Most economic models assume that people make choices based on achieving the best possible economic outcome for themselves. Human behaviour, however, is often not so simple. Rather than acting like economic computing machines, people often make choices that fall short—sometimes far short—of the greatest possible economic outcome, or payoff. Why people sometimes make less-than-perfect choices is the subject of behavioural economics, a branch of economics that combines economic modelling with insights from human psychology. Behavioural economics grew out of economists’ and psychologists’ attempts to understand how people actually make—instead of theoretic-ally make—economic choices.

It’s well documented that people consistently engage in irrational behaviour, choosing an option that leaves them worse off than other available options. Yet, as we’ll soon learn, sometimes it’s entirely rational for people to make a choice that is different from the one that generates the highest possible profit for themselves. For example, Maria may decide to earn a social work degree because she enjoys social work more than financial services, even though the profit from the social work degree is less than that from continuing with financial services.

The study of irrational economic behaviour was largely pioneered by Daniel Kahneman and Amos Tversky. Kahneman won the 2002 Nobel Prize in economics for his work integrating insights from the psychology of human judgment and decision making into economics. Their work and the insights of others into why people often behave irrationally are having a significant influence on how economists analyze financial markets, labour markets, and other economic concerns.

If you are rational, you will choose the available option that leads to the outcome you most prefer. But is the outcome you most prefer always the same as the one that gives you the best possible economic payoff? No. It can be entirely rational to choose an option that gives you a worse economic payoff because you care about something other than the size of the economic payoff. There are three principal rational reasons why people might prefer a worse economic payoff: concerns about fairness, bounded rationality, and risk aversion.

Concerns About Fairness In social situations, people often care about fairness as well as about the economic payoff to themselves. For example, no law requires you to tip a waiter or waitress. But concern for fairness leads most people to leave a tip (unless they’ve had outrageously bad service) because a tip is seen as fair compensation for good service according to society’s norms. Tippers are reducing their own economic payoff in order to be fair to waiters and waitresses. A related behaviour is gift-giving: if you care about another person’s welfare, it’s rational for you to lower your own economic payoff in order to give that person a gift.

Bounded Rationality Being an economic computing machine—choosing the option that gives you the best economic payoff—can require a fair amount of work: sizing up the options, computing the opportunity costs, calculating the marginal amounts, and so on. The mental effort required has its own opportunity cost. This realization led economists to the concept of bounded rationality—making a choice that is close to but not exactly the one that leads to the highest possible payoff because the effort of finding the best payoff is too costly. In other words, bounded rationality is the “good enough” method of decision making. When someone needs to replace an appliance like a broken washing machine, it is too time-consuming to research each available model. Some people might read magazines such as Consumer Reports or check online for reviewer comments before making a choice. The washing machine might not maximize their payoff in terms of features based on the price paid, but the new machine is good enough.

Retailers are particularly good at exploiting their customers’ tendency to engage in bounded rationality. For example, pricing items in units ending in 99¢ takes advantage of shoppers’ tendency to interpret an item that costs, say, $2.99 as significantly cheaper than one that costs $3.00. Bounded rationality leads them to give more weight to the $2 part of the price (the first number they see) than the 99¢ part.

Risk Aversion Because life is uncertain and the future unknown, sometimes a choice comes with significant risk. Although you may receive a high payoff if things turn out well, the possibility also exists that things may turn out badly and leave you worse off. So even if you think a choice will give you the best payoff of all your available options, you may forgo it because you find the possibility that things could turn out badly too, well, risky. This is called risk aversion—the willingness to sacrifice some potential economic payoff in order to avoid a potential loss. (We’ll discuss risk aversion in more detail in Chapter 20.) Because risk makes most people uncomfortable, it’s rational for them to give up some potential economic gain in order to avoid it. In fact, if it weren’t for risk aversion, there would be no such thing as insurance.

Sometimes, though, instead of being rational, people are irrational—they make choices that leave them worse off in terms of economic payoff and other considerations like fairness than if they had chosen another available option. Is there anything systematic that economists and psychologists can say about economically irrational behaviour? Yes, because most people are irrational in predictable ways. People’s irrational behaviour typically stems from six mistakes they make when thinking about economic decisions. The mistakes are listed in Table 9-7, and we will discuss each in turn.

Misperceptions of Opportunity Costs As we discussed at the beginning of this chapter, people tend to ignore nonmonetary opportunity costs—opportunity costs that don’t involve an outlay of cash. Likewise, a misperception of what exactly constitutes an opportunity cost (and what does not) is at the root of the tendency to count sunk costs in one’s decision making. In this case, someone takes an opportunity cost into account when none actually exists.

For example, shortly after a firm spends thousands of dollars in upgrading their equipment, newer more efficient equipment becomes available. This newer equipment would allow the firm to produce its products at lower cost (and with higher expected future profit). However, it will cost the firm thousands of dollar to acquire the equipment. Focusing on the short-run profit and thinking of the sunk costs, the firm may be reluctant to pay additional money to purchase the new equipment. However, that choice is irrational. By giving up the opportunity to use more efficient equipment, the firm forgoes higher long-run profits.

Overconfidence It’s a function of ego: we tend to think we know more than we actually do. And even if alerted to how widespread overconfidence is, people tend to think that it’s someone else’s problem, not theirs. (Certainly not yours or mine!) For example, a 1994 study asked students to estimate how long it would take them to complete their thesis “if everything went as well as it possibly could” and “if everything went as poorly as it possibly could.” The results: the typical student thought it would take him or her 33.9 days to finish, with an average estimate of 27.4 days if everything went well and 48.6 days if everything went poorly. In fact, the average time it took to complete a thesis was much longer, 55.5 days. Students were, on average, from 14% to 102% more confident than they should have been about the time it would take to complete their thesis.

