Module 4: Positive Political Economy - Game Theory - Individual Rationality - Norms,

Culture and Beliefs - Law and Economics - Old & New Institutional Economics - Behavioral
Economics, Bounded Rationality, Nudge theory .

Positive Political Economy

Positive Political Economy investigates how observed differences in institutions

affect political and economic outcomes in various social, economic and political
systems. It also examines how the institutions themselves change and develop in
response to individual and collective beliefs, preferences and strategies.

Positive political economy is an interdisciplinary field that analyses the

interplay between politics and economics, focusing on understanding how
political institutions, behaviour, and processes influence economic outcomes.
Unlike normative political economy, which prescribes how things ought to be,
positive political economy aims to describe and explain how things actually work
in the realm of politics and economics.

This field explores various aspects, such as the behaviour of voters, politicians,
interest groups, and institutions, and how these entities interact to shape economic
policies and outcomes. It delves into questions about how incentives, power
dynamics, and information asymmetries affect decision-making in the political
sphere, ultimately impacting economic processes.

For instance, studying how different political parties' ideologies or electoral

promises impact their decisions on tax rates, and how these decisions, in turn,
affect economic growth, income distribution, or investment patterns. The positive
political economy approach would seek to explain and predict these interactions
between political choices and economic outcomes based on observed data and
historical patterns.
GAME THEORY

Game theory was introduced by a mathematician, John Von Neumann and an

economist, Oskar Morgenstern, in 1950s.

The first systematic attempt of game theory is Neumann’s and Morgenstern’s

Theory of games and Economic Behaviour published in 1944.

Game theory was invented as an attempt to find a theoretical solution to the

problems posed by uncertainty in games of chance where rational players
take decision in an interdependent set up. By ‘rational player’ it is meant an
individual is assumed to take into account all the available information,
probabilities of events, and potential costs and benefits to perform the action with
the optimal expected outcome for itself from among all feasible actions. A
‘strategic scenario’ is defined as the one where actions of one individual affects
the payoff (or reward) or utility of other individuals. Game theory helps in solving
the problem and arriving at a common consensus.

A ‘Game’ is an abstract of a strategic situation involving interdependence. A

simplest form of game is defined by: players, actions or strategies and payoffs. In
game theory, players are the agents who are involved in the decision-making.
Each player has a number of strategies or action to choose from. The strategies
chosen by each player determine the outcome of the game, with each possible
outcome resulting in a payoff to each player.

1. Players: Players are the agents playing the game. They may be firms,
individuals, countries, or just about anything else that is capable of
executing a strategy. In the duopoly game, for instance, the players are the
two firms.
2. Strategies: Strategies are the actions or the set of actions available to the
players. For instance, in case of Cournot game, each firm’s strategy is to
choose its quantity, taking as given the quantity of its rivals.
3. Payoffs: Payoffs are the returns to the players at the conclusion of the
game. For instance, payoffs are the profits in case of profit maximising
firms.
TYPES OF GAMES

1. Non-cooperative versus Cooperative Games

There are two branches of the game theory, viz. cooperative and non- cooperative
game theory. Under the cooperative game theory, groups of the players make
an agreement to reach an outcome that is best for the group as a whole and
is shared equally among the members.

In contrast to this, under non-cooperative game theory, players cannot write

binding contract. Players are guided by self-interest, each player acts as an
individual who is normally assumed to maximise his own utility without caring
about the effects of his choice on other players in the game. The outcome of the
game, however, is jointly determined by the strategies chosen by all players in
the game. As a result, each player's welfare depends, in part, on the decisions of
other players in the game.

An example of cooperative game is two firms negotiating a joint investment to

develop a new technology. An example of non-cooperative game is two
competing firms taking into account each other’s behaviour when setting their
prices independently.

2. Games of Complete and Incomplete Information

In the games of complete information, the payoffs, strategies and types of players
are common knowledge. Complete information is the concept that each player in
the game is aware of the sequence, strategies, and payoffs throughout the game.
Given this information, the players have the ability to plan accordingly based on
the information to maximise their own rewards or payoff at the end of the game.

Inversely, in a game with incomplete information, players do not possess full

information about their opponents. A typical example is an auction: each player
knows his own utility function (valuation for the item), but does not know the
utility function of the other players.

