Prec) eee) eae cone Which phone should | buy? Homo economicus will 5 > > > S know exactly what she wants from her phone research the capabilities of allthe different phones. understand al the Information that is provided beable to compare athe models know the prices ofeach ‘and every phone on the ‘market ‘know how long each phone willlast know what she willneed {from her phone in two years beable to know which phone mekes her hoppiest. Inpairs, discuss how realistic ‘the statements above ae, What difficulties might homo economicus face? What are the key assumptions behind the theory of demand? ‘As was explained in the first chapter, economic models are developed to explain economic behaviour, In creating these models certain assumptions have to be made in order to test and validate the hypotheses that are needed to generate economic theories. In neoclassical theory, key assumptions are made about the way in which consumers, as economic “agents”, make their choices. In this standard economic model, itis assumed that consumers behave rationally. This ‘means that faced with an economic decision, consumers are able to consider all the possible options and work out which option will give them the most satisfaction, or utility. In other words, consumers will always seek to maximize their utility. In making their decisions, itis assumed that consumers act only in their own self-interest; they do not take into account the interests of others. Furthermore, itis assumed that when making decisions or choices, consumers have access to all the relevant information about each of their choices. This is known as the assumption of perfect information. In the standard model, this rational consumer is known as homo ecanomicus, When faced with choices, itis assumed that homo economicus will make intelligent, logical and well- considered decisions that give them the most utility What is behavioural economics? Richard Thaler is regarded as a pioneer in the field of behavioural ‘economics and won a Nobel Prize for his work in 2017. He refuted the notion that consumers are “rational maximizers” who are essentially ‘mathematical machines able to carefully calculate every decision to enable them to maximize their utility. He observes that a problem with the field ‘of economics is that it studies the behaviour of people that simply do not exist, presenting the view that there is no such person as homo economicus. We are all homo sapiens! In everyday English, he uses the terms “Econs” for homo economicus and “Humans” for “real people”. According to Thaler, Econs and Humans exhibit the following characteristics: + Have perfectinformation + Have incomplete information + Are extremelyinteligent,andableto perform | + Are nota intelligent a Econs complex ealelations quickly + Have limited ability to amy out + Seekto maximize their own utity complex ealelations + Make decisions based ontheirown sel + Are social beings, and make interest ecisions ina socal context + Have consistent preferences overtime + Changetheirtastesavertime + Haven seltcontal problems + Mayhave sel'contl issues + reunbiasesHow realistic are the key assumptions of the rational consumer model? ‘One key assumption of the standard economic model that is challenged by what actually happens in the real world is that of perfect information. ‘This is the assumption that all economic agents have access to all the same information at the same time. This would imply that consumers have perfect information about the price and quality of all products in the market. There are several problems associated with this. One is that in the real world, there are “information asymmetries” were different economic agents (consumers, producers and the government) have different levels of information available to them where economic transactions are concerned. Another relates to the fact that even if all the information were available, humans face limits in terms of how they can actually process the information that is available to them. In today’s world, with the Internet providing access to seemingly infinite information, we often face the situation of information overload. ‘Therefore, in the real world, consumers make decisions based on imperfect information, ‘Consumers face huge challenges in making economic choices and are unable to make decisions in the rational manner assumed by the standard economic model. The term bounded rationality is used to explain the notion that the rationality of consumers is limited by the information that they have, and the fact that they do not have the time nor the cognitive abilities to weigh up all the options, In the standard economic model, humans act in their own self-interest. In other words, consumers are assumed to act selfishly, only taking their own objective of utility maximization into account when making choices. In fact, humans do care about others. We volunteer work, we give to charities, we buy Fairtrade products because we are concerned about the wellbeing of farmers. All of these show that the assumption of self-interest may be challenged, The term bounced selfishness is used to explain that humans do not always act in their own self-interest as assumed by the neoclassical