Behavioral Economics Definition
Everyday life is full of decisions and choices. Economic decisions are especially important to our lives whether we are deciding what to buy for lunch, shopping around for the best price on books, thinking about saving for vacation, or negotiating for a better salary. An important question for many researchers is how people make economic decisions. Specifically, researchers are interested in the assumptions, beliefs, habits, and tactics that people use to make everyday decisions about their money, work, savings, and consumption. Behavioral economics is a field of study that combines the techniques, methods, and theories of psychology and economics to research, learn about, and explain the economic behavior of real people. Whereas neoclassical economics has traditionally looked at how people should behave, behavioral economics tries to answer the question of why people act the way they do.
Behavioral economics can inform a variety of real-world phenomena, including stock market pricing, bubbles, crashes, savings rates, investment choices, buying habits, consumption addiction, and risky behavior— all of which are important economic issues with tremendous monetary and lifestyle implications for all of us. Although behavioral economics is a relatively new field of study, it has attracted supporters in academia, industry, and public policy along with criticism from skeptics, who question its contribution and methods.
Behavioral Economics History
As neoclassical microeconomics developed during the 20th century, psychology as an academic discipline was in its infancy—with techniques, theories, and methods that were not considered well developed by many academicians. As a result, those who studied economics viewed psychology skeptically, and the two disciplines developed independently. As psychology developed into a sound, theoretically based discipline, its theories and findings were nonetheless largely ignored by economists because of the long and separate history between the two disciplines. As a result, economists and psychology have tended to look at financial behavior through different lenses. Neoclassical economists tend to assume that human beings will, for the most part, act rationally when it comes to decision making and money. They also assume that people know what they want, try to always get the most that they can and consistently make the same types of choices under similar circumstances. On the other hand, psychologists have come to understand that human beings are prone to make mistakes, are fickle and inconsistent, and often do not get the best deal when making financial choices. Psychologists investigate the biases, assumptions, and errors that affect how people make decisions in all aspects of life. Over time, economists also began to wonder why financial markets and the individuals that participate in them did not always act according to traditional economic theory. The convergence of economics and psychology eventually created a new field of study referred to as behavioral economics.
Theoretical Developments in Behavioral Economics
The concept of bounded rationality is extremely important to understanding behavioral economics. Bounded rationality suggests that people are neither purely rational nor completely irrational in their economic behavior but instead try to be sensible and thoughtful economic decision makers. Bounded rationality further suggests that because human beings are limited in how much information they can process at any one time, they are prone to errors and biases when they formulate their preferences and choices. We often make decisions based on emotion, whim, or by mistake. We sometimes even avoid making certain financial decisions, such as saving for retirement, because the process is just too complicated or we are having too much fun doing other things. People tend to cope with difficult economic decisions by using tricks like mental accounts, habits, heuristics (simple rules of thumb), satisficing (settling for a minimum but not the maximum level of an outcome), maximization, and selective processing of information. These are the phenomena that behavioral economists are interested in. Although traditional economists prefer to assume that people (or agents as they are referred to by economists) are perfectly rational and will try to maximize their own personal, financial gain (or maximize utility as economists like to say), bounded rationality suggests that we do not always choose the most rational or even the most optimal choice when making economic decisions.
A key paper in the development of behavioral economics was published in 1979 by Daniel Kahneman and Amos Tversky and introduced prospect theory, which stimulated interest in understanding the underlying psychological mechanisms of economic preference, judgment, and choice. In 2002, Vernon Smith (who was instrumental in developing economics into an experimental discipline) and Kahneman were awarded the Nobel Prize in Economics for their contributions to experimental and behavioral economics.
Behavioral Economics Methodology
Behavioral economics tends to use experiments to test theories and hypotheses. However, more recent work has included many other techniques used in traditional economics studies, including field data, field experiments, and computer simulations. In addition, studies in behavioral economics have also used tools from social psychology and cognitive science—including brain scans, psychophysical techniques such as galvanic skin conductance, hormonal levels, and heart rate—to measure subject response.
Over the past 50 years, scientists have experimented with a number of hypothetical game scenarios to deter-mine models of how people make choices in economic situations. Researchers often use games to simulate the kind of financial scenarios that happen in the real world. One game often used in behavioral economics studies is the ultimatum game, which is also called the “take it or leave it” game. In the ultimatum game, a player, Ann, is given a sum of money (usually referred to in economics as an endowment) and is asked to split the money between herself and another player, Bob. At that point, Bob can decide whether to take it or leave it. In other words, if the split is accepted, each player gets what Ann had originally decided to give, but if Bob decides that the deal is not good enough, he can reject the deal and neither player will get anything, thereby ending the game. Classical game theory assumes that we will all act rationally and choose to maximize our own outcome. Therefore, according to game theory, Bob should accept any amount that Ann offers as long as it is more than zero, since something is better than nothing. If Ann assumes that Bob is perfectly rational, Ann will offer the minimum amount, say $1, to Bob so that she is maximizing her own “expected utility.” However, in repeated experiments of the ultimatum game, a surprising outcome occurs. People don’t act rationally when they feel others are taking advantage of them, and people often choose to act altruistically so that a sense of fairness exists between the two players. Neither of these two strategies leads to a traditional type of income maximization.
