- Rationality
- Rationality means that people take all the available information and make consistent, informed decisions that are in their own best interest.
- Behavioural economics
- Behavioural economics is the study of decision-making that brings the insights of psychology into economics.
Where real decisions depart from the model
Can you name the four ways real decisions depart from the rational model?
Bounded rationality is deciding within limits of information, time and the ability to process it, so people settle for a choice that seems good enough rather than searching for the best.
Can you think of an example?
Faced with dozens of energy tariffs, a household might compare two or three, pick one that looks fine and never read the rest, even if a cheaper deal sits further down the list.
Loss aversion is focusing more on a loss than on an equal gain, so that losing a sum pains people more than gaining the same sum pleases them.
Can you think of an example?
Lose a £10 note and find an extra £10 in your pay, and you are no worse off. Kahneman and Tversky found a loss pains people about 2.25 times as much as an equal gain pleases them, so most feel worse.
Bounded self-control is having less than the complete self-control the model assumes, so people give in to temptation or pay a price to guard against it.
Can you think of an example?
Smokers often buy cigarettes by the pack rather than the cheaper carton. They pay more per cigarette to keep fewer in the house and so smoke less.
Mental accounting is putting money into different mental categories where it takes different values, rather than treating every pound as worth the same.
Can you think of an example?
A student treats £25 found in the street as spending money and blows it on a whim, yet would weigh every penny of £25 earned from three hours behind a counter.