Beginnings

What is behavioral economics? 

Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the decisions of individuals and institutions and how those decisions vary from those implied by classical economic theory.¹ 

According to its theories, actual human behavior is less rational, stable, and selfish than traditional normative theory suggests, due to bounded rationality, limited self-control, and social preferences.

Short history 

The story about the beginnings of behavioral economics is so nicely presented in the book Misbehaving where Richard H. Thaler, one of the founding fathers of this discipline explains it all. According to Thaler, the interest in the underlying psychology of human behavior returns economics to its earliest roots. Even Adam Smith talked about key concepts as loss aversion, overconfidence, and self-control in the book The Theory of Moral Sentiments published way back in 1759. In it, he proposed psychological explanations of individual behavior, including self-interest and sympathy, fairness, virtue and justice. Most importantly, he argues that this social psychology is a better guide to moral action than reason.²

Much later, during the development of neoclassical economics, economists sought to reshape the discipline as a natural science, deducing behavior from assumptions about the nature of economic agents.³ This pushed the discipline more to mathematics, leading to development of predictability models and giving birth to “homo economicus”, or the “rational man,” a perfectly rational agent who weight up all cost and benefits and makes decision giving him always the best outcome.

In the 1970s, psychologists Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. What they found is that we are not as rational as the neoclassical theory suggests. They looked at the psychology involved in decision-making, and backed up their hypotheses with empirical examples. Their key paper Prospect Theory: An analysis of decision under risk, outlined a theory that marked the start of a new branch of study known as behavioural economics.⁴

As a trained economist, but with a flare for sociology and psychology, I like the fact that economics is returning to other social sciences, adopting their contributions along the way. I like the idea shared by Jean Tirol that all these the sciences, anthropology, law, economics, history, philosophy, psychology, political sciences, and sociology are in a way one unique discipline, because they have the same subject of study: same faces, same groups, same organizations.⁵ 

Main concepts⁶

• Bounded rationality –  is a concept proposed by Herbert Simon that challenges the notion of human rationality as implied by the concept of homo economicus. Rationality is bounded because there are limits to our thinking capacity, available information, and time (Simon, 1982), and it is one of the psychological foundations of behavioral economics.

• Choice architecture – term coined by Thaler and Sunstein refers to the practice of influencing choice by “organizing the context in which people make decisions” (Thaler et al., 2013). A frequently mentioned example is how food is displayed in cafeterias, where offering healthy food at the beginning of the line or at eye level can contribute to healthier choices. 

• Cognitive bias – A cognitive bias (e.g. Ariely, 2008) is a systematic (non-random) error in thinking, in the sense that a judgment deviates from what would be considered desirable from the perspective of accepted norms or correct in terms of formal logic. The application of heuristics is often associated with cognitive biases.

• Dual-system theory – Dual-system models of the human mind contrast automatic, fast, and non-conscious (System 1) with controlled, slow, and conscious (System 2) thinking (see Strack & Deutsch, 2015, for an extensive review). Many heuristics and cognitive biases studied by behavioral economists are the result of intuitions, impressions, or automatic thoughts generated by System 1 (Kahneman, 2011). Factors that make System 1’s processes more dominant in decision making include cognitive busyness, distraction, time pressure, and positive mood, while System 2’s processes tend to be enhanced when the decision involves an important object, has heightened personal relevance, and when the decision maker is held accountable by others.

• Heuristic – are commonly defined as cognitive shortcuts or rules of thumb that simplify decisions, especially under conditions of uncertainty. They represent a process of substituting a difficult question with an easier one (Kahneman, 2003). Heuristics can also lead to cognitive biases. 

• Mental accounting – is a concept associated with the work of Richard Thaler. According to Thaler, people think of value in relative rather than absolute terms. For example, they derive pleasure not just from an object’s value, but also the quality of the deal—its transaction utility (Thaler, 1985). According to the theory of mental accounting, people treat money differently, depending on factors such as the money’s origin and intended use, rather than thinking of it in terms of the “bottom line” as in formal accounting (Thaler, 1999). An important term underlying the theory is fungibility, the fact that all money is interchangable and has no labels. In mental accounting, people treat assets as less fungible than they really are. 

• Nudge – According to Thaler and Sunstein (2008, p. 6), a nudge is “any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level counts as a nudge. Banning junk food does not.” Perhaps the most frequently mentioned nudge is the setting of defaults, which are preset courses of action that take effect if nothing is specified by the decision-maker.

• Prospect theory – is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty (e.g. % likelihood of gains or losses). It demonstrates that people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes. Prospect theory was developed by framing risky choices and indicates that people are loss-averse; since individuals dislike losses more than equivalent gains, they are more willing to take risks to avoid a loss. 

References

1. Lin, Tom C. W. (April 16, 2012). “A Behavioral Framework for Securities Risk”. Seattle University Law Review and Zeiler, Kathryn; Teitelbaum, Joshua (March 30, 2018). “Research Handbook on Behavioral Law and Economics,” Wikipedia

2. The Theory of Moral Sentiments, Adam Smith Institute

3.  Behavioral economics – Wikipedia

4. The Economics Book, DK Publishing, London 

5. Economics for The Common Good, Jean Tirole, 2016

6. The main concepts explained are taken from the The Behavioral Economics Guide 2021, where you can find much comprehensive edition of the behavioral science concepts and more.