What is Behavioural Economics Theory?

Behavioural Economics depends on scientific studies of human behaviour, showing that humans don't always make whatever mainstream economists deem the rational decision, even when they have all the necessary knowledge and tools.

Why do individuals typically avoid or postpone Investing, knowing that this would benefit others? And, even though the odds stay the same irrespective of "streaks," why do gamblers generally risk more?

The area of behavioural Economics views people as those who are prone to emotions and impulses or who are impacted by their surroundings and circumstances by asking questions such as the ones specified above and determining solutions through studies.

Behavioural economics research has yielded several ideas that have aided economists in better understanding human economic behaviour. Governments and corporations have created policy frameworks based on these concepts to encourage individuals to make specific decisions.

People always make the best decisions to benefit them and give them the most pleasure in the real world. When people are provided with numerous choices in a scarce situation, rational choice asserts that they will choose the alternative that maximizes their satisfaction. This theory suggests that people can make rational decisions based on preferences and limits by effectively balancing each available option's benefits and costs. The ultimate conclusion will become the best option for the concerned person. The rational individual is self-controlling, unaffected by emotions or external forces, and knows what's best for them. Behavioural economics explains that humans aren't rational and incapable of making sound decisions.

Consumer Behaviour in Economics

Consumer behaviour also called buyer behaviour, is defined as the actions of people who are actively involved in the acquisition, use, and disposal of financial services and goods and the decision-making processes for these actions. It relates to human behaviours that influence buying decisions. When customers make purchases, they are involved in a problem-solving conversation to attempt to meet a perceived need.

Economic Model of Consumer Behaviour

The consumer behaviour's economic model is based on the assumption that humans are rational. Even though this belief has been disproved in recent events, this model still holds in some scenarios. People evaluate the following questions in this light:–

• What is in it for me?
• What will I have to pay for it, and can I afford it in exchange for what kind of performance and quality?
• Is it possible to postpone a purchase due to future aspirations, such as owning a garment to wear on special occasions?

The Underlying concept of long-term commitment is frequently used to answer this question.

According to this paradigm, consumer behaviour is guided by the principle of maximum utility, which is dependent on the rule of diminishing marginal utility. The law of declining marginal utility states that as consumption grows, the marginal utility of each new unit decreases. As a result, the choice to purchase a product is influenced by two factors:

• The cost of purchase
• The amount of food consumed in this particular period.

Price Effect

Price Elasticity states that people will purchase it more frequently when a product's price is low. This will increase demand, which will allow producers to profit by selling more products at a fixed price. When the price is high, customers are more likely to buy smaller amounts of things. If you get an offer of free wine for upselling, people will like to buy it for sure.

Price Elasticity = Price / Buy Quantity

Substitution Effect

It refers to a consumer's general preference for alternative items over an existing one. Some people prefer product A more than product B, but if the price difference between the two things is large, they will switch altogether. People are more likely to switch from beer to wine if offered free wine with their meal (on upselling). As this new drink has a large profit margin, it will improve the Income of restaurant owners and managers.

Substitutability Effect = Price / Preferences

Income Effect

It is also known as elasticity of demand and describes how responsive people are to changes in their income. In other words, people with higher Earnings will spend a larger share of their money than people with lower incomes.

Income Effect = Price / Income

In Behavioural Economics, What is a "Nudge"?

A "nudge" is a method of manipulating people's choices to lead them to make specific decisions in behavioural economics: For example, in a high school cafeteria, placing fruit at eye level or near the cash register is an example of a "nudge" to encourage pupils to choose healthier options. One of the most important characteristics of nudges is that they are non-coercive: The prohibition of junk food and the punishment of people who choose unhealthy options is not a nudge.

The technical phrase Thaler and Sunstein use to characterise a situation based on nudges is "libertarian paternalism"—libertarian in the sense that it preserves choice yet paternalistic in favouring specific conduct. Thaler says that If you want people to do something, make it easy.

Applications of Behavioural Economics

Heuristics, or using rules of thumb or mental shortcuts to make a quick decision, is one application of behavioural economics. On the other hand, heuristics might lead to cognitive bias if the decision made is incorrect. As game theory tests and examines people's decisions to make illogical choices, behavioural game theory, an emergent game theory class, can also be applied to behavioural economics. Behavioural finance, which aims to explain why investors make impulsive decisions when trading in the Capital markets, is another sector where behavioural economics can be applied.

As businesses recognise that their customers are irrational, an effective strategy to include behavioural economics into the company's decision-making rules affecting internal and external stakeholders may prove worthwhile if done correctly.

Advances in Behavioural Economics

Colin F. Camerer, George Loewenstein, and Matthew Rabin edited the book: Advances in Behavioural Economics.

Behavioural economics didn't exist as a field twenty years ago. The idea of incorporating psychological insights into economics was met with scepticism, if not outright hostility, among most economists. However, behavioural economics is now almost universally accepted. It's well-represented in prestigious journals and top economics departments, and behavioural economists, including several contributors to this volume, have won some of the profession's most distinguished prizes.

This collection brings together the most relevant behavioural economics studies released in 1990. There are several updates and extensions of prior foundational contributions among the 25 articles and cutting-edge publications that break new theoretical and empirical ground.

Advances in behavioural economics serve as the authoritative one-volume resource for those interested in learning more about the area or keeping up with the newest advancements. It will be used by professional economists, psychologists, and social scientists interested in how behavioural insights are applied in economics.

Conclusion

Behavioural economics combines economics and psychology to investigate why people make illogical judgments and why and how their behaviour differs from what economic models predict. Most people make decisions, like how much to pay for a cup of coffee, whether to go to graduate school, whether to maintain a healthy lifestyle, how much to contribute to retirement and so on at some point in their lives. Behavioural economics explains why a person chooses option A over option B. Ideally, humans make decisions not in their best interests because they are emotional and easily distracted.