Unit 2: Microeconomics Part I - Behavioural Economics
Understanding Real Human Behavior and Alternative Business Objectives
Introduction: Beyond Traditional Economic Theory
Traditional economic theory assumes that individuals are perfectly rational, have complete information, and consistently make decisions that maximize their utility. Behavioural economics challenges these assumptions by incorporating insights from psychology, recognizing that humans are predictably irrational and often make systematic errors in judgment.
Key Questions Behavioural Economics Addresses
- Why do people make decisions that don't maximize their well-being?
- What psychological factors influence economic choices?
- How can understanding human behavior improve policy design?
- Why don't firms always maximize profits?
Part 1: Behavioural Economics
The Rational Choice Theory (Traditional View)
Assumptions of Rational Economic Behavior:
- Rationality: Individuals make logical, consistent decisions
- Self-Interest: People act to maximize their own utility
- Complete Information: Decision-makers have access to all relevant information
- Perfect Calculation: Individuals can process information and compute optimal choices
- Consistency: Preferences remain stable over time
Traditional Utility Maximization
Consumers aim to maximize utility subject to budget constraint:
\[ \max U(x, y) \text{ subject to } P_x \cdot x + P_y \cdot y = M \]Where:
- • \(U(x, y)\) = Utility function
- • \(x, y\) = Quantities of goods X and Y
- • \(P_x, P_y\) = Prices of goods X and Y
- • \(M\) = Income (budget)
Optimal condition: Marginal utility per dollar spent must be equal across all goods
\[ \frac{MU_x}{P_x} = \frac{MU_y}{P_y} \]Bounded Rationality
Bounded rationality (Herbert Simon) recognizes that human cognitive abilities are limited. People cannot process all available information or consider all possible alternatives.
Limitations include:
- Cognitive limitations: Limited ability to process complex information
- Incomplete information: Lack access to all relevant data
- Time constraints: Must make decisions quickly
- Computational limits: Cannot calculate optimal solutions for complex problems
Result: People use mental shortcuts (heuristics) and make "good enough" decisions rather than optimal ones.
Cognitive Biases and Heuristics
Cognitive biases are systematic patterns of deviation from rationality. Heuristics are mental shortcuts that simplify decision-making but can lead to errors.
1. Anchoring Bias
Definition
Anchoring occurs when individuals rely too heavily on the first piece of information (the "anchor") when making decisions, even if that information is irrelevant.
How it works: Initial information disproportionately influences subsequent judgments.
Examples of Anchoring
Price Perception:
- A shirt originally priced at $100, on sale for $60, seems like a great deal
- The same $60 shirt without the $100 reference seems expensive
- The $100 price serves as an anchor
Salary Negotiation:
- First number mentioned in negotiation becomes the anchor
- If employer offers $50,000 first, final salary likely clusters around this figure
- If candidate requests $70,000 first, negotiation centers on higher range
Restaurant Menus:
- Expensive items listed first make mid-priced items seem reasonable
- $50 steak makes $30 pasta appear affordable
2. Availability Bias (Availability Heuristic)
Definition
Availability bias occurs when people judge the probability of events based on how easily examples come to mind, rather than actual statistical probability.
Recent, dramatic, or emotional events are overweighted.
Examples of Availability Bias
Fear of Flying:
- After plane crash news, people overestimate flight danger
- Driving is statistically more dangerous, but car accidents are less memorable
- Vivid plane crash images create availability bias
Market Panics:
- After stock market crash, investors overestimate future crash probability
- Recent losses are readily available in memory
- Leads to excessive selling and market overreaction
Insurance Decisions:
- After natural disaster coverage on news, flood insurance sales spike
- Without recent events, people underestimate risks
3. Framing Effect
Definition
Framing effect occurs when the way information is presented (framed) affects decisions, even when the actual information is identical.
Positive vs. negative framing can reverse preferences.
