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PRACTICE EXAM QUESTIONS

Behavioural and Neo-Classical Economics (Revision

Essay Plan)
Levels: AS, A Level, IB Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

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Here is an essay plan on the following question: "To what extent is behavioural economics a
solution to all of neo-classical economics’ problems?”

Neo-classical economics has been the dominant force in economic thinking and policy-
making for many years. It formulates precise economic laws regarding production and
consumption through the calculation of cost and benefit at the margin. Consumers and
businesses are both assumed to act rationally, consumers optimise their purchasing power
by equating the marginal utility per pound spent, whilst producers seek to maximise profits in
both product and labour markets. Neo-classical economics believes in the concept of
equilibrium and the power of market forces to achieve an efficient allocation of resources.
Yes, there are instances of partial and complete market failure, but neo-classical economics
favours the usefulness of conventional interventions such as taxation and subsidy to change
incentives by altering relative prices and thus alter behaviour to help align social cost and
benefits. 

The neo-classical model of behaviour is built on these assumptions:

Agents choose independently

An agent has fixed tastes and preferences

Agents gather complete information on alternatives choices

Agents always make optimal choice given his/her preferences

This is not just a micro-model (associated for example with the standard theory of the firm),
it is also the foundation of much of macroeconomics e.g. rational expectations theory. In
other words, neo-classical economics has been for decades wedded to "Homo Economicus”
(a selfish and utility-maximizing, unboundedly-rational agent).

The emerging critique of neo-classical economics came first from economists who
questioned whether there was complete information Akerlof and Stiglitz (jointly awarded the
questioned whether there was complete information. Akerlof and Stiglitz (jointly awarded the
Nobel prize) showed that agents may suffer from information failure – for example, there are
many information asymmetries and this can lead to sub-optimal decisions (aka market
failure). But in their work agents were still assumed to make the ‘best’ choice given the
information they have. The work of Stiglitz and Akerlof extended the realism of conventional
theory and has been widely absorbed into mainstream economics, especially policies
designed to change the information available to consumers when the government is trying to
change consumption of merit and de-merit goods.

Simon in an important paper published in 1955 added further to the questioning of neo-
classical economics with his concept of bounded rationality. Most consumers and
businesses are unable to make fully-informed judgements when making their decisions and
the increasing complexity of products makes life difficult. People have limited attention
spans and computational capacity. Bounded rationality suggests that consumers and
businesses opt to satisfice rather than maximise. They will use rules of thumb (known as
heuristics) and approximations when active across different markets. Behavioural
economists point out that bounded rationality is not the same as irrationality, because
decision-makers are still attempting to make as rational a decision as possible. 

Behavioural economics started to emerge with the ground-breaking work of Kahneman and
Tversky (again both awarded the Nobel for Economics although Tversky died before it was
given).  ‘Agents reason poorly and act intuitively’ according to Kahneman. This view was
based upon numerous experiments in which there is a ‘rational’ answer but people frequently
don’t choose it. Systematic deviations from rationality were observed challenging many of
the assumptions of conventional thinking. Indeed, Thaler - who has popularised the concept
of nudges - has argued that "the real point of behavioural economics is to highlight
behaviours that are in conflict with the standard rational model."

In behavioural models:

People have limited computational capacity - they aim to satisfice rather than maximise

They are strongly influenced by social networks (where copying behaviour is common)
and by prevailing social norms

They often act reciprocally by making kind and generous gestures

They lack self-control and they tend to be present-biased (for example by heavily
discounting future benefits in favour of now)

They are loss averse - hating losses far more than commensurate gains

Their behaviour is strongly attached to existing default choices

They are influenced to some extent by persistent cognitive biases. A bias is a systematic
deviation from what is believed to be rational choice

Neo-classical economics assumes that all agents act rationally in their own self-interest. In
contrast, behavioural economics emphasises altruism. This is when humans behave with
ki d df i h ld b h if h b h d i ll l i i
more kindness and fairness than would be the case if they behaved rationally. Altruism is
often linked to the concept of inequity aversion i.e. humans do not like unequal outcomes.

There are many cognitive biases that can affect behaviour. One is the anchoring effect when
people rely heavily on an irrelevant piece of information to help us make a decision. Another
is the availability heuristic where we tend to over-estimate the likelihood of something
happening because a similar event has either happened recently or because we feel
emotional about a previous similar event. The optimism bias finds that people tend to be
overly confident about the outcome of planned actions and decisions and the scarcity bias is
the tendency to value something more if it is thought of as rare.

An important aspect of behavioural theory is loss aversion. The basic idea behind loss
aversion is that people feel losses much more than gains. We see this often in financial
markets for example when stock market investors hold their investment positions with paper
losses too long (hoping to that share prices will recover) and sell their investment positions
with paper gains too early.

Loss aversion

A modern economy dominated by knowledge and information services and where networks
are vitally important is better suited to ideas drawn from behavioural economics. Incentives
still matter but behavioural economics suggests that the motivations we have when making
choices are not those that are taught in orthodox economics. When it comes to addressing
persistent economic and social problems such as gambling addiction, rising obesity, anti-
social behaviour and the causes of instability in financial markets, behavioural ideas seem to
have plenty of validity. 

That said whilst Behavioural economics can make a major contribution to overcoming the
limitations of Neo-classical economics it is not necessarily a solution. The Behavioural
Economics approach itself has been criticised. For example, the use of laboratory
experiments has come under sustained attack in recent years. Many experiments have
involved using a skewed WEIRD cohort - i.e. many people involved in the tests were drawn
from Western, Educated, Industrialised, Rich and Democratic Countries and therefore not a
representative sample. Secondly, our observed behaviour in the laboratory is unrealistic -
tests normally use small stakes involved in the dilemmas with few real and lasting financial
consequences for participants. Thirdly, discoveries about the past from behavioural
experiments do not easily generalise to the future - the social context for one generation is
often different from another. Mainstream economists from the Neo-classical school challenge
behavioural theorists by saying that consumers, given sufficient incentives, will eventually
learn that their behaviour deviates from that of the rational model and adjust accordingly.

In my opinion, the academic discipline of Economics should also draw on new ideas from
other subjects. For example, we are becoming more expert in understanding neuro-
economics - how our brain processes decisions and the limitations that our neuro-system
imposes on our choices. Cognitive overload is common when we are faced with a huge array
of choices and people frequently fall back on simple heuristics in these situations. 

Economics can also learn much about behaviour from studying the Physics of networks and
from Linguistics about how the language of communication can change behaviour. If more
students were to take courses in History alongside conventional Economics modules, they
might be able to understand deeper historical patterns for example in financial markets. The
subject can also benefit from lessons from Anthropology which studies cultural influences on
behaviour. From Anthropology we learn that humans are complex psychological beings living
in different social contexts in which self-interest and altruism are often inter-twined. Most
people have an innate sense of fairness in how scarce resources are allocated within a
community.

Final reasoned comment

Neo-classical economics has built equilibrium models that have increasingly become
divorced from the lives of real people and businesses. In our complex world where
uncertainty is the new normal we cannot use a ‘one size fits all’ model for understanding the
economy. Behavioural economics is not a solution but, as Paul Ormerod has argued, “An
economist can no longer be said to have a good training in economics if he or she is not
familiar with the main themes of behavioural economics.” 

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