3. Zero-sum versus Non-Zero Sum Games

A zero-sum game is the one in which the gain of one player comes at the expense
of the other player and is exactly equal to the loss of the other player. In other
words, the sum of the payoffs of the two players always adds to zero. An
economic application can be the transaction between a buyer and a seller at the
cost price. A non-zero sum game is when gain or loss does not come at the
expense of the other player. An example of this might arise if increased
advertisement leads to higher profits for both the firms.
Assumptions of Game Theory:

The game theory provides an appropriate solution of a problem if its conditions

are properly satisfied. These conditions are often termed as the assumptions of
the game theory.

• A player can adopt multiple strategies for solving a problem

• There is an availability of pre-defined outcomes

• The overall outcome for all players would be zero at the end of the game

• All players in the game are aware of the game rules as well as outcomes of
other players.

• Players take a rational decision to increase their profit

.

The Nature of the Problem: Prisoners’ Dilemma

The nature of the problem faced by the oligopoly firm is best explained by the
Prisoners’ Dilemma Game. To illustrate prisoners’ dilemma, let us suppose that
there are two criminals. A and B, who are partners in an illegal activity. They are
arrested by CBI and lodged in separate jails with no possibility of communication
between them. They are being interrogated separately by the CBI officials with
the following conditions disclosed to them in isolation.

1. If you confess your involvement in match fixing, you will get a five-year
imprisonment.
2. If you deny your involvement and your partner denies too, you will be set
free for lack of evidence.
3. If your partner does not confess and you confess and turn approver, then
you get two-year imprisonment, and your partner gets 10-year
imprisonment.

Given the conditions, it is quite likely that both the suspects may opt for
‘confession’, because neither A knows what B will do, nor B knows what A will
do. When they both confess, each gets a five-year jail term. This is the second
best option.
Application of Game Theory to Oligopolistic Strategy

The prisoners’ dilemma illustrates the nature of problems oligopoly firms are
confronted within the formulation of their business strategy with respect to
advertising, pricing etc.

Look at the nature of the problems an oligopoly firm is faced with when it plans
to increase its advertisement expenditure (ad-expenditure for short). The basic
issue is whether or not to increase the ad-expenditure. If the answer is ‘do not
increase’, then the questions are: Will the rival firms increase ad-expenditure or
will they not? And if they do, what will be the consequences for the firm under
consideration?

And, if the firms answer is ‘increase’, then the questions that arise are: What will
be the reaction of the rival firms? Will they increase or will they not increase their
ad-expenditure? What will be the pay-off if they do not and what if they do? The
firm will have to find answer to these questions under the conditions of
uncertainty. To find the answer, the firms will have to anticipate actions,
reactions and counteraction by the rival firms and chalk out its own strategy.

Let us now apply the game theory to our example of ‘whether or not to increase
ad-expenditure’, assuming that there are only two television companies, Sony and
Samsung i.e., the case of a duopoly. We know that in all the games, the players
have to anticipate the move made by the opposite player(s) and formulate their
own strategy to counter the different possible moves by the rival. To apply the
game theory to the case of ‘whether or not to increase ad-expenditure’ a company
needs to know or anticipate:

1. The counter moves by the rival company in response to increase in ad-

expenditure by this company and
2. The pay-offs of this strategy when (a) the rival company does not react and
(b) the rival company does make a counter move by increasing its ad-
expenditure.

After this data is obtained, the company will have to decide on the best possible
strategy for playing the game and achieving its objective of, say, increasing sales
and capturing a larger share of the market. The best possible strategy in game
theory is called the ‘dominant strategy’. A dominant strategy is one that
gives optimum pay-off, no matter what the opponent does. Thus, the basic
objective of applying the game theory is to arrive at the dominant strategy.
Suppose that the possible outcomes of the ad-game are given in the payoff matrix
presented in Table 5.5. In the figure, A indicates Sony’s gain and B indicates
Samsung’s gain in terms of increase in sales. As the matrix shows, if Sony decides
to increase its ad-expenditure and Samsung counteracts by increasing its own ad-
expenditure, Sony’s sales go up by Rs 20 million and that of Samsung by Rs 10
million. And, if Sony increases its advertisement and Samsung does not, then
Sony’s sales gain is Rs 30 million and no gain to Samsung.