Classic Framing Examples
Medical Treatment (Kahneman & Tversky):
- Positive frame: "This surgery has a 90% survival rate"
- Negative frame: "This surgery has a 10% mortality rate"
- Same information, but positive framing increases acceptance
Ground Beef Marketing:
- "90% lean" sounds healthier than "10% fat"
- Identical product, different consumer response
Default Options:
- Opt-in vs. opt-out organ donation
- Countries with opt-out have 90%+ donation rates
- Opt-in countries have <20% donation rates
4. Loss Aversion and Prospect Theory
Definition
Loss aversion (Daniel Kahneman & Amos Tversky) is the tendency for people to prefer avoiding losses over acquiring equivalent gains. Losses hurt approximately twice as much as gains feel good.
Prospect Theory Value Function
Unlike traditional utility theory, prospect theory shows that people evaluate outcomes relative to a reference point:
\[ v(x) = \begin{cases} x^\alpha & \text{if } x \geq 0 \text{ (gains)} \\ -\lambda(-x)^\beta & \text{if } x < 0 \text{ (losses)} \end{cases} \]Where:
- • \(\lambda > 1\) = Loss aversion coefficient (typically \(\lambda \approx 2\))
- • \(\alpha, \beta < 1\) = Diminishing sensitivity to gains and losses
Key insight: The pain of losing $100 > pleasure of gaining $100
Loss Aversion in Action
Endowment Effect:
- People value items more once they own them
- Experiment: Students given coffee mugs valued them 2× higher than students without mugs
- Losing the mug feels worse than not having it
Stock Market Behavior:
- Investors hold losing stocks too long (avoiding realization of loss)
- Sell winning stocks too early (securing gains)
- Opposite of optimal "cut losses, let winners run" strategy
Free Trial Strategy:
- Companies offer free trials knowing loss aversion kicks in
- Canceling feels like losing something you have
- Higher conversion rates than paid trials
5. Present Bias (Hyperbolic Discounting)
Definition
Present bias is the tendency to overvalue immediate rewards and undervalue future rewards, more than can be explained by traditional discounting.
People are "time inconsistent"—preferences change as rewards get closer.
Exponential vs. Hyperbolic Discounting
Traditional (Exponential) Discounting:
\[ V = \frac{U}{(1+r)^t} \]Hyperbolic Discounting (Behavioral):
\[ V = \frac{U}{1+kt} \]Where:
- • \(V\) = Present value
- • \(U\) = Utility of future reward
- • \(r\) = Discount rate
- • \(k\) = Hyperbolic discount factor
- • \(t\) = Time delay
Result: Near-term rewards are disproportionately preferred
Present Bias Examples
Savings and Retirement:
- People know they should save for retirement (future preference)
- But choose to spend today (present preference)
- Result: Inadequate retirement savings
Health Decisions:
- Choose unhealthy food now, plan to diet "tomorrow"
- Procrastinate exercise despite long-term benefits
- Immediate gratification overrides future health
Credit Card Debt:
- Immediate purchase pleasure vs. future payment pain
- High-interest debt accumulates
- "Buy now, pay later" exploits present bias
6. Status Quo Bias and Default Options
Definition
Status quo bias is the preference for the current state of affairs. People tend to stick with default options even when switching would be beneficial.
Related to loss aversion—change feels like potential loss.
Status Quo Bias Examples
Retirement Plans:
- Employees stick with default investment options
- Rarely rebalance portfolios
- Inertia leads to suboptimal outcomes
Subscriptions:
- Gym memberships, streaming services continue unused
- Canceling requires action (overcoming status quo)
- Companies profit from inertia
Organ Donation:
- Default opt-out: 90%+ donation rates (Austria, France)
- Default opt-in: 15% donation rates (Germany, UK)
- Most people never change default
7. Herding and Social Norms
Definition
Herding occurs when individuals copy the actions of others rather than making independent decisions based on their own information.
Social proof—if others are doing it, it must be right.
