Session 3

(HL)

09.23.2022
Irina Kovaleva
 Goals
By the end of this class, you should be able to:

1. Understand the income and substitution effects

2. Understand the concept of rational consumer choice
3. Define and explain behavioral economics
4. Explain the "Dual System Model"
5. Define and explain cognitive biases
6. Define, explain and give examples of choice architecture
and nudge theory
 How do economists explain the Law of
Demand
One explanation of the Law of Demand suggests that, when the price of а product falls,
there is an increase in the quantity demanded of the product for two reasons:
1. Income effect: When the price of а product falls, then people will have an increase
in their "real income", which reflects the amount that their incomes will buy. With this
increase in real income, the people will be likely to buy more of the product, thus partly
explaining the reason for an increase in quantity demanded when there is а fall in the price
of а product.
• Example: if someone buys 14 caffe latte coffees each week and they pay $2.95 for
each cup, then their total spending is $41.30 per week.
• If the price of the coffee is reduced to $2.45, then they will save $0.50 per cup, а total
of $7.00 per week.
• In effect, the person now has $7.00 more income to spend each week.
• Her "real income" has increased by $7.00.
• The income effect means that she may now buy more coffees, thus increasing the
quantity demanded.
 How do economists explain the Law of
Demand
2. Substitution effect: It is argued that people receive а certain amount of satisfaction
(or benefit) when they consume а product. This satisfaction is known as utility.
• When the price of а product falls, people will still gain the same amount of
satisfaction (utility) from the product as before, but they will be paying less for it. So,
their ratio of satisfaction to price will have improved.
• This means that the product will now be relatively more attractive to people
compared with other products, whose prices have stayed unchanged.
• So it is likely that consumers will purchase more of the product, substituting it for
products that have а poorer ratio of satisfaction to price.
• Example: if а person receives 10 utils (а measurement of satisfaction) from а cup of
caffe latte and the cost is $1.95, then the ratio of satisfaction to price is 1 util to $0.195.
If the price of the coffee falls to $1.45, then the ratio changes to 1 util to $0.145. The
consumer is paying less to get the same amount of satisfaction and so the coffee will
be more attractive. It will be а "better deal".
 How do economists explain the Law of
Demand
The final outcome of а fall in price on the quantity demanded of а product
will, in the end, be а combination of the income effect and the
substitution effect.