model. Finally, itis assumed that when acting rationally, consumers are able to demonstrate perfect willpower. In reality, consumers are unlikely to be able to do this. We use the term bounded self-control to illustrate this. natural tendency to give in to temptation sometimes. Boe Bien Economie Man vs Humanity: @ Puppet Rap Battle Watch this creative rap video from Kate Raworth the author of Doughnut Economics, to understand limitations of the assumption of ational human behaviour btpss/youtu be/Sx1 E8208 peu tlla eeePrec) eee Thinking and Communication Would you like a Cafe Latte, Americano, Cappuccino, Espresso, Flat White, Long Black, Mocha, Macchiato, Mochaccino,Frappuccino, Small, Medium, Large, Takeaway? Is itpossible to have too much choice? What problems do people have to face when they are presented witha vast range of choices? Does it make the decision easier cormate dificult? How can the “Dual System Model” explain how humans actually act? In order to explain why Humans make decisions that are different from Econs, behavioural economics draws on the experimental work of psychologists Daniel Kahneman and Amos Tversky who developed the “dual system model”, According to this model, individuals actually have two different systems of thinking, known as System 1, the fast ‘thinking system, and System 2, the slow thinking system. Inhis book, Nudge, Richard Thaler calls System I the “Automatic System” and System 2is the “Reflective System”. The Automatic System involves fast decisions that are essentially subconscious. The Reflective System involves slow decisions that are much more controlled. The characteristics of each of the types of thinking system are illustrated below: You would use automatic thinking to: * Answer the question, “What is ut intuitive three plus four?” fretne * Gethome from school on the route /ncontalled eo that you have taken every day for eae the last year * Speak in your mother tongue fast Impulsive * Do your grocery shopping immediateYou would use reflective thinking to: controlled + Answer the question, “What is 1989 times 317” + Choose your IB subjects caleulating deliberate System 2: Reflective + Havea conversation in a second Janguage in which you are not stow logical fluent, ‘unemational ‘A Figure 3.10 The Automat er and the Reflective System ‘Neoclassical economists would claim that rational consumers make all their decisions using reflective thinking. However, this is obviously not the case, When people have important and complex decisions to make, they usually use elements of the Reflective System and take their time to make a decision. However, sometimes they let the Automatic System take over and this can result in poor decision-making, ‘This is particularly a problem when we make a short-term decision too quickly, without considering the long-term effects. For example, if you have decided to go on a diet to become more healthy and you are offered something like a doughnut that you eat because you just can't resist it, then you are using your automatic thinking. Obviously, you should reflect on the decision and come to the rational decision that the short term benefit from the doughnut is not worth the longer term loss of remaining overweight. ‘Ona day to day basis, we make thousands of decisions, and have to cope with a tremendous amount of information. In order to make them quickly, ‘we employ certain mental “rules of thumb”. The rules of thumb that we use to make quick decisions are also known as “heuristics”. A heuristic ‘may be defined as a mental shortcut that allows people to make decisions and solve problems quickly and efficiently. However, there are “cognitive biases” implicit in the short cuts we employ that may be problematic and. result in poor decisions. If we let our impulsive automatic thinking take ‘over when making an important decision, we might make choices that we will regret later. Impulse buying is an example of this. What are the cognitive biases that affect decision-making? Psychologists have identified many biases that affect consumer choices. Behavioural economics uses the understanding of these biases to help consuumers make better choices. Some ofthese biases are © Availability bias The availability of recent information and examples tends to over- influence people's decision making. If there is a case of salmonella eee cen Thinking and ‘ryte think ofa choice that you have made and then regretted afterwards. Using the terms System 1 thinking and System 2 thinking, explain how you right have chosen different,Prec) Crue ey eri cere Several cognitive biases have been listed here. + Find your own examples of how these cognitive biases influence people. These are not the only cognitive biases that influence the decisions that consumers make. Research others, and explain their influence. in one part of a country, consumers might assume that it will occur nearby and they might choose different food options as a response, even if there is absolutely no risk in their area. It turns out that consumers are actually quite poor at assessing risk and probabilities, relying on recent examples rather than carefully-examined data. A common example is young smokers, who see a