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 realworld phenomena, including stock market pricing, bubbles, crashes, savings rates, investment choices, buying [Page 106]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.

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

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.

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