Behavioural economics is a discipline that studies how psychological factors influence economic decision-making in both individuals and institutions. Behavioural economics is always contrasted with neoclassical economics, which is based on assumptions that people will always be rational in their decision-making, make the best choices for their interests, as well as adjust their thoughts and beliefs when confronted with new information.

Behavioural economists, however, believe that people make systematic errors and are often tempted to make irrational decisions based on their unstable preferences or their environment. In short, behavioural economics considers people as human beings whose emotions, tendencies, or biases can impact their decision-making on economic aspects. By accepting this reality, the psychological realities of humans can be integrated into various economic models.

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Core Behavioural Economics Theories

Bounded Rationality

Bounded rationality is the idea that people make rational decisions but within the limits of their mental capabilities and the information available to them. Other limitations include the time available to make decisions or the difficulty of the problem. Persons that have bounded rationality are not ‘masters of rationality’ or ideal decision-makers. Rather, they are viewed as ‘satisficers’ – they look for a satisfactory solution instead of the optimal solution. In other words, they make a decision that is good enough and not necessarily the best possible option.

Satisficers generally do not have all the information required to make a purely rational decision, or they may not bother to take the time and effort required to gather relevant information. This means that they are likely to make decisions based on peer pressure, societal norms, the crowd, or even instincts. For instance, a person may pass by a grocery store and decide to buy eggs because they have been labelled ‘cage-free.’ This is a decision that will satisfy their ethics or moral values, but the person may not take the time to interrogate whether the term ‘cage-free’ applies to ‘free-run’ or ‘free-range’ chicken. The person may not even know what the words really mean. Still, it is important to point out that bounded rationality is not irrational because a person is trying to make a decision that is as rational as possible, but there are some limitations. Another example is when a person is importing a car in a country that limits the year of manufacturing. In this case, there is a time constraint, and the person may end up making a quick decision in a bid to beat the set-out deadline.

Prospect Theory

The prospect theory is a theory that attempts to describe the behaviour of individuals when confronted with choices of probability. It was first discussed by Daniel Kahneman and Amos Tversky in 1979 and awarded the Nobel Prize in Economics in 2002, but it is derived from the theory of Loss Aversion. The theory explains that when faced with a choice of loss or gain, people will tend to give more weight to outcomes that are certain compared to outcomes that are merely probable. This is the certain element of the theory.

Prospect theory also suggests that people are generally loss averse. This means they hate losses more than they would love an equivalent amount of gain. This is the reflective aspect of the theory. It illustrates that people perceive the risks involved in gains and losses differently. When assessing gains, people will generally prefer small certain gains over large probable gains.

For instance, when presented with the first option of making a guaranteed 10% gain in one investment and making a 40% gain that is probable, people will tend to choose the option that carries no risk. But when assessing losses, people prefer larger losses that are probable (there is a chance to avoid a loss) over small losses that are guaranteed. According to the prospect theory, people will tend to make decisions depending on the risk and certainty elements of the options placed on the table.

Nudge Theory

Popularised by Richard Thaler and Cass Sunstein in 2008, the Nudge Theory suggests that people’s behaviour can be influenced by suggestions and positive reinforcements, even without presenting any economic benefits or disallowing other alternatives. The theory considers that humans are vulnerable to making systematic errors, but they can be influenced to alter their behaviours so as to achieve maximum utility.

For nudges to have the desired effect, there must be positive behaviour that needs to be encouraged, and the new behaviour should ultimately be beneficial to the people targeted. For instance, a non-fit person can be encouraged to join a gym if it charges weekly fees rather than monthly fees, even though the overall cost is the same.

The nudge theory has been used by governments in areas such as voluntary inclusion in retirement plans. There is also its application in the consumer industry, where for instance, people can be ‘nudged’ by companies to buy complementary products (up-sells); or, as in the food industry, encouraged to buy healthy alternatives.

Behavioural Economics Concepts

Here are some of the main concepts of behavioural economics, as well as some examples of behavioural economics:

Heuristics

Heuristics are mental shortcuts that guide people when making economic decisions. People generally want to make a good decision, but they do not really want to take too much time or effort to make a choice. Heuristics can help people to arrive at a good enough decision, but not necessarily the best one. Some mental shortcuts can, however, limit the capability of people to make optimal decisions for their happiness or success. Examples include mental accounting, anchoring, and herd behaviour.

Biases and Fallacies

Apart from heuristics, people also possess certain cognitive biases and fallacies that may lead them to certain decisions that will impact them negatively. Examples include recency bias, gambler’s fallacy, and confirmation bias.

Learn more about cognitive biases and how they can impact your trading activity. 

Behavioural Finance

Behavioural finance studies the influence of psychology on the behaviour of investors and financial analysts, as well as the consequences of such behaviour in the financial markets. As a subset of behavioural economics, behavioural finance concedes that investors may not always act as rational, and their behaviours have the potential of having unpredictable outcomes in the financial markets.

Behavioural finance can be used to explain certain market scenarios such as abnormal price spikes, stock market bubbles, and momentous price surges. It can also help understand the behaviour of market participants in events such as high-impact news releases.

Final Word

Behavioural economics can help people understand how psychology can influence decision-making. By being aware of their mental vulnerabilities, people are then more capable of being better decision-makers over time.

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FAQ

  • What is behavioural economics?

    Behavioural economics is the study of how psychological factors influence economic decision-making among individuals and institutions.

  • What is behavioural finance?

    Behavioural finance is the study of how psychology influences the behaviour of investors and financial analysts, as well as the consequences of such behaviour in the financial markets.