Teacher's guide: individual economic decision making
This resource is provided to assist you in delivering the ‘Individual economic decision making’ section of our specification (4.1.2). It focuses primarily on the aspects of behavioural economics that are included in this section of the specification; consumer behaviour, imperfect information, aspects of theory and impact on economic policy.
How individuals make decisions matters; individual decision making provides the foundation upon which many other economic theories and models have been constructed. Traditionally, most economic models have assumed that economic agents attempt to maximise their expected individual rewards. Behavioural economists dispute this assumption because they believe it is too narrow a view of human behaviour. Consequently they also question many of the predictions of models that are based solely on this assumption.
The specification includes utility theory as an example of a traditional theory of individual economic decision making, where it is assumed that economic agents attempt to maximise their satisfaction. This is a standard model and there is an abundance of resources available that explain the principles that underpin this model.
This is widely recognised as a potential source of market failure but, for behavioural economists, providing more information isn’t necessarily the best solution. The associated problem of asymmetric information has been included in our specification for the first time; students should understand that asymmetric information usually results in an imbalance of power between the parties involved in a transaction, affecting the outcome. The result is an inefficient allocation of resources.
Aspects of behavioural economic theory
This is a rapidly growing field of study and it is only necessary to introduce students to a limited range of key concepts, as set out in section 220.127.116.11 of the specification. It is anticipated that many students will find this part of the specification particularly engaging and such students should be encouraged to explore the wealth of material that is now available, much of which should be easily accessible to most A-level students.
Behavioural economics and economic policy
Behavioural economics is starting to have a profound impact on government economic policy. In the UK, the Behavioural Insights Team uses lessons learned from behavioural economics to help the government design more effective policies, but it is not just governments that can benefit from behavioural economics. Section 18.104.22.168 of the specification introduces students to some of the ways in which governments, and other organisations, can affect the decisions people make and, hopefully, improve social welfare and efficiency.
Consumer behaviour (22.214.171.124)
When covering this section of the specification, teachers should introduce students to the notion of ‘rational economic decision making’ and the concept of homo economicus. Students should appreciate that many economic theories assume that economic agents, eg consumers, workers, and entrepreneurs, act rationally attempting to maximise their own narrow self-interest. Homo economicus is sometimes associated with 18th century thinkers such as Adam Smith who wrote in ‘The Wealth of Nations’:
‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’
This view of human behaviour is not, however, prevalent throughout the writings of Adam Smith. In his book ‘The Theory of Moral Sentiments’ he presents a broader view of human nature as illustrated by the following quote:
‘How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it.’
A-level students should recognise the basic concept of rational decision making as being ‘when individuals compare the costs and benefits of possible decisions and choose the one which maximises their personal net benefit’. It is usually, often implicitly, assumed that the individual has perfect information and has the ability to calculate and weigh up the consequences of each available choice.
Utility is usual defined as the satisfaction or happiness an individual derives from consuming a good or service. Students should know the difference between marginal and total utility, and understand the hypothesis of diminishing marginal utility. They should be able to use and interpret numerical examples and graphs illustrating these concepts. They should appreciate that utility theory assumes that consumers choose the basket of goods and services that will maximise their total utility, subject to the constraint imposed by their limited income.
Students are not expected to understand the principle of equi-marginal utility but you may decide to introduce this principle to explain the relationships between marginal utility, product prices and the maximisation of total utility. Students should, however, appreciate that the hypothesis of diminishing marginal utility lends general support to the idea of a downward-sloping demand curve.
Imperfect information (126.96.36.199)
Students should understand that good quality information is essential if markets are to operate efficiently. The model of perfect competition assumes that economic agents have perfect information about, for example: products, product prices and factor prices. In the absence of good quality information, free markets are likely to misallocate resources and price signals will be misleading. Students should recognise imperfect information is a potential source of market failure and that the pervasiveness of imperfect information casts doubt on models that are based on the assumption that economic agents make rational decisions. However, they should also appreciate that providing more and better information doesn’t necessarily result in rational, or even better, decision making, eg there are many reasons why people’s decisions may be systematically biased.
Asymmetric information occurs when one party involved in a transaction has more or superior information than another party. In most cases, the seller knows more than the buyer, eg a second-hand car salesman may know more about the car than the potential buyer. The opposite can also happen, eg an individual may know more about their own credit-worthiness than the bank providing a loan. This can lead to an imbalance of power, where one party exploits the other, resulting in market failure. It can also lead to a lack of trust and consequently a mutually beneficial trade may not take place.