Herding Examples
Stock Market Bubbles:
- Investors buy because others are buying
- Fear of missing out (FOMO)
- Dot-com bubble, housing bubble, cryptocurrency surges
Fashion and Trends:
- Consumer purchases influenced by what's popular
- Bandwagon effect
- Social media amplifies herding
Restaurant Choices:
- People choose busy restaurants over empty ones
- Assume crowd indicates quality
- Self-reinforcing cycle
8. Overconfidence Bias
Definition
Overconfidence is the tendency to overestimate one's own abilities, knowledge, and the precision of one's beliefs.
Overconfidence Examples
Investment Decisions:
- 90% of investors believe they are above average
- Excessive trading due to overconfidence
- Lower returns due to trading costs
Business Ventures:
- Entrepreneurs overestimate success probability
- 80% of businesses fail, but founders think "not mine"
- Leads to both innovation and failures
Nudge Theory and Choice Architecture
What is a Nudge?
Nudge (Richard Thaler & Cass Sunstein) is any aspect of choice architecture that alters people's behavior in a predictable way without forbidding options or significantly changing economic incentives.
Key principle: Make desired behavior easier or more attractive, not mandatory
Libertarian paternalism: Guide choices while preserving freedom
Types of Nudges
1. Default Options
- Automatic enrollment in pension plans
- Participation rates increase from 40% to 90%
- People can opt out but rarely do
- Green energy as default
- Customers must actively choose fossil fuels
- Most stick with default
2. Social Norms and Peer Comparison
- "9 out of 10 hotel guests reuse towels"
- Social proof increases compliance
- Energy bills showing neighbor comparisons
- Households reduce usage when above average
- Competition and social pressure motivate change
3. Framing and Priming
- Emphasizing losses rather than gains
- "You'll lose $100 if you don't insulate" vs. "Save $100 by insulating"
- Loss frame more motivating due to loss aversion
- Visual cues
- Footprints leading to trash cans reduce littering
4. Commitment Devices
- Save More Tomorrow programs
- Commit to saving future raises (not current income)
- Addresses present bias
- Public commitments
- Announcing goals to friends increases follow-through
5. Salience and Simplification
- Traffic light food labeling
- Red = unhealthy, Green = healthy
- Simple visual cues influence choices
- Placing healthy food at eye level
- Convenient placement increases selection
Government Applications of Nudges
UK Behavioural Insights Team ("Nudge Unit"):
- SMS reminders increase tax payment compliance
- Simplified forms boost benefit applications
- Organ donation default changes increased registrations
Retirement Savings:
- Auto-enrollment in 401(k) plans
- Automatic escalation of contribution rates
- Dramatically increased savings rates
Public Health:
- Calorie labels on menus
- Graphic warnings on cigarette packages
- Smaller plate sizes in cafeterias
Criticisms of Nudge Theory
- Paternalism concerns: Who decides what's "good" for people?
- Manipulation: Can be used unethically by governments or corporations
- Limited effectiveness: Some nudges have small or temporary effects
- Structural issues: Nudges don't address underlying economic problems (poverty, inequality)
- Transparency: Should people be informed they're being nudged?
Implications for Traditional Economic Theory
| Aspect | Traditional Economics | Behavioural Economics |
|---|---|---|
| Rationality | Fully rational decision-makers | Bounded rationality; systematic biases |
| Self-Control | Perfect self-control | Present bias; time inconsistency |
| Information | Perfect or near-perfect information | Limited information processing ability |
| Preferences | Stable and consistent | Context-dependent; influenced by framing |
| Social Factors | Independent decision-making | Herding; social norms matter |
| Policy Approach | Incentives and regulations | Nudges and choice architecture |
Part 2: Alternative Business Objectives
Traditional Profit Maximization
Standard economic theory assumes firms maximize profit:
\[ \text{Profit} (\pi) = \text{Total Revenue} - \text{Total Cost} \] \[ \pi = TR - TC \]Profit maximization condition:
\[ MR = MC \]Firms produce where marginal revenue equals marginal cost.