much older person who is also a smoker. Itis quite possible for the young smokers to delude themselves into thinking smoking is not dangerous, despite all the information to the contrary, because the older person is perfectly healthy. Anchoring bias Anchoring occurs when we are given the value of something, and then use this value as a reference point to influence future choices or decisions, Once an anchor value has been set in our minds, we tend to rely too much on it, and this can lead to poor decisions. Supermarkets use awareness of this bias in their pricing, Consumers anchor certain prices in their minds, and when there is a sale and the price drops, the consumers feel that they are getting a very good deal and may purchase more than they really need. Salespeople use this when prices are negotiable by offering a very high starting price and then accepting a lower price that is still higher than what the product should cost. Framing bias ‘The way that information is presented to us influences our choices. Inmany cases, especially where data is presented, a given piece of information may be presented in either a positive way or a negative way. When information about a product is framed in a very positive manner, it will lead consumers to think more positively about the product, Evidence of this can be seen in all kinds of marketing and advertising. If you see that a particular yoghurt is labelled as “90% fat free”, it will be a lot more appealing than a label which says, “contains 10% fat”. Although the product would be identical, the framing of the information induces a cognitive bias. Social Conformity/Herd behavior As consumers, we naturally want to fit in. The way that others behave can exert a powerful influence on our own choices. It can be very gratifying and rewarding to be like others. There is evidence of this herd behaviour (wanting to be part of a “herd”) everywhere. An obvious example would be changing clothing fashions. Producers are able to convince people to buy more clothes in order to fit into the new styles, even when their own clothes are perfectly good! This is also known as the “Bandwagon Effect” and is used to describe the behaviour of people when they join a perceived majority of people in doing something, even if it is against their best-interest.* Status Quo/tnertia bias Itis often the case that consumers, faced with a bewildering set of choices, would prefer to maintain the status quo by doing nothing. An example would be what a consumer might do when their mobile phone contract expires. It could be a very good time for the consumer to investigate other options, and maybe consider entering. into a contract with another mobile service provider. However, faced with the challenge of researching into all the available options, itis quite likely that the consumer will prefer just to stick with the same provider, even if something else might actually provide more utility. + Loss aversion bias Experiments show that humans feel that losses are far more significant than gains. It has been estimated that the pain that people feel from losing something is psychologically about twice as powerful as the pleasure that they get from gaining something, This leads to the situation where people might make poor choices because they fear that they will lose something, even if their reasoning is not well-informed. This is linked to the status quo bias, as consumers may be reluctant to change the status quo due to the fear of loss. Businesses can take advantage of this bias by making consumers fee! that they will lose something if they don’t purchase a good. Ifyou see a sign saying, “Buy now before stocks run out!”, you should be aware that the producer is trying to make you feel that you will lose out if you don’t take advantage of their offer. + Hyperbolic discounting This is a very fancy name for something that everyone can relate to, It refers to the tendency of humans to prefer smaller short-term rewards over larger later rewards. If your Economics IA is due the day after tomorrow and you haven't even started it, you should probably get started right away - at least decide on the article you are going to analyse, However, you decide that you would prefer to {go out this evening and enjoy yourself, as you convince yourself that you will do a much better job in the morning. This is an example of hyperbolic discounting ~ you prefer the short-term reward of a night out, rather than the longer-term reward of getting the work finished. This cognitive bias is even more powerful when the reward is much further in the future How can behavioural economics be used to help consumers make better choices? Given the many cognitive biases which cause consumers to make poor choices sometimes using their System 1 (automatic) thinking system, behavioural economics aims to help consumers make better choices. One way of doing this is to alter the choice architecture that consumers face. Beceer, ‘This picture was taken ina local supermarket. How has the company taken advantage ofcognitive biases totry to get consumers to buy the product? Research Black Friday and Singles’ Day. How do retailers take advantage of any ofthe cognitive bases on