Behavioural
Economics
A
brief
introduction
© Alan Newman
https://uk.linkedin.com/in/alangnewman
Thinking, Fast and Slow
This presentation is based on the book by psychologist and Nobel
Prize winner Daniel Kahneman and comprises:
1. Bounded rationality
2. Classical economics and Behavioural economics
3. System 1 Thinking and System 2 Thinking
4. Heuristics and Cognitive Biases
5. Over confidence
6. Multiple selves
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Bounded Rationality
In decision-making, the rationality of
individuals is limited by the information
they have, the cognitive limitations of
their minds, and the finite amount of
time they have to make a decision.
The term bounded rationality that
summarises this situation was first
coined by the economist Herbert Simon.
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Economics
BEHAVIOURAL
CLASSICAL
• We are non rational
• We are rational
• Subconscious decision making
• Conscious decision making
• We prefer stories
• We process facts
• We are intuitive
• We are calculating
• We optimise (‘satisficing’)
• We ‘maximise utility’
• We are time-inconsistent
• We are time-consistent
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Two Thinking Systems
System 1
System 2
• Fast
• Slow
• Effortless
• Effortful
• Subconscious
• Conscious
• Intuitive
• Calculating
• Subjective: experience based
• Objective: evidence based
• CONTEXT DEPENDENT
• CONTEXT INDEPENDENT
• We use it most of the time
• We use it rarely
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BIASES
Handedness is an example
of a muscular bias.
It is neither good nor bad.
Cognitive biases have
evolved because they work
well-enough most of the
time and make efficient use
of expensive brain power.
They, too, are
neither good nor bad.
They simply are.
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HEURISTICS
Heuristics are subconscious
short cuts that our brains use in
judgement and decision making
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A Selection of Biases and Heuristics
In this presentation we will look at eight major biases or
heuristics:
1.
2.
3.
4.
5.
6.
7.
8.
Availability heuristic
Endowment effect
Focusing illusion
Framing
Loss Aversion
Mental accounting
Optimism bias
Status Quo (or Default) Bias
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Availability Heuristic
The Availability heuristic is a mental
shortcut that relies on immediate
examples that come to mind.
When you are trying to make a decision,
a number of related events or situations
might immediately spring to the
forefront of your thoughts. As a result,
you might judge that those events are
more frequent and possible than
others. You give greater credence to this
information and tend to overestimate
the probability and likelihood of similar
things happening in the future.
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Endowment Effect
THE ENDOWMENT EFFECT refers
to those situations where we ascribe
more value to something simply
because we own it.
My precioussss
It is commonly observed with
individuals who own shares; or in
people selling their homes
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Endowment Effect
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Focusing Illusion
Nothing in life
matters quite as
much as you
Nothing in life matters
quite as much as you
think it does while you
are thinking about it.
think it does
while you are
thinking about it.
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Framing
Brains subconsciously contextualise information and, by extension,
decision making. If we are deciding how big our cup of coffee should be
and we are offered A, B or C most people opt for B. But if a fourth option
is introduced, D, more people will choose C than chose it before (and
maybe nobody will choose D) because the FRAME (context) has been
changed. C now feels more ‘normal’ than it did previously.
A
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B
C
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D
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Loss Aversion
This refers to our tendency to prefer not-losing to achieving a
gain This is not predicted by traditional economics that
assumes that the number of emotional plusses we feel when
we win £10, for example, is equivalent to the number of
emotional minuses we feel when we lose £10. In the real
world we feel the loss of £10 more strongly.
This example from the world of golf shows that players’ brains
subconsciously work harder when looking to avoid a missed
putt than they do when looking to gain a stroke with a
winning putt.
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Mental Accounting
We treat money differently
based on where it has come
from and what it is to be
used for. To economists this is
non-rational behaviour. Rather
than rationally viewing every
pound as identical, we put
different pounds in different
‘mental accounts’. We may
designate some of our pounds
as ‘safety’ money which we
invest in low risk financial
products while, at the same
time treating other pounds as
‘flutter money’.
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Mental Accounting
You take £100 to the races as
your betting money.
After 1 hour you have £500 in
your pocket. When you and
your friends leave you have
£150.