Income effect. How a change in

Substitution effect. How a
demand for a good is affected by
change in price of a good affects
a change in real disposable
demand compared to others. If
income. If price of school fees
price of apples rises, consumers
rises, this reduces disposable
will substitute apples for other
income and therefore, demand
goods like bananas.
will fall.
 What are the key assumptions behind the
theory of demand?
• Economic models are developed to explain economic
behaviour. In creating these models certain
assumptions have to be made in order to test and
validate the hypotheses that are needed to generate
economic theories.
• In neoclassical theory, key assumptions are made about
the way in which consumers, as economic "agents",
make their choices.
• In this standard economic model, it is assumed that
consumers behave rationally.
• This means that faced with an economic decision,
consumers are able to consider all the possible options
and work out which option will give them the most
satisfaction, or utility (пользу).
 What are the key assumptions behind the
theory of demand?
In other words, consumers will always seek to maximize their utility.
In making their decisions, it is assumed that consumers act only in their own self-
interest; they do not take into account the interests of others.
• Furthermore, it is assumed that when making
decisions or choices, consumers have access to all
the relevant information about each of their choices.
• This is known as the assumption of perfect
information.
• In the standard model, this rational consumer is
known as homo economicus.
• When faced with choices, it is assumed that homo
economicus will make intelligent, logical and well
considered decisions that give them the most utility.
 What is behavioral economics?
Bounded rationality is the
theory that consumers have
limited rational decision
• Richard Тhaler is regarded as а pioneer in the field of behavioral economics and
making, driven by three
won а Nobel Prize for his work in 2017. main factors – cognitive
• He refuted the notion that consumers are "rational maximizers" whotime
ability, areconstraint, and
imperfect information. For
essentially mathematical machines able to carefully calculate every decision to
example, when ordering
enable them to maximize their utility. at a restaurant,
• He observes that а problem with the field of economics is that it studies
customers themay make
suboptimal decisions
behavior of people that simply do not exist, presenting the viewbecause
that there is no
they feel rushed
such person as homo economicus. by the waiter.
• We are all homo sapiens!
• In everyday English, he uses the terms "Econs“ for homo economicus and
"Humans" for "real people". According to Тhaler, Econs and Humans exhibit
the following characteristics:
 Exercise 3.3
ATL Thinking and Communication
Which phone should I buy? Homo economicus will:
➔ know exactly what she wants from her phone
➔ research the capabilities of all the different phones
➔ understand all the information that is provided
➔ be able to compare all the models
➔ know the prices of each and every phone on the market
➔ know how long each phone will last
➔ know what she will need from her phone in two years
➔ be able to know which phone makes her happiest.
ln pairs, discuss how realistic the statements above are.
What difficulties might homo economicus face?
How realistic are the key assumptions of the
rational consumer model?
• One key assumption of the standard economic model that is challenged by what
actually happens in the real world is that of perfect information.
• This is the assumption that all economic agents have access to all the same
information at the same time. This would imply that consumers have perfect
information about the price and quality of all products in the market.
• There are several problems associated with this.
 One is that in the real world, there are "information asymmetries" where different
economic agents (consumers, producers and the government) have different levels of
information available to them where economic transactions are concerned.
 Another relates to the fact that even if all the information were available, humans face
limits in terms of how they can actually process the information that is available to
them. In today's world, with the Internet providing access to seemingly infinite
information, we often face the situation of information overload. Therefore, in the real
world, consumers make decisions based on imperfect information.
How realistic are the key assumptions of the
rational consumer model?
• Consumers face huge challenges in making economic choices and are unable to make
decisions in the rational manner assumed by the standard economic model.
• In the standard economic model, humans act in their own self-interest. In other words,
consumers are assumed to act selfishly, only taking their own objective of utility
maximization into account when making choices.
• In fact, humans do care about others. We volunteer work, we give to charities, we buy
Fairtrade products because we are concerned about the wellbeing of farmers.
• All of these show that the assumption of self-interest may be challenged.
• The term bounded selfishness is used to explain that humans do not always act in their
own self-interest as assumed by the neoclassical model.
• Finally, it is assumed that when acting rationally, consumers are able to demonstrate
perfect willpower. In reality, consumers are unlikely to be able to do this. We use the
term bounded self-control to illustrate this natural tendency to give in to temptation
sometimes.

ATL Thinking and Communication
Economic Man vs
Humanity: а Puppet Rap
Battle
Watch this creative rap
video from Kate Raworth,
the author of Doughnut
Economics, to understand
limitations of the
assumption of rational
human behaviour:
https://youtu.be/Sx13E8-zUtA
Exercises 3.4/3.5
Would you like а Caffe Latte, Americano,
Cappuccino, Espresso, Flat White, Long Black,
Mocha, Macchiato, Mochaccino, Frappuccino,
Small, Medium, Large, Takeaway?
Is it possible to have too
much choice? What
problems do people have
to face when they are
presented with а vast
range of choices? Does it
make the decision easier
or more difficult?
 How can the "Dual System Model" explain how
humans actually act?
• In order to explain why Humans make decisions that are different from Econs,
behavioural economics draws on the experimental work of psychologists Daniel
Kahneman and Amos Tversky who developed the “dual system model".

• According to this model, individuals actually have two different systems of

thinking, known as System 1, the fast thinking system, and System 2, the slow
thinking system.