As you can see in the nearby For Inquiring Minds, overconfidence can cause problems with meeting deadlines. But it can cause far more trouble by having a strong adverse effect on people’s financial health. Overconfidence often persuades people that they are in better financial shape than they actually are. It can also lead to bad investment and spending decisions. For example, non-professional investors who engage in a lot of speculative investing—such as quickly buying and selling stocks—on average have significantly worse results than professional brokers because of their misguided faith in their ability to spot a winner. Similarly, overconfidence can lead people to make a large spending decision, such as buying a car, without doing research on the pros and cons, relying instead on anecdotal evidence. Even worse, people tend to remain overconfident because they remember their successes, and explain away or forget their failures.

Unrealistic Expectations About Future Behaviour Another form of overconfidence is being overly optimistic about your future behaviour: tomorrow you’ll study, tomorrow you’ll give up ice cream, tomorrow you’ll spend less and save more, and so on. Of course, as we all know, when tomorrow arrives, it’s still just as hard to study or give up something that you like as it is right now.

Strategies that keep a person on the straight-and-narrow over time are often, at their root, ways to deal with the problem of unrealistic expectations about one’s future behaviour. Examples are automatic payroll deduction savings plans, diet plans with prepackaged foods, and mandatory attendance at study groups. By providing a way for someone to commit today to an action tomorrow, such plans counteract the habit of pushing difficult actions off into the future.

Counting Dollars Unequally If you tend to spend more when you pay with a credit card than when you pay with cash, particularly if you tend to splurge, then you are very likely engaging in mental accounting. This is the habit of mentally assigning dollars to different accounts, making some dollars worth more than others. By spending more with a credit card, you are in effect treating dollars in your wallet as more valuable than dollars on your credit card balance, although in reality they count equally in your budget.

Credit card overuse is the most recognizable form of mental accounting. However, there are other forms as well, such as splurging after receiving a windfall, like an unexpected inheritance, or overspending at sales, buying something that seemed like a great bargain at the time whose purchase you later regretted. It’s the failure to understand that, regardless of the form it comes in, a dollar is a dollar.

Loss Aversion Loss aversion is an oversensitivity to loss, leading to an unwillingness to recognize a loss and move on. In fact, in the lingo of the financial markets, “selling discipline”—being able and willing to quickly acknowledge when a stock you’ve bought is a loser and sell it—is a highly desirable trait to have. Many investors, though, are reluctant to acknowledge that they’ve lost money on a stock and won’t make it back. Although it’s rational to sell the stock at that point and redeploy the remaining funds, most people find it so painful to admit a loss that they avoid selling for much longer than they should. According to Daniel Kahneman and Amos Tversky, most people feel the misery of losing $100 about twice as keenly as they feel the pleasure of gaining $100.

Loss aversion can help explain why sunk costs are so hard to ignore: ignoring a sunk cost means recognizing that the money you spent is unrecoverable and therefore lost.

Status Quo Bias Another irrational behaviour is status quo bias, the tendency to avoid making a decision altogether. A well-known example is the way that employees make decisions about investing in their employer-directed pension plan or group registered retirement saving plan (RRSP). With a pension plan, employees can, through payroll deductions, set aside part of their salary tax-free, a practice that saves a significant amount of money every year in taxes. Some companies operate on an opt-in basis: employees have to actively choose to participate in the pension plan. Other companies operate on an opt-out basis: employees are automatically enrolled in the pension plan unless they choose to opt out.

If everyone behaved rationally, then the proportion of employees enrolled in the company pension plan at opt-in companies would be roughly equal to the proportion enrolled at opt-out companies. In other words, your decision about whether to participate in a company pension plan should be independent of the default choice at your company. But, in reality, when companies switch to automatic enrolment and an opt-out system, employee enrolment rises dramatically. Clearly, people tend to just go with the status quo.

Why do people exhibit status quo bias? Some claim it’s a form of “decision paralysis”: when given many options, people find it harder to make a decision. Others claim it’s due to loss aversion and the fear of regret, to thinking that “if I do nothing, then I won’t have to regret my choice.” Irrational, yes. But not altogether surprising. However, rational people know that, in the end, the act of not making a choice is still a choice.

So why do economists still use models based on rational behaviour when people are at times manifestly irrational? For one thing, models based on rational behaviour still provide robust predictions about how people behave in most markets. For example, the great majority of farmers will use less fertilizer when it becomes more expensive—a result consistent with rational behaviour.

Another explanation is that sometimes market forces can compel people to behave more rationally over time. For example, if you are a small-business owner who persistently exaggerates your abilities or refuses to acknowledge that your favourite line of items is a loser, then sooner or later you will be out of business unless you learn to correct your mistakes. As a result, it is reasonable to assume that when people are disciplined for their mistakes, as happens in most markets, rationality will win out over time.

Finally, economists depend on the assumption of rationality for the simple but fundamental reason that it makes modelling so much simpler. Remember that models are built on generalizations, and it’s much harder to extrapolate from messy, irrational behaviour. Even behavioural economists, in their research, search for predictably irrational behaviour in an attempt to build better models of how people behave. Clearly, there is an ongoing dialogue between behavioural economists and the rest of the economics profession, and economics itself has been irrevocably changed by it.