behavioural insights and ‘nudge’ theory

1. Introduction – What Economics Studies

• Scarcity: limited resources versus unlimited wants.
• Choice & Opportunity Cost: every decision involves giving up the next best alternative.
• Factors of Production: land, labour, capital, entrepreneurship.
• Economic Systems: market, command and mixed economies – how societies organise production and allocation.
• Economic Methodology
  • Positive statements describe how the world is (e.g. “A 10 % rise in income increases demand for restaurants”).
  • Normative statements prescribe how the world ought to be (e.g. “The government should reduce income inequality”).
  • Ceteris paribus – “all other things being equal”; used to isolate the effect of one variable.
  • Time‑period distinction: short‑run (some inputs fixed) vs long‑run (all inputs variable).

1.1 Classification of Goods

Type of Good	Key Characteristics	Typical Example
Private good	Rival & excludable	Food, clothing
Public good	Non‑rival & non‑excludable	National defence
Common (or club) good	Rival but non‑excludable (or vice‑versa)	Fishery stocks (rival, non‑excludable)
Merit good	Undervalued by consumers, socially desirable	Education, vaccinations
De‑merit good	Over‑consumed, socially undesirable	Alcohol, cigarettes

2. Production Possibility Curve (PPC)

• Shows the maximum combinations of two goods that can be produced with existing resources and technology.
• Points on the curve = efficient production; inside = inefficient; outside = unattainable.
• Movement along the curve illustrates opportunity cost – the slope is the marginal rate of transformation.
• Shifts:
  • Outward shift – economic growth (more resources or better technology).
  • Inward shift – recession, natural disaster, war.

3. Micro‑economic Foundations

3.1 The Market System

• Demand – willingness and ability to buy a good at various prices.
• Supply – willingness and ability to sell a good at various prices.
• Equilibrium – where quantity demanded equals quantity supplied; market‑clearing price.

3.2 Determinants of Demand & Supply

Demand Determinants	Supply Determinants
Income, tastes, price of related goods, expectations, number of buyers.	Input prices, technology, expectations, number of sellers, taxes/subsidies, time period.

3.3 Determinants of Price Elasticity of Supply (PES)

• Time horizon – supply is more elastic in the long run.
• Spare production capacity – firms can increase output quickly if capacity is idle.
• Mobility of factors of production – ease of moving labour, capital, and raw materials.
• Nature of the good – services with low storage costs tend to have higher PES.

3.4 Marginal Analysis & Rational Behaviour

• Marginal analysis: decisions are made at the margin (e.g., “the next unit”).
• Rational behaviour: consumers aim to maximise utility; firms aim to maximise profit.
• Bounded rationality (behavioural insight): limited information, time and cognitive ability.

4. Demand and Supply

4.1 Deriving the Demand Curve

From the utility‑maximisation framework a consumer chooses the bundle that gives the highest utility subject to the budget constraint. The resulting demand curve slopes downwards because of:

• Substitution effect – when price falls, the good becomes relatively cheaper.
• Income effect – a lower price increases real purchasing power.

4.2 Shifts vs. Movements

Demand	Cause of Shift
Right‑shift (increase)	Higher income (normal good), larger population, favourable tastes, fall in price of a complement, expectation of future price rise.
Left‑shift (decrease)	Lower income (inferior good), adverse tastes, rise in price of a complement, expectation of future price fall.

4.3 Supply Curve and Shifts

• Upward sloping because higher prices cover higher marginal costs.
• Shifts:
  • Right‑shift (increase): technological improvement, fall in input prices, more firms entering.
  • Left‑shift (decrease): higher taxes on production, rise in input prices, natural disasters.

5. Elasticities

Elasticity	Formula	Interpretation
Price Elasticity of Demand (PED)	\(\displaystyle \frac{\%\Delta Q_D}{\%\Delta P}\)	|PED| > 1 = elastic; |PED| < 1 = inelastic; |PED| = 1 = unit‑elastic.
Price Elasticity of Supply (PES)	\(\displaystyle \frac{\%\Delta Q_S}{\%\Delta P}\)	High PES when firms can adjust output quickly (e.g., services); low PES when production is capacity‑constrained.
Income Elasticity of Demand (YED)	\(\displaystyle \frac{\%\Delta Q_D}{\%\Delta Y}\)	YED > 0 normal good; YED < 0 inferior good; YED > 1 luxury.
Cross‑Price Elasticity of Demand (XED)	\(\displaystyle \frac{\%\Delta Q_{D_x}}{\%\Delta P_y}\)	Positive for substitutes, negative for complements.

Worked example (PED): Price falls from £10 to £8 (‑20 %) and quantity demanded rises from 100 to 130 (+30 %).
\[ \text{PED}= \frac{30\%}{-20\%}= -1.5 \] Because |PED| > 1, demand is elastic.