these days? a ahs eee3 Gy = = What is choice architecture? Choice architecture is the theory that the decisions that we make are heavily influenced by the ways in which the choices are presented to us. ‘We make many decisions every day but we might not realize the extent to which those choices are influenced by the way that someone, referred toasa “choice architect”, presents the choices to us. ‘Avery simple example from supermarkets can be used to explain the term. When you shop in a supermarket, you will find all kinds of products right at the cash desk that encourage you to “impulse buy”, ‘They are not there by accident; the “choice architect” has placed them there because itis assumed that while you are waiting there, you will be tempted to buy those products. This is especially the case if they are chocolate bars or candies and you are waiting with a small child who will have a temper tantrum if you don’t buy them! ‘An example of an area where choice architecture can be observed is when a default choice is changed. There ate two ways of explaining the default choice. One is that itis the pre-set option that is effectively selected if the decision-maker does nothing. In other words, itis what you get if you do nothing. For example, Google is the default search engine on many browsers ~it does not have to be selected, it opens automatically. The second is that itis the choice that is always followed unless a deliberate decision is made to change it. In other words, you carry on making the same choice because it is a habit. For exampie, if you always get a caffé latte when you go to the coffee shop, then it, becomes your default option Although the default options do not always result in a good outcome, they are very popular for many reasons. The status quo bias described earlier can be very powerful. Consumers may not have the time or the resources to research alternatives, they may lack the cognitive skills to understand the alternatives, they may lack the courage to make changes, they are comfortable with what they normally choose and they generally like the easier options! Consider the case of organ donation. There is always a shortage of ‘organs for organ transplants. One way to increase the supply of organs available for transplants is to increase the number of people that consent to donate their organs in the event of their death. There are different systems for doing this. One system is the opt-in/opt-out approach. If ‘a country operates an opt-in system, itis the responsiblity of people to actively sign up to the organ donation register. This allows hospitals to use their organs for transplants after death. In an opt-out system, ‘organs will automatically be donated unless people make a specific request before death that their organs should not be taken. Ifa country ‘operates an opt-in system, then opting-in is the default option. If people do nothing, then their organs cannot be used, as they will not have given their consent. Changing the default option from opt-in to opt-out is seen as one way of using choice architecture to inctease the number of people who consent to having their organs donated.Another way in which choice architects can influence consumers is through mandated choice. These are situations where people are required by law to make a choice in advance. In the example of an organ donation, people are required by law to indicate if they are willing to become an organ donor in the event of their death. The way that the government can do this is by requiring people to tick a box to say whether or not they are willing to be donors when they renew their driver's licences. Although many people would like to be organ donors, when left to themselves to register as donors, many do not make the effort to indicate this choice. When the choice architects force people to make the choice, the number of organ donations increases, substantially. How can people be encouraged to make better choices? Nudge theory was developed by behavioural economist Richard Thaler. ‘The theory suggests that the choice architecture offered to people can be carefully designed to gently encourage (nudge) the people to voluntarily choose the option which is better for them. Behavioural economics in general, and nudge theory in particular, became much more well-known and accessible to the general population following the publication of Richard Thaler and Cass Sunstein’s book Nudge: Improving decisions about health, wealth and happiness, The key to nudge theory is that consumers maintain their consumer sovereignty (their right to choose) but are encouraged to make better decisions. A commonly cited example of this relates to the positioning of food in a school cafeteria. If healthy foods are placed in a very convenient, easy-to-reach, easy-to-see place, evidence shows that students will consume more of them. They are not forced by anyone to choose the healthy foods, but the placement “nudges” the students subconsciously to choose them. The key thing is that the students are not forced to choose the healthy option, but they do it themselves. The argument is that students are more likely to pick up healthy habits if they are making the choices