ECON 415: Behavioural Economics

BSS (Honours) third year, Department of Economics, University of Dhaka

Week 1 Lecture 2:
Rational Decision-Making, Utility, and Preferences
Foundations of Consumer Behavior in Economics

Lecture by: Dr. Rubaiya Murshed

PhD and MPhil, Faculty of Education (Economics of Education), University of Cambridge
Assistant Professor, Department of Economics, University of Dhaka
 What is
Behavioural
“Behavioral economics is the study of
Economics? psychological, cognitive, emotional,
cultural, and social factors that influence
economic decisions. It blends insights
from economics and psychology to explain
how people make everyday economic
decisions and how these affect economic
outcomes.”
 How is Behavioural Economics
different than Traditional Economics?
 Traditional Economics –
“Rational Decision-Making"
• People are rational decision-makers
• They aim to maximize utility
• Decisions are based on complete information
• Self-interest drives choices
 Behavioral Economics
• People do not always act rationally
• Cognitive limitations affect decision-making
• Emotions and psychological biases influence
choices
• Social factors shape behavior
Example 1: Purchasing a Mobile Phone
Traditional Economics:
• Scenario: A consumer in Dhaka evaluates all
available mobile phones and picks the one with
the best cost-benefit ratio.
Behavioral Economics:
• Scenario: A consumer in Dhaka buys a mobile
phone based on a friend’s recommendation
rather than a full analysis.
 Explanation: Example 1
Traditional economics assumes that-
 Consumer is rational
 Will make a decision based on a thorough analysis of the features, price, and
benefits of each phone.
 Consumer aims to maximize utility by choosing the phone that offers the best
value for money.
Behavioral economics recognizes that-
 Consumers are influenced by social factors and cognitive biases.
 Consumer relies on a friend's recommendation due to trust and the desire to
conform to social norms, rather than conducting a detailed cost-benefit analysis.
 This behavior can be explained by the concept of "social proof" and "bounded
rationality," where the consumer's decision-making is limited by time,
information, and cognitive capacity.
 Example 2: Health and Nutrition Choices

• Traditional Economics:
• Scenario: An individual in Dhaka chooses their
diet based on nutritional information and cost.
• Behavioral Economics:
• Scenario: An individual in Dhaka frequently
chooses unhealthy snacks despite knowing they
are not good for health.
 Explanation: Example 2

Traditional economics assumes that-

 Individual makes rational choices by evaluating
the nutritional value and cost of different food
options to maximize their health and budget.
Behavioral economics explains this behavior through-
 Concept of "temptation" and "hyperbolic discounting," where
immediate rewards (tasty snacks) are given more weight than
future consequences (health issues).
 Interventions like placing healthier options at eye level in
stores or using visual cues to highlight healthy choices can
nudge individuals towards better decisions.
 So…
Behavioral economics provides a more
nuanced understanding of human behavior
by considering psychological, social, and
cognitive factors, while traditional
economics relies on the assumption of
rational decision-making.
 Countless examples from real life (1)
➢Farmers relying on past experiences rather
than full climate data when choosing crops-
Bounded Rationality
➢ An employer in Chittagong is evaluating job applicants
and assumes that a candidate with a degree from a
prestigious university in Dhaka is more competent
than a candidate from a lesser-known local college,
despite both having similar qualifications and
experience.- Representativeness Heuristic
 Countless examples from real life (2)
➢ A shopper in a local market in Sylhet is negotiating the
price of a traditional saree. The seller initially quotes a high
price of BDT 5,000. The shopper negotiates and gets the
price down to BDT 3,500, feeling they got a good deal.-
Anchoring Bias
➢ A person in Dhaka overestimates the likelihood of
severe flooding in their area because they vividly
remember the devastating floods from a few years
ago.- Availability Heuristic
➢ People prefer a '90% success rate' over a '10% failure
rate’- Loss Aversion and Prospect Theory
 Traditional vs. Behavioral Economics
• Traditional Economics: Rational decision-
makers (homo economicus)
• Behavioral Economics: Bounded rationality,
heuristics, and biases
• Traditional Economics: Stable preferences,
optimal choices
• Behavioral Economics: Preferences change,
choices are influenced by framing
 How Do We Study Behavioral
Economics?
• Lab Experiments: Controlled settings to isolate
behavior (e.g., Dictator Game)
• Field Experiments: Real-world interventions to
test behavioral theories
• Natural Experiments: Observing behavior in
naturally occurring events
Example: The Disease Framing Experiment
• Conducted by Tversky & Kahneman (1981)
• Participants choose between two treatments
for a deadly disease
• Option A: '200 people saved' vs. Option B:
'400 people will die'
• People make different choices based on
framing, even when outcomes are identical
 Behavioral Economics in Action
• Public Policy: Nudging for better health and
savings decisions
• Finance: Understanding market anomalies and
investor behavior
• Marketing: Using framing and heuristics to
influence consumer choices
• Example: Opt-out organ donation policies
increase donation rates
Quiz
Quiz: Rational decision-making, Preferences
and Utility Maximization

