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Special report: Behavioural economics

If we are persistently irrational, perhaps the behaviour is not irrational’ – Professor John Kay, renowned British economist.

The study of human thinking has uncovered a number of psychological patterns in our reasoning processes. Traditional neo-classical economic theory assumes that we act in a rational way which will maximise our self-interest. In reality, humans do not always act rationally. We can be persuaded and often make inconsistent choices based on our biases, emotions and different attitudes to risk.

Behavioural economics is an emerging (but not entirely new) area which challenges the basic tenets of neo-classical economic theory. By combining economics and other social sciences such as psychology and sociology, behavioural economics explains the psychological factors behind why and how we make our choices.

Organisations including companies and public policymakers are recognising the potential benefits of allocating more investment into understanding the context of human behaviour in their target audience. The huge challenge is to strategise these processes to achieve a favourable result. One of the key techniques is the power of ‘context’ in conveying information – this is how choices are framed. For example, which product is better – 2% fat or 98% fat free? Studies under behavioural economics have shown that we are more likely to react to labels with 98% fat free as opposed 2% fat – even though the fat content is the same. By restructuring choices, this becomes an effective way to alter our behaviour.

This report is not a comprehensive guide but has been produced to highlight the importance of understanding the human behaviour in our choice selection. It introduces the key behavioural principles that you should be familiar with as business professionals. Business applications are explored through practical examples including project appraisal, pricing and securing investment.

Recent developments in closely related fields include behavioural accounting and behavioural finance – where the techniques of behavioural economics can be further applied. These topics will be covered in future faculty publications.

Published by the Finance and Management Faculty (SR36 - March 2012)

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