• In his book, Nudge, Richard Thaler calls System 1 the “Automatic System“ and
System 2 is the “Reflective System".
 Тhе Automatic System involves fast decisions that are essentially subconscious
(по существо подсознательные).
 Тhе Reflective System involves slow decisions that are much more controlled.
 How can the "Dual System Model" explain how
humans actually act?
Тhе characteristics of each of the types of thinking system are illustrated below:
You would use automatic thinking to: You would use reflective thinking to:
 Answer the  Answer the
question, “What is question,
three plus four?” "What is 1989
 Get home from times 31?"
school on the route  Choose your
that you have taken IВ subjects
every day for the  Have а
last year conversation
 Speak in your in а second
mother tongue language in
 Do your grocery which you are
shopping not fluent.
 How can the "Dual System Model" explain how
humans actually act?
• Neoclassical economists would claim that rational consumers make all their decisions
using reflective thinking. However, this is obviously not the case.
• When people have important and complex decisions to make, they usually use elements
of the Reflective System and take their time to make а decision.
• However, sometimes they let the Automatic System take over and this can result in poor
decision-making.
• This is particularly а problem when we make а short-term decision too quickly, without
considering the long-term effects.

• For example, if you have decided to go on а diet to become more healthy and you are
offered something like а doughnut that you eat because you just can't resist it, then you are
using your automatic thinking. Obviously, you should reflect on the decision and come
to the rational decision that the short term benefit from the doughnut is not worth the
longer term loss of remaining overweight.
 How can the "Dual System Model" explain how
humans actually act?
• 0n а day to day basis, we make thousands of decisions, and have to cope with а
tremendous amount of information. In order to make them quickly, we employ certain
mental "rules of thumb".

• The rules of thumb (эмпирические правила) that we use to make quick decisions
are also known as "heuristics« (эвристика).
• А heuristic may be defined as а mental shortcut that allows people to make decisions
and solve problems quickly and efficiently.
• However, there are "cognitive biases” (когнитивные искажения) implicit in the
short cuts we employ that may be problematic and result in poor decisions.
• If we let our impulsive automatic thinking take over when making an important
decision, we might make choices that we will regret later.
• Impulse buying is an example of this.
 Exercise 3.6
ATL Thinking and Communication
Try to think of а choice
that you have made and
then regretted afterwards.

Using the terms System 1

thinking and System 2
thinking, explain how you
might have chosen
differently.
 What are the cognitive biases (искажения) that
affect decision-making?

• Psychologists have identified many biases that affect consumer choices.

• Behavioural economics uses the understanding of these biases to help consumers
make better choices:
1. Availability bias
2. Anchoring bias
3. Framing bias
4. Social Conformity/Нerd behavior
5. Status Quo/Inertia bias
6. Loss aversion bias
7. Hyperbolic discounting
 1. Availability bias
(предвзятость доступности)
The availability of recent information and examples tends to over­influence
people's decision making.
• If there is а case of salmonella in one part of а country,
consumers might assume that it will occur nearby and they
might choose different food options as а response, even if
there is absolutely no risk in their area. It turns out that
consumers are actually quite poor at assessing risk and
probabilities, relying on recent examples rather than
carefully-examined data.
• А common example is young smokers, who see а much
older person who is also а smoker. It is quite possible for
the young smokers to delude themselves into thinking
smoking is not dangerous, despite all the information to
the contrary, because the older person is perfectly healthy.
 2. Anchoring bias
(эффект привязки)
• Anchoring occurs when we are given the value of something, and then use this
value as a reference point to influence future choices or decisions.
• Once an anchor value has been set in our minds, we tend to rely too much on
it, and this can lead to poor decisions.
• Supermarkets use awareness of this bias in their pricing.
• Example. Consumers anchor certain prices in
their minds, and when there is a sale and the
price drops, the consumers feel that they are
getting a very good deal and may purchase
more than they really need.
• Salespeople use this when prices are
negotiable by offering a very high starting
price and then accepting a lower price that is
still higher than what the product should cost.
 3. Framing bias
(эффект фрейминга)
The way that information is presented to us influences our choices.
In many cases, especially where data is presented, а given piece of information
may be presented in either а positive way or а negative way.
When information about а product is framed in а very positive manner, it will
lead consumers to think more positively about the product.
• Evidence of this can be seen in all kinds of marketing
and advertising.
• Example. If you see that а particular yoghurt is
labelled as “80% fat-free", it will be а lot more
appealing than а label which says "contains 20% fat".
• Although the product would be identical, the framing
of the information induces а cognitive bias.
 4. Social Conformity/Нerd behavior
(cоциальное соответствие/стадное поведение)
As consumers, we naturally want to fit in.
The way that others behave can exert powerful influence on our own
choices. It can be very gratifying and rewarding to be like others.
An obvious example would be changing clothing fashions.
• Producers are able to convince people to buy
more clothes in order to fit into the new styles,
even when their own clothes are perfectly good!
• This is also known as the “Bandwagon Effect”.
(эффект присоединения) and is used to describe
the behaviour of people when they join a
perceived majority of people in doing something,
even if it is against their best-interest.
 5. Status Quo/Inertia bias
(возврат к исходному состоянию)