One can similarly find the pay-offs of the strategy ‘Don’t increase’ in case of both
of firms. Given the pay-off matrix, the question arises as to what strategy should
Sony choose to optimize its gain from extra ad-expenditure, irrespective of moves
of the rival Samsung. It is clear from the pay-off matrix that Sony will choose the
strategy of increasing the ad-expenditure because, no matter what Samsung does,
its sales increase by at least Rs 20 million. This is, therefore, the dominant
strategy for Sony.

CONCLUDING REMARKS

What we have presented above is an elementary introduction to the game theory.

It can be used to find equilibrium solution to the problems of oligopolistic market
setting under different assumptions regarding the behaviour of the oligopoly
firms and market conditions.
 INDIVIDUAL RATIONALITY - NORMS, CULTURE AND
BELIEFS

The Concept of Rationality

As we have just seen, the game theory is based on the assumption of rational
behaviour on the part of individuals. Individual rationality is one of the central
axioms of economics.

Individual rationality in economics examines how people make choices based on

their preferences, available information, and constraints. At its core, individual
rationality assumes that individuals act in their own self-interest, striving to
maximize utility or satisfaction.

In economics, this assumption has been highly influential, forming the basis for
many market laws. But, in recent years the logic and empirical validity of the
assumption have been increasingly called into question. This assumption, though
providing answers, can be limiting and misleading, prompting uncertainty about
its reliability. Acknowledging that human actions aren't only driven by
maximizing utility, but also by social norms, culture, psychology, and personal
histories is crucial.

In economics, a person is considered rational if, based on their information, they

choose actions that maximize their objectives, whatever those objectives may be.
These objectives are typically termed utility, measured in utils, or in game theory,
referred to as "payoff." Sometimes, profit or income serves as the specific focus.

Here, the initial critiques of rationality target the notion of selfish utility
maximization. As soon as we consider social norms and cultural limits, it's
anticipated that this assumption will face significant challenges.

Social Norms, Culture and Beliefs

Economists usually write as if social norms do not matter. In reality, social norms
and institutions play an important role in influencing not just the society but
economics and outcomes in the marketplace. The progress of an economy are not
only influenced by traditional economic factors like military strength, resource
allocation, tariff policies, fiscal policies etc – but also our attitude towards work,
level of mutual trust, standard of ethics, and social norms.
The importance of social norms as foundation for economic activity is best
illustrated by the act of exchange. According to the first principles of economics,
two agents will exchange or trade goods if the following assumptions are true: (a)
each individual prefers having more goods to less; (b) each person satisfies the
law of diminishing marginal utility; (each person experiences diminishing
satisfaction as they acquire more of a particular good,) and (c) the initial
distribution of goods is uneven, such as one person possessing all the butter while
the other has all the bread.

To many economists, (a), (b) and (c) are indeed sufficient conditions for trade to
happen. What they do not realize is that these are sufficient only when the agents
are characterized by adequate social norms. For instance, exchange is greatly
facilitated by the ability to communicate or, even better, to speak and understand
a common language. Considering that language is a product of social convention,
trade and transactions rely heavily on these established social norms.

It is useful to distinguish between three kinds of social norms: Rationality-

limiting norms, preference-changing norms and equilibrium selection norms.

A rationality-limiting norm is a norm that stops us from doing certain things or

choosing certain options, irrespective of how much utility that thing or option
gives us. Thus, most individuals would not consider picking another person's
wallet in a crowded bus. This (lack of) action they would take not by speculating
about the amount the wallet is likely to contain, the chances of getting caught, the
severity of the law and so on, but because they consider stealing wallets as
something that is simply not done.

From the above discussion it should be evident that a rationality-limiting norm

further limits the feasible set, because now certain alternatives may be effectively
infeasible to an individual not just because they are technologically infeasible
(like walking on water) or budgetarily infeasible (like buying a Jaguar car) but
because they are ruled out by the person's norms. Such a person would be
considered irrational in terms of mainstream economics.

Certain norms do get internalized. For instance, some people, due to religious
beliefs, adopt vegetarianism. Over time, a norm upheld for an extended period
can transform into a personal preference. This can explain why one finds
variations in taste across regions and nations. What starts out as a norm or a
custom can over time become part of one's preference. Such a norm may be
referred to as a preference-changing norm.

