Nudge Theory

So, when economists make their models, they generally assume that people are rational and predictable. But When we look at actual human beings, it turns out that people are impulsive, short sighted, and, a lot of times, just plain irrational. Today we’re talking about Behavioural Economics and how people actually make decisions.

Behavioural economics is a subfield of economics that focuses on the psychological, social and emotional factors that influence decision-making. That’s not necessarily new. In fact, Adam Smith, discussed it in The Theory of Moral Sentiments in 1759. But generations of economists chose to ignore many irrational elements of decision making since it makes it harder to predict human behaviour. But in the last few decades, behavioural economics has made a comeback. Several Nobel Prizes have been awarded to researchers that blend economics and psychology. Behavioural economics is being applied to more and more fields like marketing, finance, political science, and public policy. Now it’s important to mention that irrational human behaviour doesn’t negate everything in Economics. It just adds another layer of complexity. Now in most cases, people are rational. When the price falls for a product, people have a tendency to buy more of that product, so the law of demand holds true. But economists also accept that there is bounded rationality. Limits on information, time, and abilities might prevent people from seeking out the best possible outcome.

For example, if the price for product, equity or service is really low consumers might not buy more. In fact, they might buy less if they think that that low price means that product, equity or the service is bad. Now if that happens, then the law of demand doesn’t hold true, which creates a serious problem in classical economics. In the law of demand, you can’t have a situation that breaks the law and still call it a law.

That doesn’t happen in other disciplines like physics however it does. The Newtonian laws of physics, like gravity, hold true most of the time but they break down at the quantum level. They explain the orbits of planets, but they have a harder time explaining the orbits of electrons. And It’s the same in economics. Classical economic theories explain the big picture stuff pretty well, but there are still a lot of things about individual decision-making that we just don’t fully understand.

In the previous example one of the problems is lack of information. Classical economics assumes that consumers have perfect…