# Introduction to behavioural economics

> IB Economics Higher Level · Unit 1: Introduction to Economics
> Source: https://www.owlsprep.com/study/ib-economics-hl-u1-introduction-to-behavioural-economics/

This sub-topic introduces behavioural economics, which challenges the neoclassical assumption of fully rational decision-making. You will learn core concepts like bounded rationality and common cognitive biases that explain real-world economic choices.

**Prerequisites:** [Neoclassical assumptions of consumer behaviour](https://www.owlsprep.com/study/ib-economics-hl-u1-neoclassical-consumer-assumptions/)

## Learning objectives

- Distinguish between core assumptions of neoclassical and behavioural economics
- Explain the concept of bounded rationality and related ideas
- Identify and describe common cognitive biases in economic decision-making
- Outline the implications of behavioural economics for public policy

## Core Differences: Neoclassical vs Behavioural Economics

Neoclassical economics is built on the assumption that individuals are fully rational 'econs' that maximise their own utility, have perfect information, and consistently make optimal choices aligned with long-term self-interest. Behavioural economics rejects this assumption, instead integrating insights from psychology to explain how real people actually make decisions.

**Behavioural Economics** — A branch of economics that examines how psychological, social, and cognitive factors influence the economic decisions of individuals and institutions, departing from the standard assumption of full rationality.

*Example:* Behavioural economics explains why people buy unnecessary items on impulse, which neoclassical theory often cannot account for.

**Worked example:** A student argues that 'all consumers are rational, so higher cigarette taxes will always reduce smoking equally for all people.' Use core behavioural economics principles to critique this statement.

1. First, identify the neoclassical assumption the student uses: that all consumers make fully rational, utility-maximising decisions.
2. Behavioural economics notes that consumers face cognitive biases and limited willpower, so many smokers cannot easily quit even if taxes make smoking more expensive.
3. Conclusion: Higher taxes will not reduce smoking equally for all people, because addiction (a form of bounded willpower) distorts rational decision-making for some consumers.

## Bounded Rationality and Related Core Concepts

**Bounded Rationality** — A concept that describes how individuals make choices that are satisfying (satisficing) rather than optimal, limited by available information, cognitive capacity, and time constraints.

*Example:* Shoppers buying groceries do not compare the price of every single brand of milk to find the cheapest, they pick the first option that meets their requirements.

Coined by Herbert Simon, bounded rationality replaces utility maximisation with satisficing: individuals pick the first option that meets their minimum requirements, rather than evaluating every possible option to find the best global choice. Two related core concepts are:

- **Bounded willpower**: Limited ability to stick to long-term plans (e.g. sticking to a fitness diet)
- **Bounded self-interest**: People often prioritize the well-being of others over pure self-interest (e.g. donating to charity)

**Worked example:** Liam needs a new laptop for university. He spends 10 minutes searching on Amazon and buys the first laptop that fits his $1000 budget and has at least 16GB of RAM. Explain Liam's choice using bounded rationality.

1. First, recall that bounded rationality means individuals do not evaluate all possible options to find the optimal choice.
2. Liam limited his search time to 10 minutes and only checked that the laptop meets his minimum requirements. He did not compare every available laptop globally to find the best possible deal.
3. This is an example of satisficing, the standard outcome under bounded rationality, not irrationality: Liam made a good enough choice given his time constraints.

## Common Cognitive Biases

Cognitive biases are systematic, repeatable errors in thinking that affect how individuals interpret information and make decisions. They are a core concept in behavioural economics, with several commonly tested in IB HL exams:

- **Anchoring**: Relying too heavily on the first piece of information encountered when making decisions
- **Framing**: Being influenced by the way information is presented (e.g. as a loss vs a gain) rather than the information itself
- **Availability heuristic**: Judging the likelihood of an event based on how easily examples come to mind
- **Confirmation bias**: Seeking out information that confirms existing beliefs, ignoring contradictory information
- **Hyperbolic discounting**: Valuing immediate rewards more than larger future rewards

**Worked example:** A store labels a jacket with an original price of $200, then offers it on sale for $120. Most customers see this as a good deal, even if the jacket was never actually sold at $200. What cognitive bias explains this behaviour?