In many countries, driving on the right side of the road is a norm reinforced by
the law. Even if it is not a legal rule, people would likely still follow it. Without
this norm, there could be two possible equilibria: everyone driving on the left or
everyone driving on the right. Unlike the previous norms, this norm simply helps
people choose one equilibrium when more than one equilibrium is available.
That's why it's termed an "equilibrium-selection norm."

Culture, a broader concept encompassing norms, traditions, values, and

beliefs shared among a group, profoundly shapes economic behaviour.
Cultural factors affect individual preferences, risk-taking behaviour,
entrepreneurial endeavours, and even negotiation styles. For example,
cultures valuing collectivism might prioritize community welfare over individual
gains, impacting economic decision-making. In cultures valuing thriftiness,
individuals might save more and spend less, impacting their consumption
patterns.

Understanding the influence of culture on individual rationality is crucial for

policymakers. Policies that align with cultural values are more likely to be
accepted and followed by the populace. Ignoring cultural influences can lead to
ineffective policies or resistance from the community.

Individual beliefs, shaped by personal experiences, upbringing, education,

and cultural influences, significantly impact economic choices.

Beliefs about future events, market conditions, or the effectiveness of certain

actions shape economic choices. For instance, someone who strongly believes in
the growth potential of a certain industry might invest heavily in it, impacting
their financial decisions.

Beliefs influence how individuals perceive risks. Someone with optimistic beliefs
might take more risks in investments, while a person with pessimistic beliefs
might be more conservative.

Conclusion

In conclusion, individual rationality in economics isn't solely driven by self-

interest but is deeply intertwined with norms, culture, and beliefs. Understanding
these complex interconnections is crucial for policymakers, businesses, and
individuals alike to understand and anticipate economic behaviours, adapt to
changing landscapes, and foster inclusive and sustainable economic growth.
LAW AND ECONOMICS

This interdisciplinary field examines the relationship between legal systems and
economic outcomes, focusing on how laws and legal institutions impact
economic behaviour and efficiency.

One fundamental concept is efficiency. Efficiency in this context refers to

maximizing social welfare or achieving the optimal allocation of resources.
Scholars often evaluate laws and legal systems based on their ability to enhance
efficiency, whether through promoting competition, incentivizing desirable
behaviour, or minimizing transaction costs.

Concepts of Law and Economics:

According to economic theory, all people are rational. Therefore, every decision
is made through undertaking a cost-benefit analysis. It assumes that all people
prefer more to less, and to maximise net benefits as perceived by them.

Law and economics share the assumption that individuals are rational and
respond to incentives. When penalties for an action increase, people will
undertake less of that action. Law and economics is more likely than other
branches of legal analysis to use empirical or statistical methods to measure these
responses to incentives.

Strong legal institutions, such as an impartial judiciary and effective enforcement

mechanisms, are essential for upholding property rights, contracts, and the rule
of law. A robust legal framework encourages investment, entrepreneurship, and
economic growth by providing certainty and security to individuals and
businesses.

In contemporary society, the application of law and economics extends across

various domains, including environmental regulation, intellectual property rights,
criminal justice, health care, and taxation. Policymakers and legal practitioners
increasingly draw upon economic insights to design more effective and efficient
laws that balance competing interests and achieve desired societal outcomes

The legal system must perform three functions, all related to property and
property rights. First, the system must define property rights; this is the task of
property law itself. Second, the system must allow for transfer of property; this is
the role of contract law. Finally, the system must protect property rights; this is
the function of tort law and criminal law. These are the major issues studied in
law and economics.
History and Significance:

Modern law and economics dates from about 1960, when Ronald Coase (who
later received a Nobel Prize) published “The Problem of Social Cost.” Gordon
Tullock and Friedrich Hayek also wrote in the area, but the expansion of the field
began with Gary Becker’s 1968 paper on crime (Becker also received a Nobel
Prize). In 1972, Richard Posner, a law and economics scholar, published the first
edition of Economic Analysis of Law and founded the Journal of Legal
Studies, both important events in the creation of the field as a thriving scholarly
discipline.

Law and economics is an interdisciplinary field that examines the interaction

between legal principles and economic theory, shedding light on how laws and
legal systems influence economic behavior, market outcomes, and societal
welfare. Here's a more comprehensive breakdown:

Core Concepts:

Efficiency: At its core, law and economics emphasizes allocative efficiency. It

assesses whether legal rules and regulations lead to outcomes that maximize
social welfare or whether there exist opportunities to enhance overall efficiency.

