What Is Behavioral Economics?

What Is Behavioral Economics?

Let me explain behavioral economics directly to you: it's the study of how psychology ties into the economic decisions that individuals and institutions make. You'll often see it linked with normative economics, where we draw on both psychology and economics to figure out why people make irrational choices and how their behavior strays from what standard economic models predict.

Key Takeaways

Here's what you need to grasp: behavioral economics analyzes the psychological elements behind the economic decisions people make. Factors like bounded rationality, choice architecture, cognitive biases, discrimination, and herd mentality play major roles in shaping behavior. This field builds on principles such as framing, heuristics, loss aversion, and the sunk-cost fallacy. Companies apply these insights to set prices, design ads, and package products effectively.

Understanding Behavioral Economics

In a perfect scenario, you'd always pick options that give you the most benefit and satisfaction. Rational choice theory in economics says that under scarcity, people choose what maximizes their personal gain. This assumes you can rationally weigh costs and benefits of every option, leading to the best decision for yourself. The rational individual stays in control, ignoring emotions or outside influences, and always knows what's best. But behavioral economics tells you the truth: humans aren't rational and often can't make those good decisions.

Since we're emotional and easily distracted, our choices don't always serve our self-interest. Take rational choice theory: if Charles wants to lose weight and knows the calories in foods, he'd pick low-calorie options. But behavioral economics shows that even with that goal, cognitive biases, emotions, and social pressures can derail him. A TV ad for cheap ice cream, with tempting images and stats about daily calorie needs, might push him to indulge and abandon his diet, highlighting his lack of self-control.

Important Note

You should know that behavioral economics and behavioral finance share many drivers, though behavioral finance focuses more on financial markets.

History of Behavioral Economics

Key figures in behavioral economics include Nobel winners like Gary Becker for motives and consumer errors in 1992, Herbert Simon for bounded rationality in 1978, Daniel Kahneman for illusion of validity and anchoring bias in 2002, George Akerlof for procrastination in 2001, and Richard Thaler for nudging in 2017.

Back in the 18th century, Adam Smith observed that people overvalue gains and undervalue losses, believing individuals aren't rational about their limits. More recently, in the 1960s, economists spotted biases in recalling information, leading to the availability heuristic explained by Amos Tversky and Daniel Kahneman, where people misinterpret data irrationally—like overestimating shark attacks due to headlines. They also developed prospect theory, showing people hate losses more than they value equivalent gains.

In 2017, Richard Thaler won the economics prize for work on limited rationality, social preferences, lack of self-control, and individual decision-making.

Factors That Influence Behavior

Five main factors often come up when we look at what sways individual behavior. Bounded rationality means you decide based on limited knowledge, whether from lack of expertise or information— in investing, everyone has the same public data, but internal company details might be unknown. Choice architecture shows how easily you can be manipulated, like supermarket displays pairing crackers with cheese to prompt buys. Cognitive bias affects decisions subconsciously, such as picking a company to invest in based on logo color or CEO name. Discrimination ties in, as you view things through your own lens, favoring options that might not be better. Herd mentality drives choices by what others do, following the crowd even if it's not optimal, like sticking with a losing sports team because others do.

Fast Fact

Media plays a big role in behavioral economics— a single headline can push you to chase or avoid a product.

Principles of Behavioral Economics

Economics is broad, and behavioral economics is a subset with guiding principles. Framing is about how something is presented, creating bias based on structure—like viewing Babe Ruth as failing two-thirds of at-bats or as a great with a .342 average, both true but framed differently. Heuristics involve mental shortcuts instead of rational reasoning, sticking to what's familiar even if better options exist. Loss aversion means you hate losses more than you like equal gains, so losing $20 feels worse than finding $20. Market inefficiencies let markets exploit behaviors, like investors buying overpriced stocks thinking a P/E drop makes them reasonable. Mental accounting changes how you spend based on situations, like risking more with a bonus than regular funds. The sunk-cost fallacy is emotional attachment to past costs, making it hard to abandon failed investments, like holding a stock bought at $100 now worth $15.

Fast Fact

In cost/benefit analysis, ignore sunk costs since they're already spent and irrecoverable, with no bearing on future decisions.

Applications of Behavioral Economics

In financial markets, behavioral economics applies through behavioral finance, explaining rash trading decisions, much like poker players exploit irrationality. Game theory uses it to analyze irrational choices in experiments, overriding illogical behavior to predict outcomes. For pricing strategies, companies use it to boost sales, like Apple's iPhone starting at $600 then dropping to $400, making it seem like a deal. In product packaging, a soap maker might label identical products differently—one for general use, one for sensitive skin—to target groups, even though it's the same soap.

What Do Behavioral Economists Do?

Behavioral economists figure out what consumers do and why, helping markets guide those choices. They might work for governments on policies to protect you, or for companies to drive sales.

What Is the Goal of Behavioral Economics?

The aim is to understand why people make the decisions they do, especially when they skip the best outcomes due to irrationality, which can be complex and hard to explain.

What Is the Difference Between Behavioral Economics and Psychology?

Both deal with emotions and decision-making, but behavioral economics focuses on financial choices, while psychology covers broader human rationality.

What Is the Downside to Behavioral Economics?

A drawback is that it can manipulate people, exploiting predictable irrationality through packaging, pricing, or marketing to target markets.

The Bottom Line

Behavioral economics seeks to understand why people make economically irrational decisions. While rational choice theory assumes utility-maximizing choices, reality shows distractions and sways. This field explains how and why that happens.