themselves. When designing positive choice architecture, the “architects” must essentially override certain cognitive biases. If consumers use their ‘System 1 thinking system and subconsciously fall back on rules-of- thumb which cause them to make poor decisions, then they may need to be nudged towards better decisions. A good example where nudges have been used to help people make better decisions is in the area of pension savings. In many more ‘economically developed countries, governments provide pension schemes thal are designed to allow people to have a decent standard of living when they retire. However, these pensions schemes are under considerable threat due to the fact that people are living longer, and governments are unable to finance the pensions. Therefore, there is a need for people to set up private savings schemes to ensure that they ETA) ay Sea global problem is a lack of organs for organ transplants. Using. the theory of choice architecture, explain the ways that different governments approach this problem and identify which method you think is the best. Justify your choice. More Me Us Toward Better Choices Inepef wor forbes conte! maiieganclex?2019107/25/zore tridence-tha-a-menu-design-can- hudge-us- toward beter choic- ‘87274916582 vvidence That 1u Design Can Nudge eeePrec) Theory of knowledge Nudge theory has been, described as libertarian ppatermalism. How ean both words, “libertarian” and “pateralism" be perceived negatively? Despite the fact thatboth ofthe words have ‘some negative connotations, proponents of nudge theory ‘are happy to callit‘bertarian paternalism” How do they justify this? Cea) Seay Pe ‘There are countless ‘examples of the ways in which nudge theory has been adopted, by both governments and, organizations all around the world. Compile a list of examples from three different countries, and explain how your chosen “nudges” meet the requirements of getting. consumers to voluntarily change their behaviour ina positive way. Try to find nudges from different areas, eg nudges to help make people happier, nudges to help improve communities, nudges to promote sustainability. have enough money when they retire. A rational “Econ” would be able to calculate how much they are going to earn over their working life, work out how much they will need when they retire, and have the will- power to set aside just enough money each month to ensure that they have enough money when they retire. But we know that humans do rot work like this. Despite all good intentions to save, there are several reasons why people do not save for their future. Firstly, because of the hyperbolic discounting bias, people do not like to save for the future, because it means that they are giving up rewards in the present. The further away retirement is (that is, the younger people are), the less likely they are to save money. The temptation will always be to say that they will start saving later. Secondly, if people have to cut their spending in order to save, they are likely to consider this as a loss and because of the loss aversion bias they are not likely to be prepared to accept this loss of consumption in the present. Richard Thaler and fellow behavioural economist Shlomo Benartzi developed the “Save More Tomorrow (SMT)" scheme in the United States as a way of nudging people to save money for retirement. Under this scheme, which companies can offer their employees, people are encouraged to start saving early in their working lives. This scheme addresses the problem of the hyperbolic discounting bias which discourages people from saving early. In the beginning, the pension contributions are quite small. But whenever the workers get 2 pay rise, there is an automatic increase in the pension contribution. Without doing anything deliberate, those workers will be saving more. However, because they are not experiencing a loss in income (the extra saving comes from the salary increase) the loss aversion bias is addressed. Each time there is a pay increase, there is an “automatic escalation” of the pension contribution. Another key element of the scheme is that workers can opt in to the scheme, and opt out at any ‘time, This maintains their consumer sovereignty, which is considered to be a requirement when a policy is considered a “nudge”. Research shows that this scheme, along with other nudges designed by behavioural economists, has had tremendous success in raising pension contributions. The change in choice architecture, which nudges people towards an easy choice of opting into a scheme, will help people to guarantee a more comfortable future. ‘The work on nudge theory by behavioural economists has had a big impact on governments and organizations all around the world ‘who are now nudging people in countless ways to help people make “better” decisions. These have contributed to improvements in people's standards of living, their health, their communities and the environment. Nudge theory is not without its critics, Any form of government intervention may be accused of taking away individual rights. There is, also the concern that governments do not actually know what is best for people and so cannot be trusted to choose how to nudge people. ‘This