8. Behaviour in the macroeconomy

Behavioural macroeconomics has significant constraints, reflecting the difficulty of bringing together the choices of different people with widely different personality types, moods, and emotions, making decisions in complex ways using a wide range of heuristics that generate an even wider range of biases. ‘Behaviour in the macroeconomy’ explores how behavioural economists can overcome these difficulties, contributing to the development of innovative macroeconomic theories and collection of new types of behavioural macroeconomic data. It focuses on how social and psychological factors, including optimism and pessimism, help us to understand macroeconomic fluctuations; the impact of confidence and social mood on macroeconomic outcomes; and another theme in behavioural economics—happiness and well-being.

3. Social lives

‘Social lives’ explores some of the main ways in which social influences drive behaviour, including aversion to unequal outcomes, trust and reciprocity, social learning, and peer pressure. The interplay between trust and reciprocity is a key element in many of the cooperative and collaborative activities that we undertake daily. There are two main types of inequity aversion: disadvantageous and advantageous. Social norms are another set of social influences that drive our behaviour, and these are often reinforced through peer pressure. They help to explain how and why we have evolved as a cooperative species, but how do we ensure that no-one free rides on others’ generosity?

9. Economic behaviour and public policy

At its best, economics can help policy-makers to design policies that resolve a wide range of economic and financial problems, for individuals and economies as a whole. ‘Economic behaviour and public policy’ explores some key insights and evidence from behavioural public policy, particularly microeconomic policy. Instead of examining market failures, behavioural public policy looks at behaviour change—changing the way that people make their everyday decisions and choices by nudging them towards more efficient and productive decision-making. The future for behavioural public policy is promising. Policy-makers need to look carefully at how policies based around behavioural insights can be used to complement rather than replace conventional economic policy instruments.

6. Taking time

Often our everyday decisions unfold over time and what we want today is not always consistent with what we might want tomorrow. Understanding why many people do not behave in a way that is consistent with their own long-term best interests is a key challenge for behavioural economists and policy-makers. ‘Taking time’ explains how humans (and animals) suffer from present bias: we have a disproportionate preference for smaller, immediate rewards over delayed, larger rewards—a reflection of underlying time inconsistency. It considers the intertemporal tussle between our patient and impatient selves, pre-commitment strategies, and self-control. The behavioural life cycle models of choice bracketing, framing, and mental accounting are also discussed.

5. Risky choices

When we decide to cross the road, buy a lottery ticket, or invest our money, the decision involves risk and uncertainty. ‘Risky choices’ looks at how economists usually think of risk as quantifiable—in the form of expected utility theory—but behavioural economists challenge this understanding of risk. Daniel Kahneman and Amos Tversky developed prospect theory, which could incorporate the anomalous behaviour identified by the Allais and Ellsberg Paradoxes. They argued that any decision-making theory should be able to explain the certainty, reflection, and isolation effects. Alternatives to prospect theory include Richard Thaler’s mental accounting model and the regret theory of Graham Loomes and Robert Sugden.

4. Quick thinking

Deciding quickly is difficult when we face information and choice overload so in much of our everyday decision-making we use quick rules. ‘Quick thinking’ explores some of these rules—heuristics—and the consequences of using them. Sometimes heuristics work well, but sometimes they lead us into errors and mistakes. Psychologists Daniel Kahneman and Amos Tversky explore three main heuristics and the associated behavioural biases: availability, representativeness, and anchoring and adjustment. The availability heuristic can explain our habitual behaviours. Employing the representative heuristic, we match our judgements with our knowledge of prior scenarios and stereotypes. Anchoring/adjustment occurs when we anchor our decisions around a reference point, and adjust our choices relative to it.

2. Motivation and incentives

Incentives are the fundamental driver in economic analysis. Money is often the main incentive, but a complex range of other socio-economic and psychological factors also drive our decision-making. ‘Motivation and incentives’ outlines two groups of incentives and motivations: intrinsic and extrinsic. Extrinsic motivations can crowd out our intrinsic motivations when our intrinsic motivations are dampened by external rewards. Pro-social choices and image motivation are key drivers too, especially for charitable donations. Efficiency wage theory is another example of how economic and socio-psychological influences motivate effort at work. Insights from behavioural economics help us to develop a richer understanding of the complex motivations driving our choices and efforts, and their consequences.

7. Personalities, moods, and emotions

‘Personalities, moods, and emotions’ explains how and why psychological factors affect our economic and financial decision-making. It looks at measuring personality through OCEAN tests that capture traits across five dimensions: Openness to experience, Conscientiousness, Extraversion, Agreeableness, and Neuroticism. Our personalities have an impact on many of our economic and financial decisions and choices. Often decision-making requires some thought, and our personality traits can determine our cognitive skills and, through our cognition, drive our choices. Are emotions an irrational element in our decision-making or can emotions and rationality complement each other? The affect heuristic—where emotions guide our actions—is discussed along with the somatic market hypothesis, dual-system models, and neuroeconomics.

1. Economics and behaviour

Why is there so much interest in behavioural economics and how is it different? ‘Economics and behaviour’ explains how behavioural economists bring economics together with insights from other disciplines, such as psychology, sociology, neuroscience, and evolutionary biology. Using this multidisciplinary approach, behavioural economists enrich our understanding of economic and financial behaviour, without necessarily abandoning the analytical power often associated with conventional economics. Behavioural economists assume there are some limits to rational decision-making and draw on the concepts of bounded, ecological, and selective rationality. Behavioural economists also need to find relevant and reliable data including experimental and neuroscientific data. Natural experiments and randomized controlled trials are explained.