Why Firms May Not Maximize Profit
- Separation of ownership and control: Managers may have different goals than shareholders
- Incomplete information: Don't know exact demand or cost curves
- Multiple stakeholders: Must balance interests of employees, customers, community
- Long-term vs. short-term: Short-term profit maximization may harm long-term viability
- Ethical considerations: Social responsibility may conflict with pure profit motive
1. Revenue Maximization
Objective: Maximize Total Revenue
Who pursues this: Managers whose compensation is tied to sales/revenue
How: Produce where marginal revenue = 0
\[ MR = 0 \]Result: Higher output and lower price than profit maximization
Revenue Maximization Example
Streaming Services:
- Focus on subscriber growth (revenue) rather than immediate profit
- Netflix, Spotify initially operated at losses
- Goal: Market share and subscriber base
- Eventually transitions to profit focus
Why revenue maximization:
- Manager bonuses based on sales figures
- Market share important for competitive position
- Economies of scale require volume
2. Sales Maximization (Baumol's Model)
Objective: Maximize Sales Volume Subject to Minimum Profit
Developed by: William Baumol
Constraint: Must earn enough profit to satisfy shareholders
\[ \max \text{ Sales subject to } \pi \geq \pi_{min} \]Sales Maximization Examples
Automobile Industry:
- Focus on units sold and market share
- Heavy discounting to move inventory
- As long as minimum profit maintained
Publishing:
- Publishers want bestsellers (high volume)
- Willing to accept lower per-unit profit
- Prestige and market presence matter
3. Growth Maximization (Marris Model)
Objective: Maximize Rate of Growth
Focus on: Growth in sales, assets, market share, employees
Why:
- Manager prestige and compensation linked to firm size
- Job security in larger firms
- Career advancement opportunities
- Competitive positioning
Growth Maximization Examples
Tech Companies:
- Amazon prioritized growth over profit for years
- Reinvested all revenue into expansion
- Focus on market dominance
Retail Chains:
- Aggressive expansion of store locations
- Geographic coverage and brand presence
- Sometimes overextend and face losses
4. Satisficing (Simon's Model)
Objective: Achieve Satisfactory Results Rather Than Optimal
Coined by: Herbert Simon (bounded rationality)
Concept: Firms set target levels for multiple goals (profit, sales, market share) and aim to satisfy all rather than maximize any one
Why:
- Multiple stakeholders with different interests
- Information costs too high to find optimum
- Uncertainty makes optimization impossible
- "Good enough" is realistic goal
Satisficing Examples
Family-Owned Businesses:
- Balance profit with work-life balance
- Satisfactory income rather than maximum
- Maintaining family control more important than growth
Small Professional Services:
- Law firms, consulting agencies
- Target income levels for partners
- Not pursuing every potential client
- Quality of life considerations
5. Corporate Social Responsibility (CSR)
Objective: Balance Profit with Social and Environmental Responsibilities
Triple Bottom Line: People, Planet, Profit
Includes:
- Environmental sustainability
- Ethical labor practices
- Community engagement
- Charitable activities
- Fair trade practices
CSR Examples
Patagonia:
- Environmental activism central to business model
- Donates 1% of sales to environmental causes
- "Don't buy this jacket" anti-consumption campaign
- Prioritizes sustainability over profit maximization
Ben & Jerry's:
- Fair trade ingredients despite higher costs
- Social mission integrated into business
- Campaign for social justice issues
Microsoft:
- Carbon negative by 2030 commitment
- Significant investments in renewable energy
- Short-term costs for long-term sustainability
Why CSR Makes Business Sense
- Brand reputation: Consumers increasingly prefer ethical brands
- Customer loyalty: CSR builds emotional connections
- Employee attraction: Top talent seeks purpose-driven employers
- Risk management: Avoiding scandals and regulatory issues
- Long-term profitability: Sustainable practices ensure future viability
- Investor demand: ESG (Environmental, Social, Governance) investing grows
6. Managerial Utility Maximization
Objective: Managers Maximize Their Own Utility Rather Than Firm Profit
Principal-Agent Problem: Separation of ownership (shareholders) and control (managers)
Managers may pursue:
