Behavioral Economics - The basics
What is behavioral economics and why is it important?
Behavioral economics applies psychological insights into economic decision making. Its aim is to describe how real people make decisions in their private and public lives under various constraints, such as time, knowledge, cognitive processing limitations, or social pressure. From both field studies and experiments, behavioral economists now know that humans often do not behave in a rational manner in everyday life: their behavior is affected by heuristics (mental shortcuts) and biases. This is in stark contrast to the assumptions that neoclassical (mainstream) economists make about economic behavior. In this sense, behavioral economics is about misbehaving: how real humans deviate from traditional economic model predictions. This introductory chapter introduces the reader to depictions of the two main conceptions of the economic mind. Mainstream economics emphasizes ECON: the cold, rational, calculating self-interested mind; while psychology focusses on HUMAN, the flesh-and-blood being who is limited in processing capacity, patience and motivation and who is prone to a number of biases, errors and influences in decision making. We see why behavioral economics developed and how it has become more widely accepted following the 2008 global financial crisis. The introductory chapter provides a road map for this relatively new, exciting, but potentially confusing, field.
The ascent and dissent of economics
It may come as something of a surprise to learn that the roots of modern-day behavioral economics can be found in the origins of neoclassical (mainstream) economics. As the prefix suggests, neoclassical economics grew out of classical economics (sometimes referred to as the ‘dismal science’). Many behavioral economic principles are, in fact, a rediscovery of ideas that were first formulated in the work of classical economic thinkers, such as Adam Smith who is considered to be the first economist in the modern sense, and who is best known for his principles of the free market. This history and concepts based chapter describes the work of other classical thinkers, including David Ricardo, Jeremy Bentham, and John Stuart Mill, as well as early critics of the assumptions of neoclassical economics, namely Thorstein Veblen and John Kenneth Galbraith. What is important for behavioral economics is how these theorists shaped classical and, then, neoclassical economics, and how the assumptions they held still inform economic thinking today. The dawning of more sophisticated ideas in psychology in the 20th century, and the work of Tversky and Kahneman in particular, contributed greatly to the synthesis of psychology and economics in the emerging field of behavioral economics.
ECON: homo economicus
To gain a proper understanding of behavioral economics, we need to understand what came before. This chapter explores the assumptions and principles of neoclassical economics (today’s mainstream view of economics), and its very definite view of rational human behavior, exemplified by homo economicus or ECON: rational individuals with consistent preferences, making choices that serve to maximize their well-being (utility), given their budget constraints. Similarly, firms are said to seek to maximize profits. The rather abstract homo economicus (ECON) depicted in neoclassical economics is characterized, among other things, by great mathematical skills, access to relevant, full information and self-interest. However, these simplifying assumptions of human behavior do not adequately reflect everyday economic life – as experiments and field studies show, people are often altruistic and their preferences often depend on the context. Tversky and Kahneman, in particular, published highly influential research which described how humans (in stark contrast to homo economicus) are affected by biases. They proposed that we use mental shortcuts – something they called ‘heuristics’ – when making judgements. The neoclassical economic approach, therefore, seems in need of modification to include newer empirical findings and a more psychologically realistic understanding of them.
HUMAN: more Homer (Simpson) than homo economicus
People systematically deviate from how they should behave according to neoclassical economics. For example, the context in which we make decisions is often more important than the informational content that we receive. The focus of this chapter is how people actually form judgements and make decisions according to psychological insights. Heuristics and biases are central to this discussion - heuristics can be thought of as mental shortcuts that are automatic, intuitive and do not require conscious thought. Tversky and Kahneman initially outlined three heuristics in 1974: availability, representativeness, and anchoring and adjustment, and others have been identified since. The formulation of Prospect Theory by Kahneman and Tversky in 1979 proved especially influential by combining psychological insights with economic phenomena. It provides an elegant explanation of why people dislike losses more than they value equivalent gains. In particular, Prospect Theory calls attention to the importance of reference points: we do not look at things in absolute terms but, rather, we focus on relative changes around a reference point, and these can be influenced in various ways. The chapter also explores how behavioral economic phenomena are the result of specific brain-mind cognitive and affective systems that are specialized for different functions.
Manners, monkeys and moods
This chapter further explores the psychological foundations of behavioral economics that help us understand why human behavior often deviates from neoclassical assumptions. The discussion focusses on three related areas. First, we examine social psychological findings about the influence of other people’s behavior on our own (e.g., through social norms). Contrary to neoclassical assumptions, we tend to cooperate with others and show altruism in daily life and economic games played in the labs of behavioral economists. Indeed, we seem to derive personal utility from helping others and our own preferences are, thus, interdependent with those of our peers. Secondly, we will look at judgement and decision making in an evolutionary context by discussing the behavior of monkeys, which is often not that different from our own – fascinating findings suggest that human judgement and decision making are rooted in our evolutionary past. Thirdly, we consider the influence of situation-specific emotion, affect and mood and physiological states (e.g., hunger) on human behavior. As successful financial traders attest, such ‘gut feelings’ convey important information about the world. In addition to discussing these transitory states, we consider longer-term propensities in the form of personality traits (e.g., Agreeableness) which shape our preferences and drive our behavior.
Nudge: whys, ways and weasels
If citizens make bad decisions, should it be the responsibility of governments to use insights from behavioral economics to nudge their behavior in a more desirable direction? Such ‘nudging’ has been applied in countries around the world to increase pension savings, organ donation rates and affect energy consumption in homes. As one goal of governments is to enhance their citizens’ well-being, nudging may be justified, but it remains a matter of considerable debate (e.g., how can we know people’s true preferences?). In this chapter, we describe some of the ways ‘nudging’ is applied, and, also, some of its problems. We discuss why nudges are often more effective than simply using information, incentives, or regulation to change behavior. For example, social incentives and pre-commitments can help to make people adhere to their goals and not to give in to temptations of immediate gratification. Behavioral insights teams around the world now help governments to design and evaluate behavioral policies. We further discuss how some governments and organisations have highlighted the value of taking into account subjective (i.e. self-reported) well-being – acknowledging that satisfaction, a sense of purpose, and flourishing are vital components of the true wealth and health of the nation.
Sell! Behavioral science of the commercial (and political) world of persuasion
Behavioral economic insights have been used in the private sector for many decades, though they have not been labelled as such – formerly, these went by such terms as ‘motivation research’, characterized as the ‘hidden persuaders’. Advertisers have known about the power of framing to add psychological value to products, and other tricks from the behavioral economics tool kit have been used for a long time to great effect. Indeed, companies rarely just sell a product or service; rather they sell the idea and feeling of them: psychological value. The chapter discusses the advertising industry’s clever use of psychological insights such as anchoring, framing, loss aversion and decoy pricing – all aided by sophisticated behavioral science testing protocols. In this context, we discuss developments in the scientific understanding of persuasion that have led to a significant shift in strategies to communicate messages to influence consumers, as well as people more widely (e.g., government ‘information campaigns’). Psychological insights are even being employed in political campaigns to sell ideas and policies. This concluding chapter ends with a discussion of the use of social media (e.g., Facebook) and behavioral economic techniques by recent political campaigns (2016 Trump campaign, and 2016 Vote Leave Brexit campaign).