Asymmetric information can contribute to moral hazard, a concept included in section 188.8.131.52 of the specification. Moral hazard occurs where one party may choose to make decisions that are very risky because they know that another party will have to bear the burden should the risks lead to large losses rather than profits. Asymmetric information and moral hazard contributed to the 2007-08 financial crisis, for example, the monetary authorities were not fully aware of risks being taken by some financial institutions and, because many of these institutions were ‘too big to fail’, governments, and hence taxpayers, had to bail them out.
Aspects of behavioural economic theory (184.108.40.206)
Behavioural economists incorporate ideas from psychology and other disciplines to enhance their understanding of economic decision making. They reject the view that economic agents are fully ‘rational’ decision-makers and highlight the importance of psychological biases, social and emotional factors. This section of the specification includes a limited selection of key ideas that have been developed by economists and others working in this field.
Bounded rationality is a term that was first used by Herbert A Simon. It means that people’s ability to make rational decisions is severely restricted. Three main reasons are often identified:
- the human mind has limited ability to process and evaluate information
- the information available is invariably incomplete and often unreliable
- the time available in which to make decisions is limited
Therefore, even if economic agents intend to make rational choices they usually end up ‘satisficing’, accepting a satisfactory outcome rather than searching for an optimal solution. Bounded rationality often leads to economic agents using heuristics (rules of thumb) to help them make decisions. Attempting to calculate and evaluate all possible outcomes often takes ‘too much effort’ and is too complicated. As a result, people adopt these rules of thumb but they frequently lead to systematic, and often predictable, biases.
The assumption that people have complete self-control is a basic tenet of standard economics and is incorporated in the concept of homo economicus. This contrasts with view of behavioural economists that individuals have bounded (or limited) self-control. People often say that they would, for example, like to: lose weight, give up smoking, drink less alcohol or save more, but frequently lack the self-control to act in a manner that they claim is in their own best interest. Many people are well aware of the consequences of bounded self-control and may adopt strategies to help them exert better control over their decision making, for example, by joining organisations such as Weight Watchers. Behavioural economists believe that recognising that people have bounded self-control can lead to the development of approaches that help improve social welfare. For example, the recently introduced Workplace Pension Scheme automatically enrols workers in the scheme but allows people to opt out if they wish. The take-up of such schemes is far greater than if people were required to opt in.
Behavioural economists have identified a large number of cognitive biases that affect people’s decision making. Biases in decision making often result from people adopting mental shortcuts, or rules of thumb, which allow them to solve problems quickly. These rules of thumb enable people to function without always stopping to think about their next course of action. Decisions that are made in this way are associated with what Daniel Kahneman has called ‘System 1’ or ‘thinking fast’ which is instinctive and emotional. Rules of thumb often serve us well but they can also result in poor decisions which could have been improved if more ‘effort’ had been devoted to considering the alternatives available. Kahneman’s ‘System 2’, or ‘thinking slow’, is deliberate and logical but requires more effort and is often avoided, particularly for routine decisions.
Anchoring is an example of a predictable bias in individual decision making. It is the tendency to rely too much on a single piece of information, frequently the first piece of information, when making decisions. For example, the first price that is quoted for a product influences what people think is reasonable to pay for such a product. Similarly, charities, when asking for a donation, may offer some suggestions, eg £10, £15, £20 or other; the purpose of such suggestions is to influence the individual’s decision. For example, most people don’t want to appear mean and might choose to donate £10 whereas without the anchor they might have given a smaller amount.
The availability bias is when people make judgements about the probability of events by how easy it is to recall examples of such events. However, the recent occurrence of a particular event, and its consequences, is not necessarily a good guide to the underlying probability of such events occurring in the future. For example, after a very severe winter people are likely to overestimate the likelihood of future disruption and its costs. As a result, there may be a clamour to spend large amounts of money on snow-clearing equipment that isn’t really justified when long-term weather patterns are taken into account.
A social norm is a belief that is held by the group or groups of people with whom we associate about how we should behave in a given situation. Much of our behaviour is influenced by other people’s behaviour, particularly those we respect and/or ‘hang around with’. Standard economic theory tends to ignore the influence of other people and often assumes that our preferences are fixed and determined independently of other people. Behavioural economists believe that if we want to have a long-term effect on people’s behaviour, it is probably best to try to modify their social norms. For example, getting people to accept that driving after consuming alcohol is socially unacceptable is likely to more effective than just imposing large fines on offenders. In practice, behavioural approaches are likely combined with legal sanctions and other more traditional approaches.
