Behavioural Economics: A Review

This chapter reviews behavioural economics, thus setting the scene for the rest of the book. Behavioural economics first arose as an interdisciplinary endeavour between psychology and economics. Its main thrust is to challenge the rationality postulate, situated at the core of neoclassical economics. This chapter discusses the meaning of rationality, and the associated ideas of methodological individualism, rational choice, and the “Robinson Crusoe” model of an economy populated by identical representative individuals. A distinguishing feature of economics, as it embodies rationality, is its reliance on a small set of core concepts (preferences, constraints, expectations, optimisation, equilibrium) that purport to put the discipline on a secure footing. The thrust of this chapter is to review in detail the challenges and criticisms that have been directed at all these notions. Prominent in this analysis is an extensive review of the work of behavioural psychology that underpins behavioural economics. Associated with names such as Kahneman, Tversky, Thaler, and many others, it uncovers the many instances of heuristics, biases, illusions, rules of thumb, analogies, and metaphors that are commonly used in thinking and behaviour, and which violate in one way or another the rationality postulate. Instances of “boundedly rational” thinking are discussed in relation to decision-making under risk and uncertainty (prospect theory and loss aversion), intertemporal choice (present-bias and hyperbolic discounting), and in other areas. The distinction between “econs” (the fictitious agents that standard economic theory postulates) versus humans (with their behaviouristic traits) is drawn, and its implications are discussed, particularly in relation to financial markets.