6. Consumer & Producer Surplus – Measuring Efficiency

• Consumer Surplus (CS): area above the market price and below the demand curve.
• Producer Surplus (PS): area below the market price and above the supply curve.
• Dead‑weight loss (DWL): loss of total surplus when the market is not at equilibrium (e.g., tax, price ceiling, subsidy).

7. Market Failure & Traditional Government Intervention (Micro)

7.1 Types of Market Failure

• Externalities – positive (education) or negative (pollution).
• Public goods – non‑rival & non‑excludable (national defence).
• Information asymmetry – adverse selection, moral hazard.
• Imperfect competition – monopoly, oligopoly, monopolistic competition.
• Behavioural distortions – loss aversion, status‑quo bias, heuristics.

7.2 Government Tools for Micro‑intervention

Tool	Targeted Failure	How It Works	Incidence Note
Taxes (e.g., carbon tax)	Negative externalities	Raises the price by the marginal external cost (P = MC + MEC).	Incidence depends on relative elasticities – steeper demand → producers bear more.
Subsidies (e.g., R&D grants)	Positive externalities	Lowers marginal private cost, encouraging higher output.	Incidence falls on consumers when demand is elastic.
Price controls	Market power or equity concerns	Ceiling = maximum legal price; Floor = minimum legal price.	Ceilings create shortages; floors create surpluses.
Buffer‑stock schemes	Price volatility of commodities	Government buys when price is low and sells when price is high to stabilise the market.	Cost borne by taxpayers; benefits producers and consumers.
Regulation & Standards	Externalities, safety, quality	Sets legal limits (e.g., emission caps, safety certificates).	Compliance costs fall on firms; consumer safety improves.
Information provision (labelling, disclosure)	Information asymmetry	Mandates clearer information for consumers (e.g., energy‑efficiency labels).	Low fiscal cost; effectiveness depends on consumer understanding.

8. Behavioural Insights in Policy Design

Behavioural economics recognises that people often deviate from the fully rational model. Core insights used in policy:

• Bounded rationality – limited cognitive resources and time.
• Heuristics & biases – mental shortcuts that can cause systematic errors (anchoring, availability, representativeness).
• Loss aversion – losses loom larger than equivalent gains.
• Status‑quo bias – preference for the current option.
• Social norms – behaviour is shaped by what we think others do.

9. Nudge Theory

A nudge is any alteration to the “choice architecture” that changes behaviour predictably while preserving freedom of choice and without significantly altering economic incentives.

• Preserves autonomy.
• Low implementation cost.
• Evidence‑based – derived from experiments, field trials, or lab studies.

9.1 Common Nudge Tools

Tool	Mechanism	Typical Application
Default Options	Leverages status‑quo bias; most people stick with pre‑set choices.	Automatic enrolment in workplace pensions; organ‑donor registration.
Salience & Framing	Highlights particular attributes; changes perceived gains/losses.	Energy‑efficiency labels; “£X per year” cost framing for appliances.
Social‑Norm Feedback	Uses peer comparison to motivate change.	Home‑energy reports showing neighbours’ consumption.
Commitment Devices	Self‑binding mechanisms that make future‑oriented actions harder to reverse.	Public pledges to reduce plastic use; “save‑more‑tomorrow” savings schemes.
Simplification	Reduces cognitive load, making the desired action easier.	Streamlined tax‑return forms; one‑page loan applications.

9.2 Illustrative Example – Reducing Household Carbon Emissions

1. Default enrolment in a green‑tariff electricity plan.
2. Social‑norm feedback via monthly statements comparing a household’s usage with the “average neighbour”.
3. Salient visual cues – colour‑coded smart meters (red = high use, green = low use).

The combined impact can be expressed empirically as:

\[ \Delta Q = \alpha \times \text{Default} + \beta \times \text{NormFeedback} + \gamma \times \text{Salience} \]

where \(\alpha, \beta, \gamma\) are coefficients estimated from field experiments.

9.3 Evaluating Nudge Policies

• Effectiveness: magnitude of behavioural change, cost‑benefit ratio, durability over time.
• Equity: does the nudge affect all income/age groups similarly?
• Transparency: are individuals aware they are being nudged?
• Legitimacy & Accountability: consistent with democratic principles and subject to oversight.

Cost‑effectiveness illustration: A default pension enrolment costs £5 per enrollee and raises annual contributions by £200.
Benefit‑Cost Ratio (BCR) = 200 / 5 = 40 – a highly efficient policy.