Time: 15-20 minutes

Total marks: 15
Now, let’s delve into how traditional economics
explains individual decision-making, with a focus
on utility theory and rational choice.
 Rational Decision-Making – Classical View

• Consumers are rational and make optimal choices

In classical economics, decision-makers are presumed to make
choices that maximize their utility—the satisfaction or happiness
derived from consuming goods and services. Rationality in this
context refers to the ability to weigh the benefits and costs of each
decision to maximize utility.
• They have stable preferences and full information
• They aim to maximize utility given a budget constraint
• Example: When purchasing a product, consumers
compare the utility they expect to derive from the product
against its price. The decision is rational if the utility
exceeds the price.
 Utility Maximization and Preferences
• Utility: Satisfaction derived from consuming goods/services
Utility theory models how people make decisions based on preferences. If
a person prefers bundle A to bundle B, then bundle A gives them higher
utility. Utility functions are used to represent preferences quantitatively.
• Example: If a person prefers a bhelpuri over a glass of lebur shorbot,
their utility for the bhelpuri is higher than for the shorbot.

▪ Marginal Utility (MU): Additional satisfaction from consuming one

more unit
▪ Law of Diminishing Marginal Utility: Each additional unit consumed
provides less extra satisfaction
• Example: The first cup of tea provides great satisfaction, but by the
fifth, the pleasure decreases
Indifference Curves and Budget Constraints
▪ Indifference Curves and Budget Constraints: These
concepts from microeconomic theory show the
combinations of goods that provide equal utility to a
consumer. Budget constraints represent the
combinations of goods a consumer can afford, given
their income and prices.
▪ Indifference Curve: Graph of different combinations of
goods that provide the same utility
▪ Budget Constraint: Represents combinations of goods a
consumer can afford
▪ Optimal Consumption: Where the budget line is
tangent to an indifference curve
 Criticism of Rational Choice Theory (1)

• While utility theory and rational choice are

fundamental in traditional economics, they have
been criticized for over-simplifying human behavior.
• People do not always make choices that maximize
utility due to factors like cognitive biases, emotions,
and social influences.
• Behavioral economics offers a more realistic view of
decision-making, accounting for these human
limitations.
 Criticism of Rational Choice Theory (2)

• Amartya Sen's Perspective:

Economist Amartya Sen, with roots in the region, has critiqued
the narrow definition of rationality in traditional economics. He
emphasizes the role of social commitments and ethical
considerations in decision-making, suggesting that individuals
may make choices that prioritize social welfare over personal
utility maximization.
 Limitations of the Rational Model
• Real-World Deviations:

People often act irrationally due to cognitive biases

Bounded Rationality: Consumers lack full information
and cognitive capacity
Emotions & Social Factors: Decisions are often
influenced by habits and peer pressure
Example: Many shoppers in Dhaka buy brand-name
items due to social influence rather than cost-benefit
analysis
 Local applications of ‘rationality’ in Bangladesh

Grameen Bank's Microcredit Model

Founded by Muhammad Yunus, Grameen Bank provides

microloans to the rural poor, enabling them to engage in income-
generating activities. Borrowers, primarily women, make rational
decisions to invest in small businesses, leading to improved
economic conditions. The bank's approach is underpinned by the
"Sixteen Decisions," a set of principles guiding borrowers
towards disciplined and prudent financial choices.
 Class Activity – Utility Maximization Game

• Assign each student a hypothetical budget (e.g., 500 taka)

• Provide a menu of goods with different prices
• Ask students to allocate their budget to maximize their utility
– Discuss why different students made different choices
– Did they always maximize utility, or were there other
factors influencing their decisions, such as social norms or
time preferences?
Readings
Varian, H. R. (1992). *Microeconomic Analysis* – Utility
Maximization and Consumer Choice
Simon, H. A. (1955). *A Behavioral Model of Rational Choice*,
Quarterly Journal of Economics