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What is Behavioural Economics?

Before I start writing blogpost after blogpost about the wonders of the research done by behavioural economists, it might help quite a bit to establish what behavioural economics really is.

Behavioural economics is a relatively young field of research, and a part of the study of economics. Economics, or neoclassical economics as we know it now, analyses the decision-making process of the homo economicus. The homo economicus has four core assumptions when it comes to decision-making: rationality, self-interest, utility maximisation and transitivity (ur Rehman, 2016).

We will first look into the four core assumptions of the homo economicus as proposed by neoclassical economics. After that we will see how, as a reaction to these assumptions, behavioural economics became a science of its own. Studying not the decision-making process of the homo economicus, but the decision-making process of real human beings.

1. Rationality The first assumption is rationality. In neo-classical economics rationality means having all the necessary information to make the best choice, or having the time to seek out all possible information.

In this day and age to be aware of everything, let alone know and remember everything is no small feat. Not to mention that no one has the time to find out all there is to know before making a decision. Suddenly, the decision on which phone to purchase would be such a time-consuming and intensive labour, that once it would be completed, you could start over again as the market and its products keep evolving. There would be no end to it! Rather than going through all information, we employ mental shortcuts (heuristics) to make decisions quickly (Gigerenzer and Selten 2002; Tversky and Kahneman, 1974).

2. Self-interest Self-interest is defined as only looking out for oneself. Within neoclassical economics this means choosing the option that has the highest value for oneself, regardless of the consequences of this choice to others. If the option to make oneself better off whilst making others worse off is available, homo economicus will take it.

Research done on the redistribution of resources shows that people are not nearly as selfish as expected. An example of such done is the dictator game, in which participant 1 can choose how much of a resource to distribute to participant 2, with full anonymity and no punishment. In general, participants will still give around 20% to their fellow participants, in conditions of full anonymity (List, 2007). These percentages are even higher when anonymity is not ensured, or the participants have the option to communicate or know each other (List, 2007). Other phenomena that are difficult to reconcile with self-interest are (anonymous) charity donations and voluntary work.

3. Utility Maximisation The third assumption of our homo economicus is utility maximisation. Utility is the value people put on and experience from objects and/or actions. Utility can be just monetary value, but is often extended to include sentimental value, societal norms and is adjusted for risk and timing (delay) as well. Maximisation is the obtaining of the highest value possible.

Research has shown us that people are terrible at utility maximisation, and the reason that they are terrible at it is because of the first axiom not holding up. People are not rational, as a result they make decisions that are irrational, and do not maximise utility. A great example is known as the marshmallow experiment (Houser et al,2008). Kids are seated in front of one marshmallow and are told that if they manage to wait fifteen minutes without eating the marshmallow, they get another marshmallow. Homo economicus would be willing to wait to get the utility of two marshmallows. But people, especially kids, struggle and often succumb to temptation. When making decisions that involve risk, uncertainty, delayed rewards and emotions, utility maximisation is more often an ideal than a reality.

4. Transitivity The last core assumption of the homo economicus is transitivity. Transitivity is the stable ordering of preferences (Lee et al, 1996). In simple terms: If I prefer apples to oranges, and oranges to grapes, I should prefer apples to grapes. So if I have before me a fruit basket with these three fruits, and I may only eat one, I should, without fail, always choose the apple, as my preferences are stable.

Transitivity is a core axiom that does not take into account context. If I had gone 100 days of just eating apples, no one would be surprised to find me wanting an orange. However, homo economicus has established he would derive the highest utility from eating apples, and as he is a utility maximiser, he will continue to eat apples. Transitivity also assumes that we know our entire preference set, and have a ranking for all objects and actions imaginable (ur Rehman, 2016). As outlined with the first axiom, rationality, this is quite implausible given the limited time, attention span and mental capacity most people have (Gigerenzer and Selten, 2002).

As outlined above, there are some serious plot holes in the four core axioms making up the homo economicus. However, economics did not hold on these assumptions without reason. On a macro or aggregate level, the models made with these assumptions are not extremely inaccurate. To a certain extent, these models are able to represent and predict outcomes accurately enough. However, rationality, self-interest, utility maximisation and transitivity have all suffered from many studies from the fields of psychology and experimental economics (for an overview see: Gintis, 2000), proving their inability to hold up. This is where behavioural economics comes in.

Behavioural economics is simply the study of economic decision-making, releasing these four core axioms. It approaches people as decision-makers that have limited time and even less of an attention span. Decision-makers that are easily deceived by marketing ploys, have faulty memory, have priorities that are not in line with utility maximisation. Individuals that half of the time really don’t know what they want and are just following the crowd or are as indecisive as an ostrich. It takes all kinds, which is exactly what behavioural economics studies: economic decision-making of the imperfect individual.

References Gigerenzer, G., & Selten, R. (Eds.). (2002). Bounded rationality: The adaptive toolbox. MIT press.

Gintis, H. (2000). Beyond Homo economicus: evidence from experimental economics. Ecological economics, 35(3), 311-322.

Houser, D., Reiley, D. H., & Urbancic, M. B. (2008). Checking out temptation: A natural experiment with purchases at the grocery register. Unpublished manuscript, University of California, Berkeley, University of Arizona, and George Mason University.

Lee, L., Amir, O., & Ariely, D. (2006). In search of homo economicus: Preference consistency, emotions, and cognition.

List, J. A. (2007). On the interpretation of giving in dictator games. Journal of Political economy, 115(3), 482-493.

Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. science, 185(4157), 1124-1131.

ur Rehman, T. (2016). Historical context of behavioral economics. Intellectual Economics, 10(2), 128-132.


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