🛒principles of microeconomics review
6.3 Behavioral Economics: An Alternative Framework for Consumer Choice
Last Updated on June 25, 2024
Behavioral economics explores how psychological factors influence consumer choices, challenging traditional economic models. It examines present bias, hyperbolic discounting, and procrastination to explain why people often make decisions that conflict with their long-term interests.
Intertemporal budgeting illustrates how consumers allocate resources across time, balancing present and future consumption. Behavioral factors like lack of self-control, limited attention, and mental accounting help explain low US savings rates, while default effects and peer pressure significantly impact financial decisions.
Behavioral Economics and Consumer Choice
Consumer choices across time
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- Intertemporal choice involves decisions with tradeoffs between costs and benefits occurring at different points in time (choosing between buying a car now or saving for retirement)
- Present bias is the tendency to give stronger weight to payoffs closer to the present, leading to inconsistency between long-term preferences and short-term actions (planning to start a diet tomorrow but indulging in junk food today)
- Exponential discounting is the traditional economic model assuming consistent discounting of future utility, implying time-consistent preferences (valuing a 100 reward 2 years from now)
- Hyperbolic discounting is an alternative model suggesting higher discount rates for near-term events, accounting for present bias and time-inconsistent preferences (valuing a 100 reward 2 years from now)
- Procrastination involves delaying tasks despite expecting to be worse off as a result of present bias and hyperbolic discounting (putting off studying for an exam until the last minute)
Examples of intertemporal budgeting
- Intertemporal budget constraint represents the tradeoff between consumption in different time periods, determined by current income, future income, and the interest rate (choosing how much to spend versus save each month based on expected future earnings)
- Saving for retirement involves allocating current income between consumption today and saving for future consumption, with a higher savings rate enabling greater consumption in retirement (contributing a portion of each paycheck to a 401(k) plan)
- Investing in education means forgoing current income to invest in human capital with the expectation of higher future earnings (taking out student loans to pay for college tuition)
- Borrowing for a home purchase allows consuming more in the present by borrowing against future income, with mortgage payments spreading the cost over time (taking out a 30-year mortgage to buy a house)
Behavioral factors in US savings rates
- Lack of self-control makes it difficult to resist the temptation to spend now rather than save, relating to present bias and hyperbolic discounting (impulse purchases instead of saving for emergencies)
- Limited attention involves failing to consider the long-term consequences of current consumption decisions by focusing on salient near-term costs and benefits (not realizing the impact of daily coffee purchases on long-term wealth accumulation)
- Mental accounting is the tendency to treat different sources of income differently, which may lead to lower savings from "windfall" or irregular income (spending a tax refund on a vacation instead of saving it)
- Default effects have a powerful influence on retirement plan participation and contribution rates, with automatic enrollment and escalation increasing savings (employees saving more when automatically enrolled in a 401(k) plan with a default contribution rate)
- Peer effects involve social norms and comparisons affecting consumption and saving behavior, with a "keeping up with the Joneses" mentality reducing savings (feeling pressure to match friends' spending habits instead of saving for the future)
Cognitive biases and decision-making heuristics
- Bounded rationality recognizes that individuals have limited cognitive resources and make decisions based on simplified models of the world, often leading to suboptimal choices
- Loss aversion describes the tendency for people to prefer avoiding losses to acquiring equivalent gains, influencing risk preferences and decision-making
- Framing effect refers to how the presentation of information can significantly impact decision-making, even when the underlying facts remain the same
- Anchoring is the cognitive bias where individuals rely too heavily on an initial piece of information when making decisions
- Prospect theory, developed by Kahneman and Tversky, explains how people make decisions under uncertainty, incorporating concepts like loss aversion and reference dependence
- Heuristics are mental shortcuts or rules of thumb that people use to make decisions quickly, which can lead to systematic biases in judgment and decision-making
Key Terms to Review (17)
Behavioral Economics: Behavioral economics is an approach to understanding human decision-making that incorporates insights from psychology, cognitive science, and other social sciences. It challenges the traditional economic assumption of the perfectly rational, self-interested individual and seeks to explain how real people make choices in the face of cognitive biases, emotions, and other non-rational factors.