Incentives and Behavior: Central to the study of law and economics is the
analysis of incentives. Economic incentives heavily influence individual and
organizational behavior, and legal frameworks can shape these incentives. For
instance, property rights, contracts, and liability rules define the incentives for
individuals to engage in economic activities, invest, innovate, and adhere to
certain behaviors. Understanding these incentives helps in designing laws and
regulations that align individual interests with broader societal goals.

Allocation and Property Rights: Studies the role of legal systems in allocating
and protecting property rights, determining who owns what, and how these rights
can be transferred, traded, or used.
Key Areas of Study:

Tort Law: It assesses how legal rules impact accidents, negligence, and
compensation for damages. Tort law and criminal law help protect property rights
from accidental or purposeful harm. Their main goal is to make people who might
cause accidents or break the law think about the costs of their actions. When we
look at tort law from an economic perspective, it focuses on things like
distinguishing between negligence (having to pay for harm only if someone didn't
take enough care) and strict liability (having to pay for any harm caused by your
actions). Most accidents happen because both the person causing harm and the
person affected played a part (like a fast driver hitting a pedestrian who wasn't
paying attention). Good rules encourage both parties to be careful.

Contract Law: Analyses the formation, enforcement, and breach of contracts,

focusing on economic efficiency, incentive, and the reduction of transaction
costs. Contract law provides the framework for agreements and transactions
between parties. In the realm of law and economics, contracts facilitate economic
exchanges by reducing transaction costs and facilitating mutually beneficial
agreements.

Economic analysis of contracts emphasizes the role of incentives, risk allocation,

and enforcement mechanisms in fostering efficient contractual relationships.
Nobel laureate Oliver Williamson contributed significantly by exploring
transaction cost economics and the importance of contract design in mitigating
transactional uncertainties.

Efficient contract enforcement mechanisms, such as dispute resolution

mechanisms and breach remedies, are vital for fostering economic activity and
trust in markets

Antitrust Law: Explores laws and regulations aimed at promoting competition

and preventing monopolistic practices to enhance consumer welfare and
economic efficiency.

Property Law: A legal system should provide clear definitions of property

rights. That is, for any asset, it is important that parties be able to determine who
owns the asset and exactly what set of rights this ownership entails. Strong and
well-defined property rights encourage investment, as individuals are assured of
reaping the rewards of their efforts, fostering economic development.
Furthermore, property rights create incentives for optimal resource utilization.
They enable owners to internalize the costs and benefits of their decisions, leading
to more efficient allocation and management of resources. For instance, clear
property rights in intellectual property stimulate innovation by ensuring creators
benefit from their inventions.

Criminal Law: Criminal law serves as a cornerstone in maintaining social order

and addressing behaviors that undermine societal welfare. In the context of law
and economics, it plays a crucial role in shaping incentives and deterring harmful
actions that can disrupt economic activities.

Economists like Gary Becker pioneered the economic analysis of crime,

introducing the concept of "rational criminal behavior." This theory posits that
individuals weigh the costs and benefits before engaging in illegal activities. The
imposition of penalties or punishments serves as a deterrent, altering the cost-
benefit calculus and discouraging criminal behavior.

Moreover, the allocation of law enforcement resources is a key consideration in

the economic analysis of criminal law. Optimal resource allocation involves
balancing the costs of enforcement with the benefits derived from crime
prevention. Economic analysis aids in evaluating policies such as policing
strategies, incarceration rates, and rehabilitation programs in terms of their cost-
effectiveness and societal impact.

Influential Figures and Theories:

Ronald Coase: Known for the Coase Theorem, which discusses the role of
property rights and transaction costs in achieving efficient outcomes in the
presence of externalities.

Richard Posner: Emphasized the economic analysis of law and promoted the
idea that legal rules should be economically efficient.
OLD & NEW INSTITUTIONAL ECONOMICS

In contrast, the "New Institutional Economics" emerged later, gaining

prominence in the latter half of the 20th century, with scholars like Douglass
North, Oliver Williamson, and Ronald Coase at its forefront. This approach
builds upon the foundations laid by the Old Institutional Economics but
emphasizes more formal analysis and incorporates ideas from neoclassical
economics. It emphasizes the role of institutions in reducing transaction
costs, shaping incentives, and facilitating efficient economic exchange.

