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Introduction to Behavioral Economics

Behavioral Economics is the intersection of Economics and Psychology and it examines the market forces when some agents exhibit human limitations and impediments. It is a branch of economic research that combines fundamentals of psychology to long-established models of economics to realize and understand decision-making by investors, consumers and other economic participants.

How is Behavioral Economics Different from Traditional Economics?

Economics conventionally conceptualizes a world populated by calculating, unresponsive optimizers known as “Homo economicus”. The theory talks about how humans are “consistently rational and narrowly self-interested agents who usually pursue their subjectively-defined end optimally”. The typical economic framework ignores or rules out virtually all the behavior studied by cognitive and social psychologists. This economic model of human behavior includes three unrealistic traits i.e. boundless rationality, uncontrolled willpower, and unrestrained selfishness and these are modified by behavioral economics. Behavioral economics developed after the realization that human behavior and choices change and this also affects the decision making process.

Behavioral economics is concerned with improving the explanatory power of economic theories by giving them a sound psychological basis to explain wide variety of glitches. Behavioral economics believes that human beings do have bounded willpower, rationality and self interest because due to this only people make choices which are not in their long run interest, limited cognitive abilities which constrain their problem solving skills and sometimes people are willing sacrifice for the well being of others.

The field of behavioral economics talks about how individuals do not behave in their own best interests. It provides an outline on how people make errors. These systematic errors or biases persist in particular circumstances. Thus, through behavioral economics creates such an environment which will help people to take better decisions. Individuals are in the best position to know what is best for them. Thus, the behavioral goal of an individual can be affirmed as maximizing happiness and reaching this goal requires contributions from several brain regions.

This branch attempts incorporate psychologists’ understanding of human behavior into economic analysis. Also, it recommends the policy makers on how to restructure the environments to facilitate better choices. For example, basically rearranging items that are offered within the school which persuade the children to buy more nutritious items like keeping the fruit nearby, making choices less convenient by moving soda machine into more distant areas, or requiring student pay cash for desserts and soft drinks.

In sum, this approach complements and enhances the traditional economic model and helps in understanding that where people go wrong and helping them for the same.

History of Behavioral Economics

Behavioral economics was first acclaimed by Adam Smith in 18th century where he addresses the issues related to human psychology and how it is imperfect and how these imperfections impact economic decisions and affect market forces.

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Until the early 20th century, behavioral economics was unpopular. However, economists such as Irving Fisher and Vilfredo Pareto started believing in the idea of “human” factor in economic decision-making and how it was a potential reason for the stock market crash of 1929 and the events that happened after.

In 1955, economist Herbert Simon coined the term bounded rationality within the backdrop of behavioral economics and believed that human beings do not have the capabilities of taking infinite decisions and choices. This branch of research has been ignored for several years. In 1979, Kahneman and Tversky gave the Prospect Theory that offered a framework for how people structure economic outcomes as gains and losses and it affects people's preferences.

Behavioral economics is still a new field and many new concepts are yet to be explained.

Rational Choice

Human behavior changes in different situations depending on location, time, and influences of the society, emotional judgments, and thoughts based on prejudice, and simultaneously it affects their choices. In the 1976, Gary Becker establishes the rational choice theory and its relationship with human behavior. This theory assumes that human beings have stable preferences and engage in maximizing behavior.

Read more about Rational Expectations and Adaptive expectations

Prospect Theory

Prospect theory discusses about the nature of people i.e. how people dislike losses more than they like equal gains i.e. giving up on something is more painful than the joy we derive from receiving it. This pillar of behavioral economics deals with the number of observed biases that the traditional models could not explain. Also, the theory tells us that decisions are not always optimal and our willingness to take risks is manipulated by the way in which alternatives are framed, i.e. it becomes context-dependent.

Dual System Theory

Daniel Kahneman talks about a dual-system framework which explains why our judgments and decisions often do not match to the prescribed rules of rationality. Firstly, system 1 which comprises of thinking processes those are instinctive, automatic, experience-based, and quite unconscious. Second, system 2 is more reflective, restricted, conscious, and logical.

