Behavioural economics

Topic: Schools of Economic Thought and Economic Laws · NCERT: Beyond NCERT

Meaning

Behavioural economics is a field that combines psychology and economics. It studies how biases (errors in judgement that repeat in a set pattern), heuristics (mental shortcuts) and social norms (what people around us do or expect us to do) push real decisions away from strict rationality.

• It matters because these errors are systematic, not random. Random errors cancel out across a large population. Systematic errors add up and move savings rates, asset bubbles and tax compliance.
• Governments now use it to design low-cost policies called nudges. India's Economic Survey 2018-19 gave a full chapter to them [8].

Explanation

1. From homo economicus to real people

• Homo economicus ("economic man") is the textbook person who is fully rational and fully selfish. This person knows every option, calculates perfectly and always picks the best one.
• Thaler's work showed that human limits and biases shape economic decisions in a large and systematic way, for both individuals and institutions. This goes against the standard assumption that people always act rationally and selfishly [6].
• Bounded rationality (Herbert Simon, Nobel 1978): people are rational only within limits of:
• information: they do not know every option;
• time: decisions have deadlines;

• brainpower: the mind cannot compare hundreds of options.

• So people satisfice (satisfy + suffice). They pick the first "good enough" option instead of searching for the best one.

• Example: a job-seeker accepts the first offer above ₹30,000 a month and does not compare all 50 openings.
• The neoclassical consumer maximises utility (satisfaction). Simon's consumer satisfices.

2. Heuristics and biases (Kahneman–Tversky, 1974)

Heuristics save effort, but they cause systematic biases.

• Anchoring: leaning too heavily on the first number you see.

• A high printed MRP (maximum retail price), or "was ₹999, now ₹499", is shown → the buyer's idea of a "fair price" moves up → they are willing to pay more.

• Availability heuristic: judging how likely something is by how easily examples come to mind.

• Heavy media coverage of an air crash → the crash is easy to recall → people fear flying, even though road travel is riskier.

• Confirmation bias: looking only for information that supports what you already believe.

• Example: an investor who likes a stock reads only positive reports about it.

• Overconfidence bias: overrating your own knowledge or forecasting skill.

• Example: retail traders in derivatives (contracts such as futures and options, whose value comes from a share or an index).

3. Prospect theory (Kahneman–Tversky, 1979; Kahneman Nobel 2002)

• Prospect theory: people judge outcomes as gains or losses from a reference point, such as the price they paid. They do not judge them by their final total wealth. Standard expected utility theory says only final wealth matters.
• The 2002 Nobel is seen as the prize for behavioural economics, meaning the use of psychology in economic theory [7].
• Loss aversion: a loss hurts about 2 times as much as an equal gain pleases. This factor is the loss-aversion coefficient, λ (lambda).
• Worked example: a coin toss. Heads, you win ₹150. Tails, you lose ₹100.
• Expected value = 0.5 × 150 − 0.5 × 100 = +₹25. A fully rational person accepts the bet.

• Felt value = 0.5 × 150 − 0.5 × (2 × 100) = −₹25. A loss-averse person refuses. They accept only if the win is more than ₹200.

• Endowment effect: people value a thing more just because they own it. For example, a farmer will not sell inherited land at the market price but would never buy the same land at that price. Selling feels like a loss.

• Framing effect: the same facts, presented differently, change choices. Patients accept surgery more readily when told "90% survival" than when told "10% mortality".

4. Thaler's anomalies (Nobel 2017)

An anomaly is behaviour that standard theory cannot explain. Thaler co-wrote "Nudge: Improving Decisions about Health, Wealth, and Happiness" [6]. His prize is described as the prize for behavioural public policy [7].

• Mental accounting: treating money differently by its source or purpose, as if money were not fungible (every rupee can be swapped for any other rupee).

• Example: a person keeps ₹50,000 in savings at 3% and also carries ₹50,000 of credit-card debt at 36%. Paying off the debt would save ₹16,500 a year (33% of ₹50,000), but their "mental accounts" stop them.

• Present bias and hyperbolic discounting:

• Rational (exponential) discounting uses one fixed rate: PV = A / (1 + r)ᵗ. Here PV is present value, A is the amount, r is the discount rate and t is time.
• Hyperbolic discounting: PV = A / (1 + k·t), where k is an impatience parameter. The discount rate falls as the delay grows, so preferences are time-inconsistent.

• People take ₹100 today over ₹110 tomorrow. Yet they take ₹110 in 31 days over ₹100 in 30 days. When day 30 comes, they switch back → under-saving for retirement.

• Status quo bias: preferring the current state, even when better options exist. This is why defaults (the option that applies if you do nothing) are so powerful.

• Sunk cost fallacy: continuing something because of past spending that cannot be recovered.

