Behavioural Economics, Business Decision Making and Applied Policy Analysis

Abstract

The emergence of behavioural economics has provided new insights into economic and business phenomena by integrating elements of economic theory and experimental psychology. So far, the behavioural economics research agenda has concentrated on the empirical validity of foundational assumptions, producing new descriptive accounts of behavioural patterns that are difficult to explain using traditional neoclassical assumptions. This agenda has now developed sufficiently to begin exploring how to apply these descriptive findings to improve human performance, business decision making and economic policy.

Forging a new normative economics based on behavioural theory is an ambitious project. There is not yet consensus, among behavioural economists or otherwise, that standard normative theories in economics such as the Fundamental Welfare Theorems built on axiomatic assumptions of self-interest, self-consistent utility maximisation and perfect information are in need of revision. From the observation that individual behaviour systematically deviates from textbook prescriptions for rational decision making, a broad range of sometimes conflicting conclusions about normative economics can be drawn.

For example, some argue that when behaviour deviates from textbook prescriptions, policy should seek to revise people’s behaviour rather than economists revise their normative models, e.g., teaching MBA students to correctly apply Bayes Rule rather than abandoning Bayes Rule as a criterion for rational decision making. Others argue that, because individuals fail to meet the idealised standard of perfect economic rationality, behavioural theory provides a new rationale for paternalistic intervention aiming to ‘de-bias’ individual behaviour, e.g., taxing potato chips and subsidising carrots to correct for impulsive consumer decisions at the grocery store. Still others argue that normative benchmarks such as transitivity, expected utility axioms, set-theoretic logic and probability theory, are largely irrelevant criteria for deciding whether a particular decision process works well in its respective environment. There is another possibility, infrequently mentioned: that economists abandon the singular normative framework based on axiomatic rationality in favor of empirical studies of behavior that is successful by a well defined criterion in a particular context - the concept of matching behavior to environment referred to as ecological rationality.

Rather than achieving a unified consensus, there clearly are multiple approaches with different priorities for bringing the descriptive findings of behavioural economics’ early years to bear on normative economics. Behavioural economics’ goal of improved empirical realism will necessitate more attention among researchers to the problem of connecting theory to applied problems and contemporary debates in business, economics and political economy.

Keywords: Normative Economics, Behavioral Economics, Policy, Bounded Rationality, Ecological Rationality, As-If, Methodology, Choice Under Uncertainty, Procedural Rationality

JEL Classification: D03