Behavioral Economics

Behavioral economics is the study of the effects of psychology on economic decision- making. In other words, it is about how people’s emotions and thoughts can affect their decisions regarding money. One of the supporters of this idea was Adam Smith. Behavioral economics was later disregarded when a more rational approach was taken in the 1800’s. However by the mid 1900’s there had been a clear understanding of how much psychology influences economics.

The first is that people generally act on ‘rules of thumb’ as opposed to rational thought. A rule of thumb is a principle that turns out to be true in majority of the situations. An economical example of this is the phrase “you get what you pay for”. However, sometimes cheaper products are as just as good as, if not better than the brand with the highest price. However most people do buy the more expensive product assuming that they it is good in quality.

 Behavioral Economics and Behavioral Finance are closely related fields making up a separate branch of economic and financial analysis using social, cognitive and emotional factors in understanding the economic decisions of customers, borrowers and investors and their effects on market prices. Behavioral analyses are not only concerned with the effects of market decisions but also with public choice.

Behavioral Economics differs from traditional economics

The standard economic framework ignores or rules out virtually all the behavior studied by cognitive and social psychologists. This “unbehavioral” economic agent was once defended on numerous grounds: some claimed the model was right and most others simply argued that the standard model was easier to formalize and practically more relevant.

Behavioral economics blossomed from the realizations that neither point of view was correct. The standard model of human economic behavior includes three unrealistic traits- unbounded rationality, unbounded will power and unbounded selfishness, all of which are modified by behavioral economics.

Key Observations

Three themes predominate in behavioral economics:

Heuristics: People often make decisions based on approximate rules of thumb.

Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters which individuals rely on to understand and respond to things.

Market inefficiencies: This includes mis-pricings, non-rational decision making and return anomalies

Methodology

Behavioral economics is different from experimental economics, which uses experimental methods to study economic situations. While many experiments in economic studies probe psychological aspects of decision making to explore institutional features for new market mechanisms, not all economic experiments are psychological. And not all behavioral economics uses experiments; rather behavioral economists rely heavily on theory and observational studies in the field.

Questions:

• What is Behavioral Economics?
• What are the key observations made in behavioral economics?