Have you won £50 or lost £350?
What do you think most people
would say? What does this tell
you?
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Optimism Bias
In the UK a child will
have typically cost
her/his parents £200k
by the time she/he is 18
If you had to go to your
Finance & Budgeting
Committee would you
get the go-ahead to have
a baby? Probably not.
But in the real world the
having-children
calculation is more
optimistic.
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Status Quo Bias
The impact of defaults is clear when we look at countries that have
presumed consent (where approximately 80% of people are organ
donors) and contrast them with countries that have active consent
(where approximately 20% of people are organ donors.)
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Status Quo Bias
The use of defaults has been successfully applied with
pension scheme auto-enrolment.
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Over confidence
If, in general, we weren’t confident in the decisions we’d made – who to marry or not marry;
what car to buy; what job offer to accept – we’d spend so much time asking ourselves “What
if?” or thinking “If only” that life would be difficult and unpleasant. We lead better lives, it
seems, if we have confidence in our decisions even when there is evidence that our
confidence is misplaced.
Because it takes time and energy to work something out, and because we are a social species,
one strategy we have for dealing with complexity or information scarcity is to rely on experts.
But there is abundant evidence that we, and the experts themselves, tend to be unaware of
the limitations of expertise. Professional sports people don’t beat the bookies when it comes
to choosing winners; stock pickers never outperform the market in the long term; and expert
clinicians are outperformed by algorithms when it comes to diagnosing illnesses.
The next three slides provide three examples of over-confidence.
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Over confidence
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Over confidence
While it is common sense that people
make mistakes, behavioural
economics takes us beyond intuition
and helps us be precise in detecting,
understanding, and remedying
Ironically, perhaps, this comment from
the 2013 FCA Paper is an example of
over-confidence, one of the cognitive
biases that has been highlighted by
behavioural
economics
research.
Human behaviour is complicated and
contextual so it is difficult to be precise
in detecting or remedying ‘mistakes’.
problems that arise from consumer
mistakes. Integrating behavioural
economics into the FCA can therefore
help it be an effective regulator.
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Over confidence
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Multiple Selves
Each of us is a personal
combination of :
•
•
•
•
•
Bargain hunter
Gambler
Miser
Spender
Tycoon
Under what circumstances does
each one step forward?
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Multiple Selves
Starting in 2011, The Open University and UCL, with the involvement of money guru Martin Lewis,
undertook research for the BBC Big Money Test. One of the findings was that each of us has a
particular mix of money personas and different personas take to the stage under different
circumstances. The personas are:
•
•
•
•
•
Bargain hunter
Gambler
Miser
Shopper
Tycoon
What is your particular ranking? And what insight do you get if you assign a personal % to each of
these personas?
From a different perspective Daniel Kahneman talks about two selves: the experiencing self and
the remembering self. (Subconsciously) the remembering self is constantly updating and revising
memories in the light of new experiences and an ongoing, personal narrative each of us has to
explain why we do what we do.
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© alan g newman
Thinking, Fast and Slow
This presentation has been based on the book by psychologist and
Nobel Prize winner Daniel Kahneman and comprised:
 Bounded rationality
 Classical economics and Behavioural economics
 System 1 Thinking and System 2 Thinking
 Heuristics and Cognitive Biases
 Over confidence
 Multiple selves
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© alan g newman
To learn more about ‘BE’ google . . . .
Affective reasoning, Anchoring, Base rate neglect, Belief
perseverance, Black swans, Choice architecture, Cognitive
dissonance, Confirmation bias, Decoy effect, Defaults, Gambler’s
fallacy, Group think, Habits, Halo effect, Herd instinct, Hindsight
bias, Hyperbolic discounting, Illusion of causality, MINDSPACE,
Money (or Big Number) Illusion, the MPG Illusion, Narrative
fallacy, Norms, Nudging, the Planning fallacy, Procrastination, the
Representativeness heuristic, Salience, Sunk cost fallacy, the
Ultimatum game, Wilful blindness, Winner’s curse, Zero risk bias.
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Thank
you
© Alan Newman
https://uk.linkedin.com/in/alangnewman