Behavioral Economics

The standard theoretical model of economic behavior presents human beings as calculating, rational agents who (a) are motivated by self interest and make clear and logical decisions based upon their preferences and incentives, and (b) possess an unlimited capability to process information. Although intuitively appealing, this model of consumer decision making has been criticized by many for its highly stylized presentation of reality that systematically fails to explain specific behavior. For some, the rational choice model has simply collapsed under the weight of contradictory evidence. Behavioral economics seeks to provide economic analysis with a more realistic, psychological foundation by examining the ways in which various aspects of individual and collective psychology influence economic decision making.

It is impossible, in the space available, to consider the full range of ideas associated with behavioral economics and its empirical findings. The following will therefore concentrate on outlining a number of key areas. The first point to consider is the notion of “bounded rationality.” This refers to the view that economic agents are incapable of fully comprehending the complexity of the world in which they live, implying that they do not possess an unlimited capability to process information. A desire for cognitive simplification leads individuals to employ a number of techniques or rules-of-thumb, sometimes referred to as “cognitive heuristics” or “heuristics rules” in order to process information, evaluate outcomes and so make decisions and choices.

These “heuristics” highlight the human tendency to rely heavily upon specific reference points such as the use of memories, ideas they are familiar and comfortable with, and things that they have seen or heard in everyday life. If an unemployed worker is questioned about the total unemployed labor force in the economy, it is probable he or she will overestimate the figure due to the frequency of their contact with other unemployed workers. “Heuristics” are extremely important in economic decision making as they can lead to systematic errors such as overconfident assessments of future events. A famous example of this is the “gambler's fallacy,” which highlights people's intuitions about probabilities and the erroneous belief that because a particular event has not been [Page 128]observed in a number of repeated independent trials it is likely to occur in the future.

Another key feature of behavioral economics is “framing” and the view that decisions or preferences are heavily influenced by the ways in which a choice is presented. This idea contradicts the predictions of the standard model of economic rationality and can be illustrated by means of the following example. Assume than an epidemic is predicted to kill 10,000 people. Two different programs, A and B, are proposed to deal with the problem, and it is left to the government to decide which to implement. If the government selects program A, 4,000 people will survive; if it selects program B, there is a 40 percent chance that 10,000 people will survive and a 60 percent that nobody will survive. Based on this information, research suggests that a majority of people would select program A. Let us now alter the way in which the choice is “framed” and suggest instead that the selection of program A will lead to 6,000 people dying, while under program B there is a 40 percent chance that nobody will die, and a 60 percent chance that 10,000 people will die. Even thought the second decision problem is identical to the first, research suggests that people will actually reverse their initial preferences and now select program B. By “framing” the decision problem in a different way, individuals have switched from being risk averse to exhibiting risk-seeking behavior.

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