• It is often the case that consumers, faced with a bewildering (сбивающий с

толку) set of choices, would prefer to maintain the status quo by doing nothing.
• An example would be what a consumer might do when their mobile phone
contract expires.
• It could be a very good time for the consumer
to investigate other options, and maybe
consider entering into a contract with another
mobile service provider.
• However, faced with the challenge of
researching into all the available options, it is
quite likely that the consumer will prefer just to
stick with the same provider.
 6. Loss aversion bias
(неприятие потерь)
Experiments show that humans feel that losses are far more significant than gains.
• It has been estimated that the pain that people feel from losing something is
psychologically about twice as powerful as the pleasure that they get from gaining
something.
• This leads to the situation where people might make poor choices because they fear
that they will lose something, even if their reasoning is not well-informed.
• Businesses can take advantage of this bias by
making consumers feel that they will lose
something if they don't purchase а good.
• If you see а sign saying, "Buy now before stocks
run out!", you should be aware that the
producer is trying to make you feel that you will
lose out if you don't take advantage of the offer.
 7. Hyperbolic discounting
• This is very fancy name for something that everyone can relate to.
• It refers to the tendency of humans to prefer smaller short-term rewards over
larger later rewards.
• Example. lf your Economics IA is due the day after tomorrow and you haven't
even started it, you should probably get started right away - at least decide on
the article you are going to analyze.
• However, you decide that you would prefer to go
out this evening and enjoy yourself, as you
convince yourself that you will do a much better
job in the morning.
• This is an example of hyperbolic discounting - you
prefer the short-term reward of a night out, rather
than the longer-term reward of getting the work
finished.
Cognitive biases that affect
decision-making

1. Availability bias
2. Anchoring bias
3. Framing bias
4. Social Conformity/Нerd behavior
5. Status Quo/Inertia bias
6. Loss aversion bias
7. Hyperbolic discounting
 Exercise 3.7
ATL Thinking and Communication
This picture was taken in а local supermarket.

How has the company taken advantage of

cognitive biases to try to get consumers to
buy the product?

Research Black Friday and Singles’ dау.

How do retailers take advantage of any of the

cognitive biases on these days?
 How саn behavioural economics bе used to
help consumers make better choices?
Given the many cognitive • Choice architecture is the theory that
biases which cause consumers the decisions that we make are heavily
to make poor choices influenced bу the ways in which the
sometimes using their System
choices are presented to us.
1 (automatic) thinking system,
behavioural economics aims to • We make many decisions every day
help consumers make better but we might not realize the extent to
choices. which those choices are influenced bу
One way of doing this is to alter the way that someone, referred to as а
the choice architecture that "choice architect", presents the
consumers face. choices to us.
 1. Impulse buy
A very simple example from supermarkets can be used to
explain the term.
• When you shop in a supermarket, you will find all kinds of
products right at the cash desk that encourage you to
"impulse buy".
• They are not there by accident; the "choice architect" has
placed them there because it is assumed that while you are
waiting there, you will be tempted to buy those products.
• This is especially the case if they are chocolate bars or
candies and you are waiting with a small child who will have
a temper tantrum (истерика) if you don't buy them!
 2. Default choice
• An example of an area where choice architecture can be observed is when а
default choice (выбор по умолчанию) is changed.
• There are two ways of explaining the default choice.
1. One is that it is the pre-set option that is effectively selected if the decision-
maker does nothing. In other words, it is what you get if you do nothing.
• Example. Google is the default search engine on many browsers - it does not
have to be selected, it opens automatically.
2. The second is that it is the choice that is always followed
unless а deliberate decision is made to change it. In other
words, you carry on making the same choice because it is а
habit.
• Example, if you always get а caffe latte when you go to
the coffee shop, then it becomes your default option.
 2. Default choice

