Classical economic models assume that people are rational, predictable, and make the most optimal choices, but are we really so? Trying to answer this question, a new economic sub-field emerged and it’s called “behavioral economics”. It is an attempt to prove that there are psychological, social, and emotional factors that influence our decision-making.
Behavioral economics is a branch of economics that seeks to understand how the human mind makes decisions when faced with scarce resources. Essentially, it’s about taking psychology and other social sciences into account to understand economic decision-making.
Unlike the classical economic models, behavioral economics approaches the subject by taking into account that humans act and react to a number of different factors, not just pure economic rationality, and tries to analyze why humans behave irrationally and unpredictably from an economist’s perspective.
The goal of behavioral economics is to understand those factors and determine how they can be incorporated into economic models.
Several principles that emerged from behavioral economics research have helped economists better understand human economic behavior. From these principles, governments and businesses have developed policy frameworks to encourage people to make particular choices.
The origins of behavioral economics:
Although the term “behavioral economics” was first coined by psychologist Daniel Kahneman in his groundbreaking work “Thinking Fast and Slow” in 2011, it has a long history that can be traced back to 18th-century Scottish economist Adam Smith.
Smith is mostly known for his “invisible hand theory” which argues that economic agents, by following their own interests, can lead the economy to prosperity. But he also acknowledged that people are often overconfident in their abilities, more afraid of losing than eager to win, and more likely to seek short-term benefits than long-term ones. These ideas (overconfidence, loss aversion, and self-control) are today fundamental concepts of behavioral economics.
More recently, the work of Israeli psychologists Amos Tversky and Daniel Kahneman on uncertainty and risk has made the biggest contributions to this field so far.
Tversky and Kahneman came up with a concept known as the “availability heuristic” that states that, when making a judgment or a decision, people often rely on easily recalled information, rather than actual data, it’s the tendency to use information that comes to mind quickly and easily rather than conducting research and collecting reliable data. This concept contradicts the classical “utility theory” that states that economic agents are always well-informed and have all the needed data to make the most optimal decisions.
Another Tversky and Kahneman theory that reinforced behavioral economics is the ” prospect theory”.
According to prospect theory, we don’t evaluate the possibilities of gains and losses in the same way, we are more concerned about avoiding losses than making gains.
For example, studies have shown that if presented with an opportunity to win $250 guaranteed or gamble on a 25% chance of winning $1,000 and a 75% chance of winning nothing, most people will choose the sure win. But if presented with the chance to lose $750 guaranteed or a 75% chance to lose $1,000 and a 25% chance to lose nothing, most people will risk losing $1,000, hoping for the slim chance that they will lose nothing at all.
So, the prospect theory, also known as the loss-aversion theory, shows how, presented with a choice, both equal, most of us will choose the one presented in terms of potential gains.
If people were rational they would consistently make the same decision given identical options, but studies show that most of the time people’s preferences are dependent on how options are presented, psychologists call this type of cognitive bias: the framing effect.
What is a “nudge” in behavioral economics?
A nudge in behavioral economics refers to any aspect of the choice architecture that tries to influence people’s behavior and decision-making. A “nudge” is a way to manipulate people’s choices to lead them to make specific decisions but without forbidding any options or significantly changing their economic incentives.
An example of a nudge: putting fruit at eye level or near the cash register at a high school cafeteria to get students to choose healthier options.
It is to note that behavioral economics doesn’t blow up the traditional economic theory, it just seeks to understand when and why people behave differently than old economic models suggest.
Classical economists ignored many irrational elements of decision-making, behavioral economics tries to fill this void by treating the topic from another perspective and covering those neglected elements.
It’s a relatively new field so its implications are still being debated by economists. suffice to say, however, that behavioral economics casts doubts on some of the fundamental assumptions of classical economic