10. Macro‑economic Overview

10.1 National‑income Aggregates

Aggregate	Definition	Adjustment to Basic Prices
GDP (Gross Domestic Product)	Total market value of all final goods and services produced within a country in a year.	Market price → subtract indirect taxes, add subsidies = GDP at basic prices.
GNI (Gross National Income)	GDP + net primary income from abroad (factor income earned by residents minus income paid to non‑residents).	GNI at basic prices = GDP at basic + net primary income.
NNI (Net National Income)	GNI – depreciation of capital stock.	Provides a measure of the income actually available for consumption and saving.

10.2 The Three Macro‑objectives

• Economic growth – sustained increase in real GDP.
• Low unemployment – maximising the utilisation of labour resources.
• Price stability – keeping inflation low and predictable.

10.3 Circular Flow of Income

11. Aggregate Demand & Aggregate Supply (AD/AS) Model

• Aggregate Demand (AD): total spending on domestically produced goods and services (C + I + G + (NX)). Downward sloping because of the wealth effect, interest‑rate effect and exchange‑rate effect.
• Short‑run Aggregate Supply (SRAS): upward sloping; firms respond to higher prices by increasing output (sticky wages & prices).
• Long‑run Aggregate Supply (LRAS): vertical at potential output (Y*), determined by factor endowments, technology and institutions.

11.1 AD/AS Shifts and Macro‑objective Impact

Shock / Policy	AD Shift	SRAS Shift	Effect on Growth	Effect on Unemployment	Effect on Inflation
Expansionary fiscal (higher G or tax cut)	Right (↑ AD)	–	↑ Real GDP (short‑run)	↓ Unemployment (short‑run)	↑ Price level (inflationary pressure)
Contractionary fiscal (lower G or tax rise)	Left (↓ AD)	–	↓ Real GDP (short‑run)	↑ Unemployment (short‑run)	↓ Price level (deflationary pressure)
Supply‑side reform (e.g., deregulation)	–	Right (↓ SRAS)	↑ Potential output (long‑run growth)	↓ Unemployment (long‑run)	↓ Inflation (cost‑push pressure eases)
Oil price shock (negative supply shock)	–	Left (↑ SRAS)	↓ Real GDP (short‑run)	↑ Unemployment (short‑run)	↑ Inflation (stagflation)

12. Government Macro‑policy Toolkit

12.1 Fiscal Policy

• Definition: use of government spending and taxation to influence the economy.
• Tools
  • Government expenditure (G)
  • Direct taxes (income, corporation)
  • Indirect taxes (VAT, excise)
  • Transfer payments (benefits, pensions)
• Expansionary fiscal policy: increase G or cut taxes → right‑shift AD.
• Contractionary fiscal policy: decrease G or raise taxes → left‑shift AD.

12.2 Monetary Policy

• Definition: actions by the central bank to control the money supply and interest rates.
• Tools
  • Policy interest rate (bank rate)
  • Open market operations (buying/selling government securities)
  • Quantitative easing (large‑scale asset purchases)
  • Reserve requirements (ratio of deposits banks must hold)
• Expansionary monetary policy: lower interest rates or increase money supply → right‑shift AD.
• Contractionary monetary policy: raise interest rates or reduce money supply → left‑shift AD.

12.3 Supply‑side Policy

• Definition: measures intended to increase the productive capacity of the economy (shift LRAS right).
• Tools
  • Investment incentives (tax relief for R&D)
  • Education and training programmes
  • Deregulation and competition policy
  • Infrastructure development (transport, broadband)
  • Labour‑market reforms (flexibility, minimum‑wage adjustments)
• Result: higher potential output, lower long‑run unemployment, reduced upward pressure on prices.

12.4 Policy Mix & Trade‑offs

• Combining fiscal, monetary and supply‑side tools can target multiple macro‑objectives simultaneously.
• Potential conflicts (e.g., expansionary fiscal + tight monetary policy) must be managed to avoid offsetting effects.
• Timing and credibility are crucial – expectations can amplify or dampen policy impact.

13. Summary of Key Points

• Economics studies scarcity, choice, and the allocation of resources; methodology distinguishes positive from normative analysis.
• Micro‑foundations: demand‑supply equilibrium, elasticities, and welfare analysis (CS, PS, DWL).
• Market failures justify government intervention – traditional tools (taxes, subsidies, price controls, buffer‑stock, regulation, information) and their incidence.
• Behavioural economics adds insights on bounded rationality, heuristics, loss aversion and social norms.
• Nudge theory changes behaviour through choice‑architecture while preserving freedom of choice; effectiveness is judged by impact, equity, transparency and legitimacy.
• Macro‑economics uses national‑income aggregates, the AD/AS model and a clear policy toolkit (fiscal, monetary, supply‑side) to achieve growth, low unemployment and price stability.