Behavioural economics studies how real decision-making departs from the fully rational, fully informed optimization assumed in many baseline economic models, and what those departures imply for markets and policy.
What it adds to standard models
A standard micro model assumes people maximize a stable utility function with correct beliefs and unlimited cognitive capacity. Behavioural economics relaxes those assumptions in structured ways:
- preferences can be reference-dependent,
- people can display present bias,
- limited attention can distort response to prices and information,
- heuristics can create predictable decision errors.
The field is not built on the vague claim that people are irrational. It is built on the stronger claim that the deviations are systematic enough to model.
Core mechanisms
Prospect theory
Prospect theory emphasizes loss aversion and probability weighting. People often evaluate outcomes as gains or losses relative to a reference point rather than in absolute utility terms.
Present bias
One common reduced-form model is (\beta)-(\delta) discounting:
$$ U_t = u(c_t) + \beta \sum_{k=1}^{\infty} \delta^k u(c_{t+k}), \quad 0 < \beta \le 1 $$
When (\beta < 1), near-term temptations are overweighted relative to long-run plans.
Limited attention and salience
Consumers may react strongly to visible prices or defaults while underweighting hidden fees, long-run costs, or low-salience information.
Why it matters in economics
Behavioural frictions can affect savings, debt, labor supply, insurance demand, asset pricing, and policy design. Choice architecture, disclosure rules, and default settings can matter even when the feasible set of options has not changed.
Related Terms
- Bounded Rationality
- Prospect Theory
- Hyperbolic Discounting
- Time Inconsistency
- Expected Utility
- Rational Expectations