• Although the default options do not always result in а good

outcome, they are very popular for many reasons.
1. Consumers may not have the time or the resources to
research altematives,
2. they may lack the cognitive skills to understand the
alternatives,
3. they may lack the courage (храбрость) to make changes,
4. they are comfortable with what they normally choose and
they generally like the easier options!
 3. Opt-in/opt-out approach
Consider the case of organ donation.
There is always а shortage of organs for organ transplants.
One way to increase the supply of organs available for transplants is to increase the
number of people that consent to donate their organs in the event of their death.
There are different systems for doing this.
One system is the opt-in/opt-out approach.
• If а country operates an opt-in system, it is the responsibility of people to actively sign up
to the organ donation register. This allows hospitals to use their organs for transplants
after death.
• In an opt-out system, organs will automatically be donated unless people make а specific
request before death that their organs should not be taken. If а country operates an opt-
in system, then opting-in is the default option.
• Changing the default option from opt-in to opt-out is seen as one way of using choice
architecture to increase the number of people who consent to having their organs
donated.
 4. Mandated choice
• Another way in which choice architects can influence consumers is through
mandated choice.
• These are situations where people are required by law to make а choice in
advance.
• In the example of an organ donation, people are required by law to indicate if
they are willing to become an organ donor in the event of their death.
• The way that the government can do this is by requiring people to tick а box
to say whether or not they are willing to be donors when they renew their
driver's license.
• Although many people would like to be organ donors, when left to themselves
to register as donors, many do not make the effort to indicate this choice.
When the choice architects force people to make the choice, the number of
organ donations increases substantially.
 How can people be encouraged to make
better choices?
• Nudge theory (теория подталкивания) was developed by behavioural
economist Richard Thaler.

• The theory suggests that the choice architecture offered to people can be
carefully designed to gently encourage (nudge) the people to voluntarily
choose the option which is better for them.

• Behavioural economics in general, and nudge theory in particular, became

much more well-known and accessible to the general population following
the publication of Richard Thaler and Cass Sunstein' s book Nudge:
“Improving decisions about health, wealth and happiness”.
 Nudge theory
• The key to nudge theory is that consumers maintain their consumer
sovereignty (their right to choose) but are encouraged to make better
decisions.
• А commonly cited example of this relates to the positioning of food in а
school cafeteria.
• If healthy foods are placed in а very convenient, easy-to-reach, easy-to-see
place, evidence shows that students will consume more of them.
• They are not forced by anyone to choose the healthy foods, but the
placement "nudges" the students subconsciously to choose them.
• The key thing is that the students are not forced to choose the healthy option,
but they do it themselves.
• The argument is that students are more likely to pick up healthy habits if they
are making the choices themselves.
 Nudge theory
• If consumers use their System 1 thinking system and subconsciously fall
back on rules-of thumb which cause them to make poor decisions, then
they may need to be nudged towards better decisions.
• А good example where nudges have been used to help people make
better decisions is in the area of pension savings.
• In many more economically developed countries, governments provide
pension schemes that are designed to allow people to have а decent
standard of living when they retire.
• However, these pensions schemes are under considerable threat due to
the fact that people are living longer, and governments are unable to
finance the pensions.
• Therefore, there is а need for people to set up private savings schemes
to ensure that they have enough money when they retire.
 Nudge theory
The work on nudge theory by behavioural economists has had а big impact on
governments and organizations all around the world who are now nudging people in
countless ways to help people make ‘’better" decisions. These have contributed to
improvements in people's standards of living, their health, their communities and the
environment.
Nudge theory is not without its critics.
Any form of government intervention may be accused of taking away individual rights.
There is also the concern that governments do not actually know what is best for people
and so cannot be trusted to choose how to nudge people.
However, behavioural economists argue that the belief that markets operate efficiently
on their own is based heavily on the assumption that consumers act rationally and this
assumption can be easily challenged.
Their vast experimental work shows how the insights from psychology can be used to
select carefully designed and tested interventions to nudge consumers in the right
direction, without taking away their rights to choose.