An Introduction to Behavioral Economics
BE uses psychological experimentation to develop theories about human decision-making and has identified a range of biases as a result of the way people think and feel.
BE is trying to change the way economists think about people’s perceptions of value and expressed preferences. According to BE, people are not always self-interested, benefits maximizing, and costs minimize individuals with stable preferences—our thinking is subject to insufficient knowledge, feedback, and processing capability, which often involves uncertainty and is affected by the context in which we make decisions.
In an ideal world, our decisions would be the result of a careful weighing of costs and benefits and informed by existing preferences. We would always make optimal decisions.
The theory of rational choice assumes that human actors have stable preferences and engage in maximizing behavior.
Our willingness to take risks is influenced by the way in which choices are framed, i.e. it is context-dependent.
Amos Tversky and Daniel Kahneman are perhaps best known for the development of prospect theory and published a number of papers that show that decisions are not always optimal.
Bounded rationality is a term associated with Herbert Simon’s work of the 1950s. According to this view, our minds must be understood relative to the environment in which they evolved. There are restrictions to human information processing, due to limits in knowledge and computational capacities.
While the idea of human limits to rationality was not a radically new thought in economics, Tversky and Kahneman’s ‘heuristics and biases research program made important methodological contributions. 30 years later, their thinking entered the mainstream.
The economist Richard Thaler coined the concept of mental accounting. According to Thaler:
Humans’ bounded rationality is particularly well illustrated by the concept of choice overload. This phenomenon occurs as a result of too many choices being available to consumers.
Overchoice has been associated with unhappiness, decision fatigue, going with the default option, as well as avoiding making a decision altogether, such as not buying a product. Factors that contribute to perceived choice overload: the number of options and attributes, time constraints, decision accountability, alignability and complementarity of options, and consumers’ preference uncertainty, etc.
Experience, good information, and prompt feedback are key factors that enable people to make good decisions.
Information avoidance in behavioral economics refers to situations in which people choose not to obtain knowledge that is freely available.
Active information avoidance includes physical avoidance, inattention, the biased interpretation of information (see also confirmation bias) and even some forms of forgetting.
In behavioral finance, for example, research has shown that investors are less likely to check their portfolio online when the stock market is down than when it is up, which has been termed the ostrich effect.
Daniel Kahneman uses a dual-system theoretical framework to explain why our judgments and decisions often do not conform to formal notions of rationality.
Judgments influenced by System 1 are rooted in impressions arising from mental content that is easily accessible. System 2, on the other hand, monitors or provides a check on mental operations and overt behavior—often unsuccessfully.
Present events are weighted more heavily than future ones; for example, many people prefer to receive £100 now over £110 in a month’s time.
Discounting is non-linear, and its rate is not constant over time. People’s preference for receiving £100 a week from now versus £110 a month and one week from now will not be the same as their preference for receiving £100 a year from now versus £110 a year and one month from now. Although the gap is one month in both cases, the value of events that are farther in the future falls more slowly than those closer to the present.
Time inconsistency also occurs when our present self fails to predict accurately the preferences of our future self, a point illustrated well by diversification bias.
When shopping for multiple future consumption episodes, I may choose the variety pack of cereal, only to realize two weeks later that I would have enjoyed my breakfasts more if I had just stuck to my favorite kind.
This inability to appreciate fully the effect of emotional and physiological states on decision-making is known as the (hot-cold) empathy gap.
When we make plans for the future, we are often too optimistic.
For example, we are subject to committing the planning fallacy by underestimating how long it will take us to complete a task and ignoring past experience. Similarly, when we try to predict how we will feel in the future, we may overestimate the intensity of our emotions.
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