Behavioural economics

Cognitive system 1 and cognitive system 2

System 1

System 1 is involved in tasks such as answering to 2+2, driving your car on an empty street, and understanding simple sentences in a language you know. These are examples of decision processes that are fast, almost automatic, and effortless. System 1 handles automatic actions and observed impressions and insights.

System 1 gives inputs to system 2, which transforms these inputs into actions for elaborations. If system 1 encounters difficulties, system 2 takes a more active role.

System 2

System 2 is responsible for tasks like giving your phone number, answering to 24x17, parking in a limited space, and reading complex texts such as "behavioral economics." These decision processes are slow, deliberate, and effortful.

System 1 and system 2 are always active in humans. This dual system is efficient and saves cognitive costs. While system 1 often leads to good decisions and actions, it can also result in biases, leading to systematic errors. Errors are predictable, and when biases are made by consumers, firms can exploit them.

Conflicts between systems

Sometimes the two systems can conflict. System 1 might provide distorted information, such as visual illusions, while system 2 may be lazy in addressing these errors.

Traditional economic models

The traditional model of economics is concerned with system 2, focusing on deliberate reason where people make decisions in a fully rational way. However, system 1, with its perceptions, impressions, and intuitions, also impacts decision-making. The dual system influences our behavior.

Preferences and rationality

Fully rational approach of consumer

Consumers may have preferences between two goods, A and B, in different quantities. E represents the basket containing these two goods. Given two baskets, E’ and E’’, consumers can express preferences (>, <, =) or be indifferent. When consumers have preferences between baskets, they have complete preferences, and these preferences are transitive.

Non-satiation

Consumers are happier with a higher quantity of goods. A consumer with complete and transitive preferences is considered rational. Preferences can be expressed through a utility function: U(E) > U(E’’). If a consumer can choose within a set of baskets, they will choose the preferred basket given their preferences, maximizing utility.

Budget constraint

To buy a good, consumers must pay a price, p, within their limited income, constraining them to a certain level of consumption. This is known as the budget constraint.

Happiness and utility

Content of preferences

What makes us happy? How do events impact our happiness? Understanding this is important for two aspects: policy, where government interventions aim at maximizing social welfare through nudging, and business, where firms need to know what consumers want.

The trap of biases

There can be a trap in biases, as we apply the term "happiness" to many things, whether being happy in life or with your life.

Two selves

There are two selves: one experiencing self that lives in the present and knows the present.