burdens are distributed.

Altruism means acting partly out of concern for others' welfare, even when the action has a personal cost. A consumer may donate money or help a neighbour without payment. A simple model that assumes only personal material gain would miss this. A broader utility model can include satisfaction from helping others, so altruism need not be inconsistent with rational utility maximisation.

Perceptions of fairness concern whether a distribution or process seems acceptable. In an illustrative bargaining game, one person proposes how to share £10 and the recipient can accept or reject. Rejection gives both people nothing. A model concerned only with the recipient's immediate money payoff predicts accepting any positive amount. A recipient who rejects £1 may prefer to sacrifice that pound rather than endorse an unequal division. They may also want to discourage unfair offers if the interaction will be repeated. The explanation depends on the rules and motives; the choice alone does not prove an inability to understand arithmetic.

Fairness can affect wages, prices and effort. Workers who see a pay change as unfair may reduce cooperation or leave, affecting a firm's costs and output. Different people can judge the same outcome differently: equal pay, pay according to effort and pay according to need are competing fairness principles. Choosing which principle policy should prioritise involves a value judgement, while whether workers respond by leaving is an empirical question.

These perspectives improve enquiry by asking which assumptions fit the setting. Use evidence to distinguish misunderstanding, stable social preferences, reputational incentives and short-term bias. A behavioural explanation can identify a regular tendency, but it does not predict every person's action or make the traditional incentive model useless.

Quick recap

Limited processing differs from difficulty carrying out a plan. Heuristics can help, yet anchoring and availability can bias judgements. Norms, altruism and fairness show why choices involve more than immediate personal money gain. Good economic explanation tests the relevant mechanism and assumptions against evidence.