- Prestige: Large offices, company cars, expense accounts
- Power: Control over more employees and resources
- Job security: Avoiding risky but profitable ventures
- Leisure: Comfortable workload rather than profit-maximizing effort
Managerial Utility Examples
Corporate Perks:
- Excessive executive compensation
- Lavish corporate retreats
- Private jets for convenience rather than necessity
- Costs borne by shareholders
Empire Building:
- Managers pursue acquisitions for prestige
- Build larger organizations even if unprofitable
- Personal power and salary tied to firm size
7. Social Enterprise Objectives
Objective: Achieve Social Mission While Being Financially Sustainable
Definition: Organizations that apply commercial strategies to maximize social/environmental impact
Hybrid model: Not pure charity (needs revenue) but not pure profit-seeking
Social Enterprise Examples
TOMS Shoes:
- One-for-one model: Buy one, give one
- Social mission: Provide shoes to children in need
- Must be profitable to sustain giving
Grameen Bank:
- Microfinance for poor entrepreneurs
- Mission: Poverty alleviation
- Charges interest to cover costs but lower than traditional banks
The Big Issue:
- Magazine sold by homeless individuals
- Provides income and pathway out of homelessness
- Social impact primary; profit secondary
Comparison of Business Objectives
| Objective | Focus | Output vs. Profit Max | Price vs. Profit Max |
|---|---|---|---|
| Profit Maximization | Maximum profit (\(MR = MC\)) | Baseline | Baseline |
| Revenue Maximization | Maximum revenue (\(MR = 0\)) | Higher output | Lower price |
| Sales Maximization | Maximum sales (subject to min profit) | Higher output | Lower price |
| Growth Maximization | Firm expansion | Reinvest profits | Variable |
| Satisficing | Satisfactory targets | Variable | Variable |
| CSR | Social/environmental + profit | Variable | May accept lower profit |
Policy Implications of Behavioural Economics
Advantages of Behavioural Insights for Policy
- Cost-effective: Nudges often cheaper than traditional interventions
- Freedom-preserving: No mandates or bans
- Quick implementation: Simple changes can have large effects
- Addresses real behavior: Works with how people actually think
Business Applications
- Marketing: Framing, anchoring, social proof in advertising
- Product design: Default settings, ease of use
- Pricing strategy: Reference prices, loss-framed discounts
- Customer retention: Status quo bias, switching costs
- Employee management: Commitment devices, goal-setting
Evaluation and Criticisms
Limitations of Behavioural Economics
- Not a complete theory: Collection of biases, not unified framework
- Context-dependent: Biases vary across individuals and situations
- Difficult to predict: Multiple biases may conflict
- Cultural differences: Biases may not apply universally
- Ethical concerns: Manipulation vs. helpful guidance
- Overreliance on nudges: May avoid addressing structural problems
IB Economics Exam Tips
How to Approach Behavioural Economics Questions
- Define clearly: Explain what behavioural economics is and why it differs from traditional theory
- Use examples: Real-world cases make abstract concepts concrete
- Link biases to outcomes: Show how specific biases lead to market failures or suboptimal decisions
- Discuss policy applications: How nudges can address problems
- Evaluate: Consider effectiveness, ethics, and limitations of behavioural interventions
- Connect to other topics: Market failure, government intervention, welfare
Alternative Business Objectives Questions
- Explain why: Why might firms not profit-maximize?
- Consequences: How does each objective affect output, price, efficiency?
- Stakeholder analysis: Who benefits from each objective?
- Real examples: Identify companies pursuing alternative objectives
- Evaluation: Trade-offs between profit and other goals
✓ Behavioural Economics Checkpoint
You should now understand how behavioural economics challenges traditional assumptions of rationality; recognize key cognitive biases and heuristics; appreciate how nudges can influence behavior without removing choice; understand why firms may pursue objectives other than profit maximization; and apply these insights to real-world policy and business decisions. These concepts help explain market failures, consumer behavior, and the rationale for certain government interventions throughout your IB Economics SL course.