Present Bias: Present bias is a cognitive bias that describes the tendency for people to place a greater value on immediate rewards or gratification rather than considering long-term consequences. This bias can lead to impulsive decision-making and a lack of self-control, as individuals prioritize short-term benefits over potentially more beneficial long-term outcomes.
Bounded Rationality: Bounded rationality is the idea that when individuals make decisions, their rationality 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. This concept challenges the traditional economic assumption of perfect rationality, where individuals are assumed to have complete information and the ability to make optimal choices.
Loss Aversion: Loss aversion is the tendency for people to strongly prefer avoiding losses to acquiring equivalent gains. It is a key concept in behavioral economics that challenges the traditional economic assumption of rational decision-making. Loss aversion explains why people's responses to potential losses and gains are often asymmetrical, with losses being more impactful than gains of the same magnitude.
Mental Accounting: Mental accounting is a behavioral economics concept that describes how individuals assign different values to different categories of money and make decisions based on those perceived values rather than on the actual economic value. It explores how people mentally organize, categorize, and evaluate their financial activities.
Heuristics: Heuristics are simple, efficient rules that people often use to form judgments and make decisions, especially when facing complex problems or incomplete information. They serve as mental shortcuts that allow individuals to solve problems and make judgments quickly, though they may not always lead to the most optimal or accurate outcomes.
Consumer Choice: Consumer choice refers to the decision-making process by which individuals or households select the goods and services they will purchase based on their preferences, budget constraints, and other factors. It is a central concept in the field of microeconomics that examines how consumers make decisions to maximize their utility or satisfaction.
Procrastination: Procrastination is the act of delaying or postponing tasks or decisions, despite knowing that it may have negative consequences. It is a common human behavior that can have significant impacts on productivity, goal achievement, and overall well-being, especially in the context of consumer choice and decision-making.
Procrastination is a complex phenomenon that has been studied extensively in the field of behavioral economics, which provides an alternative framework for understanding consumer behavior beyond the traditional economic models.
Intertemporal Budget Constraint: The intertemporal budget constraint is a concept in behavioral economics that describes the trade-offs individuals face when making consumption and savings decisions over multiple time periods. It represents the relationship between an individual's current and future resources, and how they allocate those resources to maximize their overall well-being.
Prospect Theory: Prospect theory is a behavioral economics model that describes the way individuals make choices in situations involving risk and uncertainty. It suggests that people's decisions are influenced by how the options are presented, rather than solely by the objective outcomes.
Intertemporal Choice: Intertemporal choice refers to the decision-making process individuals engage in when making choices that involve trade-offs between costs and benefits occurring at different points in time. It encompasses the way people make decisions that balance present and future considerations.
Framing Effect: The framing effect is a cognitive bias that occurs when the way information is presented influences an individual's decision-making. The way a choice is framed, either positively or negatively, can have a significant impact on how people perceive and respond to that choice, even if the underlying information is the same.
Hyperbolic Discounting: Hyperbolic discounting is a behavioral economic concept that describes the tendency of people to place a higher value on immediate payoffs rather than larger but delayed rewards. It is a departure from the standard economic assumption of exponential discounting, where the value of a future reward decreases at a constant rate over time.
Default Effects: Default effects refer to the tendency of individuals to stick with the pre-set or pre-selected options, even when other options may be available or preferable. This concept is a key principle in behavioral economics and is closely tied to the framework of consumer choice.
Exponential Discounting: Exponential discounting is a method used to determine the present value of future cash flows or payments by applying a continuously compounded discount rate. This concept is particularly relevant in the context of behavioral economics and consumer choice, as it helps explain how individuals perceive and value future rewards or costs.
Peer Effects: Peer effects refer to the influence that an individual's peers, or social network, can have on their behavior, decisions, and outcomes. This concept is particularly relevant in the context of behavioral economics, where it provides an alternative framework for understanding consumer choice beyond the traditional rational choice model.
Anchoring: Anchoring is a cognitive bias in which an individual relies too heavily on one piece of information, known as an 'anchor,' when making decisions. This bias can significantly influence judgments and choices, particularly in situations involving uncertainty or ambiguity.