Behavioral Economics, Explained

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.

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:

• People think of value in relative rather than absolute terms. They derive pleasure not just from an object’s value, but also the quality of the deal.
• People fail to fully consider opportunity costs and are susceptible to the sunk cost fallacy.
• People treat money differently, depending on the money’s origin and intended use, rather than thinking of it in terms of the “bottom line” as in formal accounting.
• People don’t like to spend money. We experience the pain of paying because we are loss averse.