is a good example of the debate between those who believe thatgovernments have an important role to play in the functioning of markets and those who believe that market forces operate efficiently on their own. However, behavioural economists argue that the belief that markets operate efficiently on their own is based heavily on the assumption that consumers act rationally and this assumption can be casily challenged. Their vast experimental work shows how the insights from psychology can be used to select carefully designed and tested. interventions to nudge consumers in the right direction, without taking eee away their rights to choose. oar) ‘Nowadays, many people are “voting with their dollars” (or renminbi ‘or pesos or rupees or euros) where they indicate their beliefs to producers by buying (or not buying) their brands. This has also been referred to as ethical consumption or “belief-driven buying”. In the 2018 “Edelman Eamed Brand Report” based on surveys of ‘consumers from Brazil, China, France, Germany, India, Japan, the UK and the US, it was demonstrated that an average of 64% of consumers choose, switch, avoid or boycott a brand based on its stand on societal issues. Belet-Driven Buying As the graph suggests, the percentage of consumers who care ‘enough about issues to change their buying habits has grown in all eight of the surveyed economies. This suggests that demand can be a force for positive change on the issues related to social justice that consumers care about. For example, consumer concer about the impact of single-use plastics, ‘was instrumental in incentivizing coffee chains to promote the use of reusable cups and stop offering plastic straws to their customers. Producers, secking to maintain demand, are paying much more attention to their use of plastics at all levels of production, and this ‘may be instrumental in reducing plastic waste. In this way, consumer demand can contribute to positive changes in terms of sustainability, 63Of course, the cynical among us will say that the producers have no genuine interest in the environment or other social issue and they are only doing it to increase their profits. But if positive change is the result, does it matter what their main goal is? (There is no right answer to this question!) Have you ever purchased a product because the company. showed concem for an issue that you care about? Ask around to see if others have done the same Have you ever thought about not buying a product because the company showed a lack of concern about something that you think is important? Ask around to see if others have done the same. Find an example of a company that has responded to consumer ‘concerns about a social issue by changing what it produces or the way it produces. Which social issue is the company responding to (eg sustainability, gender equity, racial equity)? How is it responding? How can you determine if the company behaviour is contributing to a positive change? Theory of knowledge Usiitaianism isa philosophy stemming from the English philosophers and economists, Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1873). thas applications in economics. Utlitarianism tries to answer the question, "What should a person do?" The utlitarian answer [sthatthe person should actto try to produce the best consequences from his orheractions. In terms of consequences, a utlitaian person attempts to ‘evaluate all ofthe goad things and bad things produced by an ‘act whether they happen after the acthas been performed ‘orduring its performance, Utiitarians believe that an action {srightfthe happiness produced by tis greater than the ‘unhappiness. They believe that ifallindividuals were to follow this ethos, then the outcome would be the greatest {2004 forthe greatest numberof people. Happiness. sometimes referred to as utility and attempts to measure positive and negative happiness are often calculated in utils, which are measures of happiness, and negative utils, which are measures of unhappiness. The consumption of products can be measured in utils and tis assumed thatthe marginal utility, the extra utility {gained from consuming an extra unit ofa product, wll decrease as consumption increases. People will et less happiness from eating a second ce cream than they did {fom consuming the fist on. Its this theory thathas been sedi economies ina simplistic sense, to explain why the demand curve slopes downwards. Consumers ill only purchase more ofa produtfitis cheaper, since theyreceive ess extra utlityas they increase their consumption, and so will at pay as much ort 1. Research the basi concept of uitaianism, Youhave $20 and are considering going out forthe ‘evening o giving the meney tothe World Wife Fund. Consider we would benefit rom the two options and tryto give ut values tthe options inorder to decide the right course of action, (Remize all those who would benefit and lose from each option) Drink ive glasses of mineral water and aterptto give marginal tity value teach glass. How does your ‘marginal utility change a you consume each extra lass ofater? How would this affectthe amount that {you ate prepared to pay fora glass? Dees uiitaranism assume rational consumer behaviour?