Although standard economic theory does not preclude altruism, it emphasises that the primary motive for, and influence on, people’s behaviour is self-interest. Behavioural economic theory recognises that people have a conscience and often choose to ‘do the right thing’. We have a sense of fairness and are not only influenced by how we are affected; we also take into account the impact of our actions on others. Offering financial rewards can sometimes have unexpected effects, contradicting predictions that are based on the assumption of self-seeking behaviour. For example, some studies have shown that when payments are made for donations of blood, the supply of willing donors falls; introducing the market can crowd out altruism as a motive for making such donations. The desire to act fairly can also persuade firms to pay above the ruling market, or minimum wage to their employees. The established relationships and obligations between the employer and employee can also influence the wage paid. The payment of what is perceived to be a fair wage can affect motivation and productivity.
Psychologists and behavioural economists have identified a large number of cognitive biases that can affect people’s behaviour. It is not expected that A-level students should have a detailed or wide-ranging knowledge of these biases. However, they should understand that the existence of such biases calls into question economic models that assume people always act rationally, attempting to maximise their individual self-interest. Students should also be able to recognise and provide examples of how the biases identified in this section of the specification can influence decision making. If in their answers to examination questions students use other relevant examples of cognitive biases, they will be rewarded appropriately.
Behavioural economics and economic policy (220.127.116.11)
This part of the specification requires that students are able to apply aspects of behavioural economic theory to economic policy. In the examination, students could, be asked to consider how behavioural economics might contribute to the design of government policies that could be adopted to deal with a particular economic problem. Students might be expected to compare such policies with ‘traditional’ economic policies or to consider how they might complement each other. Many governments have used the insights gained from behavioural economics to help them draft more effective policies to deal with a variety of social and economic issues.
Framing is the tendency for people to be influenced by the context in which the choice is presented when making a decision. How choices are framed, including the words used, affects the choices people make. For example, advertising the cost of gym membership at £25 per week is probably more palatable to most people than £1,300 per year.
Choice architecture is about how choices can be influenced by the way in which the various options are presented to the decision-maker. Governments can use choice architecture in an attempt to achieve what they perceive to be a more socially desirable outcome. For example, countries that require people to opt out of organ donations generally have a much higher proportion of the population willing to donate than countries who ask people to opt in. As with the Workplace Pension Scheme, opting in is the default choice. A variation of default choice is mandated choice; this is where people are required by law to make a decision. For example, when people apply for important national documents, such as a passport or driving licence, they could be required to choose whether or not they are willing to donate their organs when they die.
The way in which the options are categorised and presented to the decision-maker can also be used to influence people’s choices. For example, in the case of pensions, offering people a vast number of options can result a low take-up rate and inappropriate decisions being made. More information doesn’t always lead to the best outcome, restricted choice may be better.
A nudge is a means of changing people’s behaviour in a predictable manner without removing their freedom of choice. The use of nudges is part of the choice architecture. Banning junk food in school canteens is not a nudge, but placing healthy food in easy reach and making junk food less accessible is an example of a nudge. The use of nudges can be seen as an alternative to passing laws and banning certain activities. Thaler and Sunstein have labelled the use of nudges as ‘libertarian paternalism’. Nudges attempt to influence people’s decisions, and thereby increase social welfare, without coercion.
Critics of the use of nudges and choice architecture assert that they are manipulative and interfere with an individual’s freedom to choose. However, if people are always influenced by the context in which decisions are made, complete freedom of choice isn’t really feasible. Thaler and Sunstein argue that since people are unlikely to have complete information, unlimited cognitive ability and unrestrained will power, they will inevitably make sub-optimal choices and so using nudges can improve people’s well-being.
In summary, behavioural economists don’t deny that rational considerations play a part in people’s decision making but they believe that traditional models provide an incomplete account of the factors that influence the choices people make. Behavioural economic analysis extends the traditional model in an attempt to provide a better, more realistic explanation of human decision making.
Thaler R & Sunstein C, Nudge: Improving Decisions About Health, Wealth and Happiness, ISBN-13: 978-0141040011, Penguin, 2009
Ariely D, Predictably Irrational: The Hidden Forces That Shape Our Decisions, ASIN: B004SSZRAS, Harper Perennial, 2010
Kahneman, D, Thinking Fast and Slow, ISBN-13: 978-0141033570, Penguin, 2012 (Note: This is a less accessible book but many teachers and some students will find it interesting.)
Pamphlets (The New Economics Foundation)
Behavioural economics sections in advanced texts
Sloman, Wride & Garrett, Economics (8th Ed) Pages 124 – 128
Perloff, Microeconomics (6th Ed) Pages 124 – 127
Pindyck & Rubinfeld, Microeconomics (8th Ed) Pages 189 – 197
Podcasts (Social Science Bites)
iTunes - Podcasts - Social Science Bites by Edmonds and Warburton (including Daniel Kahneman on bias and Robert Shiller on behavioural economics)