Another game that is often used in behavioral economics experiments is called the trust game, or the stock broker game. Just as in the ultimatum game, Ann starts off with a pot of money, usually $10, and she can choose to keep some of the money for herself and invest the remaining amount with Bob. Bob functions like a stock broker or a trustee. The money that Ann gives Bob is tripled, and Bob can now decide how much he wants to keep and how much he wants to give back to Ann. This game tests how altruistic, trusting, and trustworthy people are when in comes to money. Again, experiments have uncovered an interesting effect. If the game is repeated over many rounds, investors tend to invest about half of their money with the broker and the brokers tend to return to the investor more than was originally sent or about half the tripled amount. This indicates that people do not always try to get as much as they can for themselves, but instead try to play fair most of the time—especially when they are involved in multiple transactions with the same partner.
Behavioral Economics Topics
A number of topics have been investigated by behavioral economists. Some of the key topics in behavioral economics include intertemporal choice, loss aversion, framing, and fairness.
Intertemporal choice deals with how people choose to make decisions about events in the past, present, and future. Examples of the type of intertemporal choices that people make every day include deciding whether to save for retirement or choosing to buy a new outfit on impulse. While neoclassical economists assume that people discount the future at a rational and constant rate, behavioral economists look at how the psychology of an individual shapes the decisions and choices about the future.
Loss aversion is an important phenomenon investigated in seminal papers by Tversky and Kahneman. They found that people tend to value losses and gains differently. In fact, the research found that people are much more sensitive to suffering a “loss” than they are to netting a “gain.” According to neoclassical economics, people should value both losses and gains the same as long as the final outcome is the same. However, experiments have found that a loss is seen by most people as much more painful than the pleasure from an equal gain.
Framing is another important concept that developed from the loss aversion finding. Framing refers to how outcomes that are presented or stated to a person will influence which choice the person will make. An example of the framing effect can be seen in the Asian disease problem. The problem poses to research subjects a hypothetical situation wherein a disease threatens 600 citizens and the subjects need to choose between two options. In the positive frame, subjects are given the choice between (a) a 100% chance of saving 200 lives, or (b) a one-third chance of saving all 600 with a two-thirds chance of saving no one. In the negative frame, subjects are given the choice between (c) 400 people dying for sure, or (d) a two-thirds chance of 600 dying and a one-third chance of no one dying. Although all of the choices result in the same number of lives at risk, most people choose a over b in the positive frame, switching their preferences to choose d over c in the negative frame. Depending on which frame is presented, research subjects tend to change the type of solution they choose, which would be considered inconsistent and irrational by neoclassical economists.
Fairness is an interesting concept that seems to have a great deal of impact on economic choices, but it is not included in traditional economic models. Studies have found that people tend to reject inequality even if it means walking away from a reward, which does not seem to indicate a rational agent in all situations. The ultimatum game and the trust game have been used in experiments to test when fairness, altruism, and trust influence economic decision making.
New Directions in Behavioral Economics
New research directions based on ideas and theories from behavioral economics have started to use methods developed in cognitive neuroscience. Advances in brain imaging technology (e.g., functional magnetic resonance imaging, or fMRI), in addition to clinical studies using patients with brain lesions compared to normal subjects, have been used to examine which neural substrates underlie economic decision making. This new area, coined as neuroeconomics, has opened up new areas of inquiry for behavioral economic questions. Neuroeconomics is interested not only in exposing brain regions associated with specific behavior but also in identifying neural circuits or systems of specialized regions that control choice, preference, and judgment.
Criticism of Behavioral Economics
Behavioral economics has been criticized in a number of ways. One criticism is that it focuses on anomalies in behavior instead of creating a unified theory that explains what people usually do. However, researchers in this area argue that anomalies in behavior may be just as important to understanding economic choice since these anomalies have proven to have powerful effects in markets. Examples of these powerful effects can be seen in bubbles and crashes in the stock or real estate markets, anger at the gas pump when prices rise too quickly, or conflict in deciding whether to save a tax refund or spend it on a fancy dinner.
In addition, some have criticized the validity of experiments (which are based in the laboratory) because they are seen as being too different from real-world situations. However, the use of repeated experimental tests of findings and the additional use of field data have been cited as substantiating the findings in the lab.
Current models of decision making only partially explain human behavior. When the actual behavior of real people is examined, these elegant, simple, mathematically based models are not always very accurate or realistic. Behavioral economists defend their discipline by arguing that behavioral economics augments and informs these traditional economic models and provides a more realistic view of the how and why of financial decision making.
Behavioral economics, like the related disciplines of behavioral finance, behavioral game theory, economic sociology, and neuroeconomics, attempts to enrich the classical theories of economics to build better theories, concepts, and models about economic decision making. By attempting to integrate psychological factors into economic theory, it is not the intent of behavioral economists to supplant the important contributions that traditional economics has made, but instead to enhance and augment economic theory so that a more complete and realistic view of economic behavior can be developed. Understanding market phenomena, such as stock market crashes and real estate bubbles, why people do or don’t save, how people spend their money and how people make risky decisions, is important not only to academicians but also to public policymakers who seek to create as stable an economic system as possible to preserve the public good. Behavioral economics can even be applied to public health issues such as smoking and other risky behaviors by attempting to under-stand what economic mechanisms underlie people’s consumption choices.
Above all, behavioral economics strives to improve understanding of the financial choices that are an important part of everyday life. Through experiments and field data, behavioral economics has been able to test new ideas about how people make economics choices in a variety of settings in an attempt to create better predictive models of economic and financial decision making and to hopefully help everyone make better financial choices.
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