• Example: a project has used ₹800 crore. It needs ₹500 crore more and will return ₹300 crore. The rational choice is to stop, because 300 < 500.

• Herd behaviour: following the crowd and ignoring your own information.

• Others buy → I buy → prices rise → more people join → a bubble forms and then bursts. Herding also drives bank runs and IPO frenzies.

In India

• Economic Survey 2018-19, Chapter "Leveraging the Behavioural Economics of 'Nudge'":
• The Survey's theme was "Shifting Gears" towards #Economy@5trillion, including behavioural nudges to design and deliver better outcomes. It cites the 2017 Nobel to Richard Thaler as the peak of the field's progress [9].
• Nudges sit between laissez-faire (leaving people fully alone) and incentives (paying or fining them). They change the choice architecture, meaning the way options are presented, and still leave people free to choose [8].
• The Survey named the Swachh Bharat Mission (SBM) and Beti Bachao Beti Padhao (BBBP) as success stories. #SelfieWithDaughter became a worldwide hit, and celebrating the girl child became a social norm that more people wanted to follow [5].

• It noted that people suffer from great inertia (reluctance to change) and stick to the default. Changing the default on an enrolment form costs almost nothing and uses this inertia for people's own good [8].

• Agenda proposed by the Survey [5]:

• from BBBP to BADLAV (Beti Aapki Dhan Lakshmi Aur Vijay Lakshmi);
• from Swachh Bharat to Sundar Bharat;
• from "Give it up" for the LPG subsidy to "Think about the Subsidy";

• from tax evasion to tax compliance.

• SEBI evidence of biased retail investors:

• About 9 out of 10 individual traders in equity F&O made net losses in both FY 2018-19 and FY 2021-22 [3].
• 93% of individual traders made losses in equity F&O between FY22 and FY24. Their total losses were more than ₹1.8 lakh crore over those three years [1][2].
• 7 out of 10 individual intraday traders in the equity cash segment made losses (SEBI study, July 2024) [4].
• Most traders keep trading despite repeated losses. This reflects overconfidence, herding and the sunk cost fallacy.

Don't confuse with

• Neoclassical (rational choice) economics: assumes homo economicus, who maximises. Behavioural economics says real people have bounded rationality and often satisfice.
• Efficient-market hypothesis (EMH): says share prices already reflect all information, so no one can beat the market regularly. Behavioural finance (Shiller, Thaler) challenges EMH. It argues that overconfidence and herding push prices away from true value.
• Nudge vs mandate/incentive: a nudge changes how options are presented and keeps free choice. A mandate forces a choice, and an incentive pays or fines. Nudges cannot replace mandates where the harm is serious [8].
• Exponential vs hyperbolic discounting: exponential uses a constant rate, so preferences stay consistent. Hyperbolic uses a rate that falls with delay, so preferences are time-inconsistent.

Prelims Hooks

• Nobel timeline: Herbert Simon (bounded rationality, satisficing) 1978; Kahneman 2002; Thaler 2017 [6]. The heuristics-and-biases paper came in 1974 and prospect theory in 1979.
• Loss aversion (losses weigh about 2× equal gains) and the endowment effect come from prospect theory, not from Thaler's list of anomalies.
• Framing trap: "90% survival" and "10% mortality" give the same facts but lead to different choices.
• Mental accounting breaks the idea that money is fungible. Status quo bias is why defaults (opt-out designs) work [8].
• The Economic Survey chapter on "Nudge" appeared in 2018-19. It named SBM and BBBP as successes and proposed BADLAV [5][9].
• SEBI: 93% of individual equity F&O traders made losses between FY22 and FY24, with total losses above ₹1.8 lakh crore [1].

Mains Points

• Nudge as low-cost governance (GS-II/GS-III):
• Changing defaults and using social norms costs little and keeps people free to choose. Examples are SBM, BBBP (#SelfieWithDaughter) and "Give it up" [5][8].

• Limits: nudges cannot replace mandates where the harm is serious [8]. Critics also call nudges paternalism, meaning the state deciding what is good for people.

• Retail investor protection:

• Overconfidence, herding and loss aversion help explain why 93% of individual F&O traders lost money between FY22 and FY24, with losses above ₹1.8 lakh crore [1].

• This supports SEBI-type action on disclosure and entry barriers, along with financial literacy.

• Savings and public investment:

• Present bias explains under-saving for retirement. Auto-enrolment and default contributions in pension schemes can raise household savings, which fund investment.
• The sunk cost fallacy keeps stalled projects alive. Reviews based only on future costs and benefits, and time-bound exit rules, improve how well public capital is used.

Related concepts

• Bounded rationality
• Satisficing
• Heuristics
• Anchoring
• Availability heuristic
• Confirmation bias
• Overconfidence bias
• Prospect theory
• Loss aversion
• Endowment effect

Read more

• Behavioural economics: bounded rationality, heuristics and biases