The "Old Institutional Economics" traces its roots to scholars like Thorstein
Veblen and John R. Commons. This approach focused on the role of
institutions—social norms, customs, traditions, and organizational structures—in
shaping economic behavior. Veblen, in particular, highlighted the significance of
social institutions in influencing individual choices and economic activities.

Veblen's ideas, including "conspicuous consumption" highlighted how social

institutions and cultural practices shape patterns of consumption and investment
decisions. Commons, on the other hand, focused on institutional arrangements
and the importance of property rights, contracts, and collective action in
economic transactions. He emphasized the role of institutions in mitigating
conflicts of interest and fostering cooperation.

NEW INSTITUTIONAL ECONOMICS

Key contributors to New Institutional Economics include Ronald Coase,

Douglass North, Oliver Williamson, Elinor Ostrom, and others who
advanced the understanding of how institutions shape economic behaviour
and development through their work on transaction costs, property rights,
governance structures, and resource management.

Institutions Matter:

NIE emphasizes that institutions are active forces that shape economic behavior.
These institutions encompass formal entities like laws, regulations, property
rights, and contracts, as well as informal norms, customs, and traditions within
societies. They establish the rules of the game, defining how economic agents
interact, transact, and trade.

Institutions create a structure within which markets operate, influencing choices

made by individuals and firms. For instance, property rights determine how assets
can be owned, used, and transferred. Strong and protected property rights
encourage investment and entrepreneurship, while weak or insecure rights may
hinder economic activity.

Transaction Costs:

Transaction costs refer to the expenses incurred in carrying out economic

transactions beyond the actual price of goods or services. These costs include
information gathering, negotiation, enforcement of contracts, and monitoring.
NIE suggests that high transaction costs can impede economic activity and that
efficient institutions aim to reduce these costs.

Efficient institutions, such as well-defined property rights or standardized

contracts, can help minimize transaction costs. Lower transaction costs facilitate
more exchanges, leading to increased economic efficiency and growth.

Property Rights:

Secure and well-defined property rights are fundamental to economic

development according to NIE. Clear property rights provide individuals and
businesses with the confidence to invest, innovate, and trade. When property
rights are protected, individuals are more likely to put effort into improving their
assets, knowing that they can reap the rewards without fear of expropriation.

Countries with strong property rights frameworks tend to attract more investment,
both domestic and foreign, fostering economic growth and development.

Adaptation and Change:

NIE recognizes that institutions are not static; they evolve over time in response
to changing circumstances. As societies face new challenges or opportunities,
institutions adapt to accommodate these changes. This adaptability is crucial for
institutions to remain effective in facilitating economic activities.

Incentives:

Institutions shape incentives for economic actors. They influence behavior by

defining the rewards and penalties associated with specific actions. By altering
incentives, institutions can encourage or discourage certain behaviors, impacting
the overall functioning of markets and economies.
Contributions:

Understanding Development Disparities: NIE has helped economists

understand why some countries or regions experience greater economic
development than others. By focusing on the quality of institutions, it highlights
how differences in institutional frameworks can lead to disparities in economic
outcomes.

Policy Implications: The insights from NIE suggest that policymakers should
consider the institutional context when designing economic policies. Reforms
targeted at improving institutions can have a significant impact on economic
performance, encouraging growth, and reducing disparities.

OIE v/s NIE

Old Institutional Economics:

Focus: OIE emerged in the late 19th and early 20th centuries, primarily
represented by economists like Thorstein Veblen and John R. Commons. It
emphasized the study of institutions, social norms, and historical contexts in
economic analysis.

Key Tenets: OIE focused on the examination of institutional evolution, social

and cultural factors, and their impact on economic behavior. It highlighted the
significance of power relationships, social classes, and historical traditions in
shaping economic institutions.

Critique of Markets: OIE was critical of classical economics' assumption of

perfect markets, emphasizing market imperfections and the influence of social
and institutional factors on economic activities.

New Institutional Economics:

Focus: NIE emerged in the latter half of the 20th century, with notable
contributions from scholars like Ronald Coase, Douglass North, and Oliver
Williamson. It aimed to integrate institutional analysis into neoclassical economic
theory.
Key Tenets: NIE focused on transaction costs, property rights, and the impact of
formal and informal institutions on economic behavior. It emphasized the role of
institutions in reducing transaction costs, fostering efficient markets, and
promoting economic growth.

