The Basics of Behavioral Economics

Behavioral economics studies about why we buy how we buy and which are the factors that lead us to make a particular decision. So, we will speak about how psychology interact with our decisions involving an economical factor.

Rational choice

The theory of rational choice assumes that humans have stable preferences and engage in maximizing behavior.  Becker believed that some academic disciplines like sociology could learn from the ‘rational man’ assumption advocated by neoclassical economists since the late 19th century. The decade of the 1970s, however, also witnessed the beginnings of the opposite flow of thinking, as discussed in the next section.

Prospect theory

Amos Tversky and Daniel Kahneman published a number of papers that appeared to discover ideas about human nature held by economics. They are known for the development of the prospect theory, which shows that decisions are not always the most efficient nor optimal. Our desire to take risks is influenced by the context in which we make those choices.

As an example:

Which of the following would you prefer:

  1. A) A certain win of 1000 €, vs.
    B) A 25 % chance to win 4000 € and a 75 % chance to win nothing
  2. C) A loss of 750 €, vs.
    D) A 75 % chance to lose 1000 € and a 25 % chance to lose nothing?

Tversky and Kahneman’s research demonstrate that answers are different if choices are contextualized as a gain or a loss, as in the example above. When having to decide according to the first type, a bigger proportion of people will choose the riskless alternative which is A). However, for the second situation, people are more likely to choose the riskier, which is D). The explanation of this is because we do not like to loose more than we like an similar gain: Giving something up is more painful than the feeling from receiving it.

Bounded rationality

Before Tversky and Kahneman’s research, some philosophers were interested in the psychological contextualization of basic economic life. Researchers increasingly tried to emulate the natural sciences, because they wanted to differentiate themselves from the “not scientific” area of psychology at that time.  Bounded rationality (a term which is associated with Herbert Simon’s research) explains that our minds must be understood according to the environment in which they evolved. Decisions are not always optimal nor efficient as there are restrictions to human information processing and filtering due to limits in knowledge.

Gerd Gigerenzer proposed that the rationality of a decision depends on structures found in the environment. People are “ecologically rational” when they make the best possible use of limited information-processing abilities, by applying simple and intelligent algorithms that can lead to near-optimal inferences (Gigerenzer & Goldstein, 1996).

Tversky and Kahneman research program made some very important methodological contributions, in that they demonstrated an experimental approach to understanding economic decisions based on measuring choices made under different environmental conditions.

Mental Accounting

Richard Thaler (economist, Nobel Prize in 2017) a keen observer of human behaviour and founder of behavioral economics, was inspired by Kahneman & Tversky’s research. The notion behind the Mental Accounting Theory is that people think of value in relative rather than absolute terms. They appraise pleasure not just from the value of an object, but also taking into account the quality of the deal (utility). Humans often fail to consider fully opportunity costs and are susceptible to the sunk cost fallacy.

What is the sunk cost fallacy?

“The idea that a company or organization is more likely to continue with a project if they have already invested a lot of money, time, or effort in it, even when continuing is not the best thing to do.”

People treat money differently, depending on factors such as its origin and use, in spite of thinking of it in terms of accounting. An important term to explain behavioral economics is fungibility, the fact that all money is the same and has no labels. An example from mental accounting is credit card payments, which are treated differently than cash. Mental accounting theory suggests that credit cards decouple the purchase from the payment by separating and delaying the payment. Credit card spending is attractive because on credit card bills, the individual items will lose their importance when they are seen as a small part of a larger amount.

Limited Information and Feedback

Thaler and Sunstein point out that good information and quick feedback are key factors that enable people to make good decisions. For instance,  in healthcare systems, feedback is often poor.

Generic feedback aimed at inducing behavioral change has been limited to information ranging from the economic costs of the unhealthy behavior to its potential health consequences (Diclemente et al., 2001). Recent behavior change programs usually provide positive and personalized behavioral feedback (we can find this facts within health app in our cell phone).

Irrational Decision Making

Research on irrational decisions discusses about involving prices and value perception. One study asked participants whether they would buy a product for a euro amount that was equal to the last two digits of their social security number. They were then asked about the maximum they would be disposed to pay. In some cases, people in the top 20% of social security numbers were eager to pay three times as much compared to those in the bottom 20%. The experiment demonstrates that a process where a numeric value provides a non-conscious reference point that influences subsequent value perceptions (Ariely, Loewenstein, & Prelec, 2003).

There is also introduced the zero price effect (a product is advertised as free), consumers perceive it unconsciously as more valuable. Price is often taken as an indicator of quality, and it can serve as a cue with physical consequences, just like a placebo in medical studies. For instance, some experiments gave participants a drink that helped mental acuity. When people received a discounted drink their performance in solving puzzles was significantly lower compared to regular-priced and control conditions (Shiv, Carmon, & Ariely, 2005).

Choice under uncertainty studies were pioneered by Kahneman and Tversky’s. The psychology of “homo economicus”—a rational and selfish individual with relatively stable preferences—has been challenged, and the traditional view that behavior change should be achieved by informing, convincing, incentivizing or penalizing people has been questioned (Thaler & Sunstein, 2008). The field associated with this stream of research and theory is behavioral economics, which suggests that human decisions are  influenced by context, including the way in which they are presented to us. Behavior varies across time and space, and it is subject to cognitive biases, emotions, and social influences. Decisions are the result of less deliberative, linear, and controlled processes than we would like to believe.

Theory of the Dual System

Daniel Kahneman uses a dual-system theoretical framework to explain why our judgments and decisions very often do not conform to formal rationality. The first system  consists of thinking processes that are intuitive, automatic, experience-based, and relatively unconscious. The second system is reflective, controlled, deliberative, and analytical. Judgments influenced by System 1 are rooted in impressions arising from mental content that is easily accessible. System 2 provides a check on mental operations and over behavior, often unsuccessfully.

Temporal dimensions

Another important area of behavioral economics is the time dimension for human evaluations and preferences. This area acknowledges that people are oriented towards the present and not very good predictors of future experiences, value perceptions, and behavior.

Forecasting and Memory

When we make plans for the future, we are often too optimistic. We are subject to committing the planning fallacy by underestimating how long it will take us to complete a task and ignoring past experience (Kahneman, 2011). When we try to predict how we will feel in the future, we can overestimate the intensity of our emotions (Wilson & Gilbert, 2003).



Source: An introduction of Behavioral Economics, by Alain Samson, PhD.


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