ECON30019 Chap.1 What Behavioural Economics Adds to the Standard Model
What Behavioural Economics Adds to the Standard Model
A theory can be asked to do two jobs. A normative theory states how decisions ought to be made; a descriptive theory describes how they in fact make them. The standard model of economics, committed to rationality assumptions, has traditionally been asked to do both at once, and behavioural economics is what follows from doubting that a single theory can.
The chapter sets the two positions out as claims that evidence can settle: whether deviations from rationality are small and unsystematic, or large, systematic and therefore predictable.
It then covers how the field produces evidence, from laboratory experiments to field experiments, and works two anomalies that set the pattern for everything after them: sunk costs, where the rule is one line long and almost everybody breaks it, and opportunity cost, where a sharp prediction about labour supply was reversed in the field by drivers working to a daily income target.
What this chapter covers
- 01
Normative and descriptive theory, and why one model was asked to be both
- 02
The neoclassical position, stated as three claims
- 03
The behavioural position, stated as two claims
- 04
Why the approach builds on rational choice rather than discarding it
- 05
The three aims the subject states for itself
- 06
Four ways to gather evidence, and what each one buys and costs
- 07
Theory running from evidence to model, and from model to fresh prediction
- 08
Sunk cost, the sunk-cost fallacy, and the escalation situation
- 09
Opportunity cost as a maximum over the alternatives you did not take
- 10
The labour-supply prediction and the income-target result that reversed it
Should the extra spending happen?
- 1Identify the 18 million as a sunk cost: incurred, unrecoverable, and identical under both remaining options, so it cancels from the comparison.
- 1Value finishing: a further 9 million spent for 10 million of value, a net position of positive 1 million.
- 1Value abandoning: 1 million spent for nothing, a net position of negative 1 million.
- 1Conclude and diagnose. Finishing is better by 2 million, so the council should finish, but the councillor's argument from money already spent is the sunk-cost fallacy and would have recommended a loss had the remaining cost been 12 million.
Key terms
- Normative theory
- A theory stating how decisions ought to be made, judged by whether its prescriptions are defensible rather than by whether people follow them.
- Descriptive theory
- A theory reporting how decisions are actually made, judged by predictive accuracy rather than by whether the behaviour it predicts is sensible.
- Sunk cost
- A cost already incurred that cannot be recovered. Because it is identical under every remaining option, it cannot discriminate between them and should not enter the decision.
- Escalation situation
- A dynamic in which a sunk cost encourages a further irrational investment, which leaves a still larger sunk cost that is harder again to set aside.
- Opportunity cost
- What the best alternative you gave up was worth, written formally as a maximum over the actions not taken rather than as a sum of them.
What Behavioural Economics Adds to the Standard Model FAQ
Is behavioural economics saying that people are irrational?
No, and the subject is explicit about it. The behavioural approach builds on rational choice and equilibrium models instead of discarding them. The claim is narrower and more testable: that deviations from perfect rationality are large enough, systematic enough and therefore predictable enough to be worth modelling, which is a claim about the size and regularity of errors rather than about human competence.
Why does the subject spend so long on research methods?
Because the strength of a claim depends on how it was produced, and evaluation questions ask you to judge that. A laboratory experiment buys clean causal identification at the cost of external validity; a field study buys real stakes at the cost of randomisation; a field experiment buys both at the cost of expense and control. Naming the method is the first sentence of a good evaluation.
Why is the taxi-driver result used so often in this subject?
Because it has all four parts an examinable anomaly needs. There is a precise standard prediction, that people work more hours when wages are high; a measured behaviour running the other way, with fewer hours on more profitable days; a mechanism, a daily income target reached faster on good days; and a cost, since reallocating hours was estimated to raise earnings by around ten per cent.
Exam move
Learn this chapter as a template rather than as content. For every anomaly in every later chapter, write down four things: the standard prediction and the assumption behind it, the behaviour actually observed, the mechanism that would produce it, and the cost of behaving that way.
If you can fill all four slots you can answer almost any question about that anomaly, and if you cannot fill the first you have nothing to measure the rest against. Practise the sunk-cost and opportunity-cost calculations until the marginal comparison is automatic, because both reappear as steps inside longer questions later.
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