System 1 works repeatedly and quickly and requires less effort and has no sense of voluntary control. On the other side, system 2 distributes our attention to the effortful mental activities. The operations of system 2 are biased because it varies with our choice and concentration. System 1 is fast and apprehends the situation quickly around us both knowingly and unknowingly whereas system 2 is slow and planned. The interaction between these two systems yields our choices which contain bias. Different kinds of biases due to different reasons are generated such as:

  • Cognitive Biases: These biases are called “cognitive biases” because they affect our knowledge acquiring skills and decision making process.
  • Anchoring: This provide us the starting points and question our perception.
  • Availability: The prediction of the likelihood of an event is based on how readily we can think of examples of that event. Information about the accurate probabilities is less, due to which bias increases.
  • Representativeness: this bias is largely determined by chance. We overweight qualitative characteristics when they match our stereotypes in spite of probabilities that should influence us otherwise. When something seems to share enough characteristics to lump it in a given category, we over assign additional characteristics we believe to be stereotypical of that category.
  • Status Quo: People generally go with their current choices even when it is not in their best interest.
  • Framing: Framing of choices is important. People go with the decisions which are more popular among others.
  • Zero price effect: Something that is free produces irrational excitement. Free is an incredibly powerful driver of human behavior.
  • Endowment effect: Once we own something, we place a much higher value on it. In some cases, this sense of ownership comes before we actually own it based on how much work we put towards acquiring it.
  • Overconfidence: People generally overestimate their performances and this bias encourages individual to take risk.
  • Emotions: When we are aroused, angry, frustrated or hungry, we reliably make irrational decisions. Emotions control our behavior in such situations.
  • Temporal Dimensions: Time dimension do affect human evaluations and preferences. This area acknowledges that people are biased towards the present and poor predictors of future experiences, value perceptions, and behavior.

Social Dimensions

Behavioral economics also considers social forces through which decisions are made by individuals and gets shaded and embedded in the social environments. People are strongly influenced by the environment they live in and the decisions of their fellow beings.

  • Trust and Dishonesty: Trust is one of the reasons for discrepancies between actual behavior and that predicted by a model of self-interested actors. While trust can make people weak, and thereby increases the risk in revealing the preferences, which also affects social preferences. Behavioral economics perspective does not consider humans to be more honest but it takes a more social-psychological perspective by showing that dishonesty is the product of situations as well as both internal and external reward mechanisms not just about tradeoffs between external incentives such as material gains and costs such as punishments.
  • Fairness and Reciprocity: Fairness is associated to human desires for reciprocity and the tendency of people to return another’s action with another equivalent action. Reciprocity can have positive and negative aspects too.
  • Social Norms: Norms are the behavioral expectations within a society or group. They have a powerful automatic effect on behavior and sometimes that power comes from penalties inflicted for not following the norm, other times that power comes from the social benefits received from following them. The social network too is very essential; people imitate the behavior of others in their network, regardless of whether it is in their best interest.
  • Consistency and Commitment: There is a continuous and consistent human need for building its self image. Consistency can be achieved by making a commitment only and pre-committing to a goal is one of the most often applied behavioral devices to achieve positive change.

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Conclusion on Behavioral Economics

The application of behavioral economics is related with the decision makings of the market as well as the individual preferences and choices. The central point of behavioral economics is to suggest a better approach for the economic analysis, enhance the study of Economics by all means-producing hypothetical experiences and bring about a significant improvement in forecasting the field phenomena using psychological experimentation.

Behavioral economics has changes the way economists think about people’s perceptions of value and expressed preferences. It suggests that people’s thinking is subjected to insufficient knowledge, feedback, processing ability which also involves uncertainty and people do not always have stable preferences. Behavioral economics acknowledge the fact that people are social beings with social preferences with emotions like trust, reciprocity, and fairness and are vulnerable to social norms and there always exist a need for self-consistency. Also, people use the available information in their memory and have poor predictions about the future.

Behavioral economics possess the capability to add value to the rational choice theory. The model of rational choice should accommodate the behavioral insights in all dimensions and then only it will be able to make better predictions and necessary prescriptions.

The implications of behavioral economics are extensive, and its ideas have been used in various domains like personal and public finance, health, energy, public choice, and marketing etc. This branch of economics has encouraged research that concerns with actual behavior and has promoted a ‘test and learn’ culture among governments and corporations. Behavioral Economics therefore needs to be considered alongside rather than as a replacement for traditional interventions.

In the private sector too, behavioral economics has revitalized practitioners’ interest in psychology, predominantly in marketing, consumer research as well as business and policy consulting.

The explanatory power of Economics has increased by behavioral economics because it provides us with a more rational, psychological foundation by surrounding various relevant aspects adhering to it. Behavioral economics has made a significant impact on the decision making of individuals and suggested the ways in which the human behavior differs depending on the circumstances, time, location, emotional judgments as well as societal influences.

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