1. Customers use the stated original $200 price as a reference point for judging the value of the sale price.
2. This is anchoring bias: the stated original price acts as an 'anchor' that shifts customers' perception of value. If the jacket was priced at $120 with no discount, customers would not see it as similarly good value.
3. Retailers regularly use this behavioural bias to increase sales, exploiting consumers' reliance on reference points.

## Policy Implications: Introduction to Nudges

One key practical implication of behavioural economics is the use of nudge policy, developed by Richard Thaler and Cass Sunstein. A nudge is any aspect of the choice architecture that alters people's behaviour in a predictable way without forbidding any options or significantly changing their economic incentives.

> **info**
>
> Nudges preserve individual choice, unlike traditional policy tools like bans or taxes, making them politically popular for many policy goals.

**Worked example:** A government wants to increase the number of people who opt in to organ donation. Explain how a nudge could achieve this, compared to a traditional policy approach.

1. Traditional policy requires individuals to actively opt in to organ donation when applying for a license, so the default option is non-donation.
2. A nudge changes the default option to 'opted in', with individuals able to actively opt out if they do not want to donate. This exploits status quo bias, where people prefer to keep the current default option.
3. No options are forbidden, and the incentive to donate does not change, so this qualifies as a nudge rather than a mandate. Studies show this increases organ donation rates by 30% or more.

## Common pitfalls

- **Wrong:** Confusing bounded rationality with irrationality
  - Why it fails: Bounded rationality does not mean people make bad or random choices; it means they make good enough choices given their constraints
  - Correct: Define bounded rationality as making satisficing (not optimal) choices due to limited information/capacity, not as irrational decision-making
- **Wrong:** Claiming behavioural economics completely rejects neoclassical economics
  - Why it fails: Behavioural economics does not discard all neoclassical principles; it adjusts the core assumption of rationality to match real-world behaviour
  - Correct: Describe behavioural economics as a complement to, not a replacement for, neoclassical consumer theory
- **Wrong:** Misidentifying framing as anchoring
  - Why it fails: Both relate to how information is presented, but they have distinct mechanisms
  - Correct: Anchoring is relying on a reference value to judge worth; framing is being influenced by whether an outcome is described as a gain or a loss
- **Wrong:** Calling a ban on sugary drinks a nudge
  - Why it fails: Nudges cannot forbid options or significantly change economic incentives
  - Correct: A ban is a traditional regulatory policy; placing sugary drinks out of easy reach is a nudge

## Cheatsheet

| Concept | Core Definition | Common Example |
| --- | --- | --- |
| Neoclassical assumption | Full rationality, utility maximisation | Consumers always choose optimal option |
| Bounded rationality | Satisficing, limited capacity/information | Buying first acceptable laptop |
| Anchoring | Rely on first stated reference point | Marked-up original price on sale items |
| Framing | Influenced by gain/loss presentation | 90% lean beef vs 10% fat |
| Hyperbolic discounting | Prefer immediate over larger future reward | Eating dessert despite fitness goals |
| Nudge | Alter choice architecture without forbidding options | Default opt-in pension schemes |

## What's next

Understanding the foundations of behavioural economics is critical for analysing real-world consumer behaviour and evaluating modern economic policy in IB Economics HL. This sub-topic builds on the core neoclassical assumptions you learned earlier in the unit, and provides a framework for explaining deviations from standard predictions that you will encounter in microeconomics and macroeconomics topics later. As you progress, you will apply these core concepts to more specific topics like consumer choice, government policy, and development economics, where behavioural insights are increasingly used to design more effective interventions. The ability to contrast neoclassical and behavioural approaches is a common requirement for extended response questions in Paper 2.

- [Cognitive biases in decision-making](https://www.owlsprep.com/study/ib-economics-hl-u1-cognitive-biases-in-decision-making/)
- [Bounded rationality and bounded self-interest](https://www.owlsprep.com/study/ib-economics-hl-u1-bounded-rationality-and-bounded-self/)
- [Introductory quantitative methods (HL only)](https://www.owlsprep.com/study/ib-economics-hl-u1-introductory-quantitative-methods/)

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