Efficiency and Institutions: NIE highlighted the importance of well-defined

property rights and efficient institutions in facilitating economic exchanges and
encouraging investment and innovation.

BEHAVIOURAL ECONOMICS

What is Behavioral Economics?

Behavioral economics is all about how people make decisions and what
influences their decisions. Behavioral economics’ main argument is that human
beings are not always rational, and there are certain factors that influence their
decisions.

Definition

Behavioral economics is a discipline that applies insights from psychology to

explain how individuals make their choices.

Behavioral Economics aims to understand economic decisions made by humans

by combining elements of psychology with classic economics. This branch of
economics looks into how and why people arrive at their economic choices, how
they differ from rational choices, and find the implications they have on various
aspects of life. It takes into account other aspects of an individual, such as their
social norms, habits, personality, etc. It does so by taking into account
psychological factors that might play a role in encouraging an individual to
choose one option over another.

It draws on psychology and economics to explore why people sometimes make

irrational decisions, and why and how their behavior does not follow the
predictions of economic models.
Understanding Behavioral Economics

In an ideal world, people would always make optimal decisions that provide them
with the greatest benefit and satisfaction. In economics, rational choice theory
states that when humans are presented with various options under the conditions
of scarcity, they would choose the option that maximizes their individual
satisfaction.

This theory assumes that people, given their preferences and constraints, are
capable of making rational decisions by effectively weighing the costs and
benefits of each option available to them. The final decision made will be the best
choice for the individual. The rational person has self-control and is unmoved by
emotions and external factors and, hence, knows what is best for himself. Alas,
behavioral economics explains that humans are not rational and are incapable of
making good decisions.

History of Behavioral Economics

Notable individuals in the study of behavioral economics are Nobel laureates

Gary Becker (motives, consumer mistakes; 1992), Herbert Simon (bounded
rationality; 1978), Daniel Kahneman (illusion of validity, anchoring bias; 2002),
George Akerlof (procrastination; 2001), and Richard H. Thaler (nudging, 2017).
Behavioral economists argue that there are many restrictions on people’s ability
to make rational decisions, and this causes them to act in an irrational way.

What Is the Goal of Behavioral Economics?

The goal of behavioral economics is to understand why humans make the

decisions they do. There are usually outcomes that are the best for people and
many times, people do not choose that outcome. Behavioral economics is an
incredibly complex and sometimes inexplainable science of why people do things
and why they choose to not be rational.

Bounded Rationality

Bounded rationality is the concept in which individuals make decisions based on

the knowledge they have. Unfortunately, this information is often limited,
whether by the individual's lack of expertise of lack of available information.

In regard to finance and investing, the same public information is available to

everyone, though investors may not know true circumstances of what is
happening with a company internally.

Bounded rationality is the idea that individuals have limits on decision making
and these limits hinder their ability to make sound rational decisions all the time.

Bounded rationality theory suggests that there are three limitations to individual
choices:

Limited information: We all face limited information or inaccurate information

about something, and this could cause us to make irrational decisions.

Mental capacity: Not all of us are able to process vast amounts of information
to make a decision, and this limits our ability to make rational choices.

Time constraints: There may not be enough time to weigh in all the alternatives
and explore all the possible choices to make a fully rational decision.
Principles of Behavioral Economics

Behavioral economics blends insights from psychology and economics to

understand how people make decisions. Here are some key principles with
examples:

1. Loss Aversion: People dislike losing more than they enjoy winning. They tend
to overvalue what they already possess. For instance, individuals are more
distressed about losing $100 than they are pleased about gaining $100.

2. Anchoring: People rely heavily on the first piece of information offered when
making decisions. Real estate pricing is a great example. A high initial asking
price (''anchor'') tends to influence the perceived value of a property, even if
subsequent negotiations lower the price.

3. The Endowment Effect: People assign higher value to things they own simply
because they own them. For instance, someone buying a unique mug for $10 at a
garage sale. After using it for a while, he refuses an offer of $20 for the same mug.
He values it more because he owns it, showcasing the endowment effect.

