Behavioural frictions in markets

The standard microeconomic toolkit assumes individuals are time-consistent, narrowly self-interested, fully informed, and consistent in choice across frames. The empirical-behavioural literature has shown that humans systematically deviate from these assumptions in patterned ways — patterns that matter for predicting behaviour and designing policy. This module bridges to the dedicated Behavioural and Household Economics course.

The descriptive vs normative distinction

Standard microeconomics is BOTH descriptive (a model of how people actually behave) and normative (a model of how they should behave for maximum welfare). When behaviour deviates from the standard model, two interpretations:

• Welfare-loss interpretation — people are making mistakes; deviations represent suboptimal decisions; correcting them improves welfare
• Different-preferences interpretation — people have richer preferences than the model captures; deviations reveal what people actually value; respecting them respects welfare

The second interpretation has gained ground over time. People's deviations from the standard model often reflect concerns the model omits — fairness, social status, identity, self-control, regret. Behavioural economics is partly the project of expanding the model to include these motives.

Present bias and hyperbolic discounting

Standard model: people discount future payoffs at a constant rate r. So PV(c_t) = c_t × (1+r)^(-t). This is exponential discounting.

Empirical observation: people are MUCH more impatient about near-future trade-offs than far-future trade-offs. Asked to choose between $100 today and $110 tomorrow, many people choose today. Asked to choose between $100 in 30 days and $110 in 31 days, most people choose 31 days. The TIME PREFERENCE is different at different time horizons.

Implications for African savings and borrowing

Present bias explains many puzzling features of African financial behaviour:

• Low savings rates despite stated preferences for saving. Surveys show overwhelming preference for retirement savings, child-education savings, household-emergency savings. Behaviour shows much lower actual rates. Present bias is the gap
• Demand for commitment devices — products that lock you out of your own savings. SACCOs that require monthly contributions and discourage withdrawal; mobile-money 'lock' accounts (M-Shwari Lock Savings, KCB-M-PESA Save); ROSCAs (rotating savings and credit associations) that physically transfer money to a different person on a schedule. These products PRECISELY exploit the desire to overcome present bias
• Persistent high-cost borrowing. People take payday loans, mobile-money instant loans at 7-15% per month (84-180% annualised) even when cheaper alternatives exist. Present bias explains the disconnect: today's immediate need outweighs tomorrow's interest cost in the choice
• Christmas-club savings — the explicit savings product where a customer commits to weekly/monthly contributions that they can only withdraw at year-end. Mauritian and Kenyan banks offer these. The product works because the customer commits when they're not present-biased (or less so), and the product locks in the commitment when they would otherwise be present-biased

Mental accounting

Thaler (1985, 1999): people don't treat money as fungible. They categorise income and spending into separate 'accounts' — household income vs windfall gain, food budget vs entertainment budget, current income vs accumulated savings. The labels of accounts affect spending decisions even though the money is identical.

• Windfall gains — lottery, tax refunds, gifts — are spent more readily than equivalent regular income. Households save 30% of regular income but only 5% of windfalls
• Earmarked savings — money labelled for a specific purpose (school fees, livestock purchase) is harder to spend on other things
• Income-source labels — money from selling crops is treated differently from money from a wage, even at the same amount. Affects spending patterns

Anchoring

Initial values strongly influence judgements, even when the values are arbitrary and irrelevant. Kahneman and Tversky's classic experiments: a spun wheel that produces a random number (clearly random and unrelated to the question) influences subjects' estimates of population statistics. In markets:

• Suggested-retail-price (SRP) labels — set the anchor for negotiation. Even when the SRP is unjustifiably high, customers pay more than they would absent the anchor
• Negotiation in markets — the first offer (mtumba clothing, used cars, fish-market prices) sets the anchor. Sellers know to start high
• Salary negotiations — the first number proposed strongly affects the negotiated outcome regardless of underlying fundamentals

Framing and loss aversion

Prospect theory (Kahneman-Tversky 1979): the value function is steeper in the loss domain than in the gain domain. People feel a $100 loss roughly twice as keenly as they feel a $100 gain. This produces 'loss aversion' — strong preference for avoiding losses.

Implications:

• Status-quo bias — people stick with default options even when alternatives are available and recognisable as better. Pension defaults (Kenya's NSSF, SACCO contributions) operate this way
• Endowment effect — people value what they own more than they value the same thing if they didn't own it. Affects property and asset markets
• Framing effects — the same choice presented as a gain (90% survival rate) vs a loss (10% mortality rate) produces different choices

Social norms and reciprocity

Beyond pure self-interest, people care about norm-conformity, fairness, and reciprocity. Ultimatum-game experiments demonstrate this: in a one-shot game where one player proposes a split of a sum and the other accepts or rejects, the standard prediction is that any positive offer should be accepted. Empirically, offers below ~30% of the pot are usually rejected — at the cost of receiving nothing. People accept zero payoff to punish unfair behaviour.

Implications for African markets:

• Informal lending and borrowing — credit decisions are heavily mediated by social ties. The lender's willingness to lend depends on the borrower's reputation (a function of past behaviour and social relationships)
• Wage bargaining — workers' acceptance of wage offers depends on perceived fairness, not just on the absolute payoff. Workers reject low wages even when their alternative is unemployment
• Tax compliance — willingness to pay tax depends partly on the perceived fairness of the tax system and the use of revenues. Tax-morale theory connects fiscal psychology to revenue mobilisation (covered in Public Finance)
• Microfinance group dynamics — peer monitoring and pressure rely on social-norm enforcement. People comply with payment to maintain standing in the group

The relationship between micro-behavioural and macro-development

Behavioural patterns at the individual level matter for development. The poverty trap of credit-constrained households (Development module 3) operates partly through present bias preventing accumulation. Social norms and trust shape institutions (Development module 6). Mental accounting affects how households deploy aid and transfers (Public Finance module 7).