Behavioral Economics – Definition

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Behavioral Economics Definition

Behavioral Economics is a branch of economics that studies the impact of psychology on the decision-making traits of consumers. This field of economics studies how cognition, emotion, and psychology of humans and institutions affect their economic decisions. Given the effects of psychology on individuals and organizations, their economic decisions vary from those expected by classical theory.

A Little More on What is Behavioral Economics

Economists who have notable works in behavioral economics are Daniel Kahneman (The illusion of validity, anchoring bias; 2002), George Akerlof  (Procrastination; 2001), Herbert Simon (Bounded rationality; 1978), and others.

Behavioral economics seeks to answer whether assumptions of utility is a way to approximate the economic behavior of individuals and whether individuals are able to fully maximize subjective expected utility. In an ideal context, individuals make economic decisions that benefit them. In rational choice theory, individuals have the tendency of making economic decisions that aim to maximize their satisfaction when presented with various options. According to the rational choice theory, a rational person is one that has cognitive and emotional control over himself when making economic decisions.

Behavioral economics is a field of economics that seeks to connect psychology and economics.  Why and how people make certain economic decisions can be linked to their psychology and emotions. While rational people make rational decisions, irrational decisions tend to emanate from individuals who lack self-control and are moved by their emotions.

When presented with various options, under certain conditions, individuals tend to make choices as influenced by their emotions and psychological. The ability to make rational choices is dependent on how well individuals can tame or control their emotions. While people who are easily moved by emotions tend to make irrational choices, those who have self-control make somewhat logical choices. Behavior economics also evaluates the tendency of people and organizations to make decisions that are not in their best interest given the influence of emotions.

Applications of Behavioral Economics

Behavioral economics can be applied to various disciplines and fields. The popular examples of the application of this branch of economics are in game theory, heuristics, behavioral finance, and others. In the finance and investment market, for instance, behavioral economics helps to explain why investors make certain decisions when trading in the market. It also explains the psychology behind the decisions made by investors.

Behavior economics is also important to companies that desire to increase their sales and drive business growth. Sales experts have started using behavioral economics to judge which products would be marketed to a certain category of people and why a population will accept a product over another. A proper understanding of the behaviors of consumers by organizations and industries helps in making favorable business decisions that will not only benefit the company but also the consumers.

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Academics research on “Behavioral Economics”

Maps of bounded rationality: Psychology for behavioral economics, Kahneman, D. (2003). Maps of bounded rationality: Psychology for behavioral economics. American economic review, 93(5), 1449-1475.

Behavioral economics, Mullainathan, S., & Thaler, R. H. (2000). Behavioral economics (No. w7948). National Bureau of Economic Research. Behavioral Economics is the combination of psychology and economics that investigates what happens in markets in which some of the agents display human limitations and complications. We begin with a preliminary question about relevance. Does some combination of market forces, learning and evolution render these human qualities irrelevant? No. Because of limits of arbitrage less than perfect agents survive and influence market outcomes. We then discuss three important ways in which humans deviate from the standard economic model. Bounded rationality reflects the limited cognitive abilities that constrain human problem solving. Bounded willpower captures the fact that people sometimes make choices that are not in their long-run interest. Bounded self-interest incorporates the comforting fact that humans are often willing to sacrifice their own interests to help others. We then illustrate how these concepts can be applied in two settings: finance and savings. Financial markets have greater arbitrage opportunities than other markets, so behavioral factors might be thought to be less important here, but we show that even here the limits of arbitrage create anomalies that the psychology of decision making helps explain. Since saving for retirement requires both complex calculations and willpower, behavioral factors are essential elements of any complete descriptive theory.

Save more tomorrow™: Using behavioral economics to increase employee saving, Thaler, R. H., & Benartzi, S. (2004). Save more tomorrow™: Using behavioral economics to increase employee saving. Journal of political Economy, 112(S1), S164-S187. As firms switch from defined‐benefit plans to defined‐contribution plans, employees bear more responsibility for making decisions about how much to save. The employees who fail to join the plan or who participate at a very low level appear to be saving at less than the predicted life cycle savings rates. Behavioral explanations for this behavior stress bounded rationality and self‐control and suggest that at least some of the low‐saving households are making a mistake and would welcome aid in making decisions about their saving. In this paper, we propose such a prescriptive savings program, called Save More Tomorrow™ (hereafter, the SMarT program). The essence of the program is straightforward: people commit in advance to allocating a portion of their future salary increases toward retirement savings. We report evidence on the first three implementations of the SMarT program. Our key findings, from the first implementation, which has been in place for four annual raises, are as follows: (1) a high proportion (78 percent) of those offered the plan joined, (2) the vast majority of those enrolled in the SMarT plan (80 percent) remained in it through the fourth pay raise, and (3) the average saving rates for SMarT program participants increased from 3.5 percent to 13.6 percent over the course of 40 months. The results suggest that behavioral economics can be used to design effective prescriptive programs for important economic decisions.

Behavioral economics: Past, present, future, Camerer, C. F., & Loewenstein, G. (2003). Behavioral economics: Past, present, future. Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations. This book consists of representative recent articles in behavioral economics. This chapter is intended to provide an introduction to the approach and methods of behavioral economics, and to some of its major findings, applications, and promising new directions. It also seeks to fill some unavoidable gaps in the chapters’ coverage of topics.

Behavioral economics, Hursh, S. R. (1984). Behavioral economics. Journal of the experimental analysis of behavior, 42(3), 435-452. Economics, like behavioral psychology, is a science of behavior, albeit highly organized human behavior. The value of economic concepts for behavioral psychology rests on (1) their empirical validity when tested in the laboratory with individual subjects and (2) their uniqueness when compared to established behavioral concepts. Several fundamental concepts are introduced and illustrated by reference to experimental data: open and closed economies, elastic and inelastic demand, and substitution versus complementarity. Changes in absolute response rate are analyzed in relation to elasticity and intensity of demand. The economic concepts of substitution and complementarity are related to traditional behavioral studies of choice and to the matching relation. The economic approach has many implications for the future of behavioral research and theory. In general, economic concepts are grounded on a dynamic view of reinforcement. The closed‐economy methodology extends the generality of behavioral principles to situations in which response rate and obtained rate of reinforcement are interdependent. Analysis of results in terms of elasticity and intensity of demand promises to provide a more direct method for characterizing the effects of “motivational” variables. Future studies of choice should arrange heterogeneous reinforcers with varying elasticities, use closed economies, and modulate scarcity or income. The economic analysis can be extended to the study of performances that involve subtle discriminations or skilled movements that vary in accuracy or quality as opposed to rate or quantity, and thus permit examination of time/accuracy trade‐offs.

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