4. Herding: Individuals tend to mimic the actions of a larger group. In finance,

it's seen when investors follow the trend of buying or selling stocks based on
others’ behaviors rather than their own analysis.

5. Status Quo Bias: People prefer things to remain the same by default. They are
more likely to stick with the current option rather than make a change. This could
be seen in choices related to subscription services where individuals might not
cancel even if they don't use it frequently.

6. Confirmation Bias: People tend to favour information that confirms their pre-
existing beliefs or hypotheses. Let’s say someone strongly believes that a certain
brand of a smartphone is the best in the market. When researching about
smartphones, they selectively focus on reviews and information that confirm their
belief in this brand's superiority. They might ignore or negative reviews that
highlight any drawbacks or praise other brands, exhibiting confirmation bias by
seeking out information that aligns with their pre-existing belief.

7. Hyperbolic Discounting: This refers to the tendency for people to have a

stronger preference for more immediate payoffs over larger but delayed rewards.
For example, someone might choose $50 today instead of $100 in a month.

8. Choice Overload: When presented with too many choices, individuals might
struggle to make a decision or even avoid making one altogether. This can be
observed in consumer behavior when faced with numerous product options,
leading to decision paralysis.

Imagine walking into an ice cream shop with over 50 flavours. Instead of feeling
excited, you might find it overwhelming to choose. With so many options, you
might spend more time trying to decide. In some cases, people might end up not
choosing at all due to the overwhelming number of choices, experiencing choice
overload.

9. Nudge Theory: Small changes in the presentation of choices can significantly

alter people’s behavior. For instance, placing healthier food options at eye level
in a cafeteria might nudge individuals towards making healthier food choices.

10. Mental Accounting: People mentally compartmentalize money into different

categories based on various subjective criteria. For instance, someone might
spend a tax refund frivolously but hesitate to spend an equivalent amount from
their regular earnings.

These principles highlight how human behavior often deviates from traditional
economic models that assume rational decision-making.

Nudge Theory

"Nudge theory” is a concept that has gained prominence in economics and

behavioral science. Nudge theory was named and popularized by the 2008
book, 'Nudge: Improving Decisions About Health, Wealth, and Happiness',
written by American academics Richard H Thaler and Cass R Sunstein.

Richard Thaler is the father of the Nudge theory, one that won him a Nobel
prize in 2017. The central concept – nudge – is a policy-making technique
that relies on indirect suggestions, positive reinforcement, and other tools to
foster the right course of action.

Instead of forcing people into a certain choice or penalizing them for not
doing something, nudge theory suggests that we should make a certain
choice easier. Nudge theory suggests consumer behaviour can be influenced
by small suggestions and positive reinforcements.
Proponents of nudge theory suggest that well-placed ‘nudges’ can reduce
market failure, save the government money, encourage desirable actions and
help increase the efficiency of resource use.

In behavioral economics, a “nudge” is a way to manipulate people’s choices

to lead them to make specific decisions: For example, putting fruit at eye
level or near the cash register at a high school cafeteria is an example of a
“nudge” to get students to choose healthier options. An essential aspect of
nudges is that they are not coercive: Banning junk food is not a nudge,
nor is punishing people for choosing unhealthy options.

It revolves around the idea of influencing people's decisions and behaviors

in a predictable way without restricting their choices. This theory is rooted
in the understanding that individuals often make decisions that are not in
their best long-term interest due to cognitive biases, or limited rationality.
Nudge theory aims to design interventions or nudges that steer individuals
towards making better choices without removing any options.

Overview and Relevance

Nudge theory initially emerged in the early 2000s USA as a radical approach to
influencing people's interaction with financial systems, notably pensions, savings
and healthcare - so as to improve quality of later life, (not to enrich financial
corporations).

From these beginnings, the Nudge concept now offers vastly bigger implications
and applications.

Nudge principles and techniques are now increasingly significant in

communications, marketing, and the motivation of groups: in business,
marketing, selling, organizational leadership, politics, economics, education,
welfare; it can also be used to influence a person or a group of people, for
example, a customer group, or an entire society - or simply yourself, as an aid to
improving personal health, wealth and well-being.

Nudge theory for example can help the parenting of a child, or at the other
extreme could help a world government manage a global population.

Nudge theory advocates change in groups through indirect methods, rather than
by direct enforcement or instruction.