Behavioral economics

Date: 1980s forward

Type of psychology: Biological bases of behavior; cognition; consciousness; emotion; learning; memory; motivation; sensation and perception; social psychology; stress

Behavioral economics is a specialty area in the discipline of economics that relies on psychological investigative methods and concepts to understand and attempt to predict people’s economic behavior. Behavioral economics differs from traditional economics in that it does not assume the primacy of rationality and logic and does not predominantly rely on mathematical and statistical models to explain observed economic behaviors. In contrast, behavioral economics examines emotional motives for economic choices.

Introduction

Behavioral economics seems like a recent hybrid, as it melds abstract, mathematically oriented economic theory with field-based, experimentally oriented motivation psychology; however, the relationship between the two was identified in the 1940s, though it found little academic support at that time.

Classical economics and neoclassical economics investigate how people allocate resources, using mathematical language and methods. Economic theory is constructed with mathematical tools, statistical modeling, and theorems, and it has traditionally assumed that people weigh costs against benefits and maximize profits and value for their own benefit. The traditional, mainstream model that economists have used in developing theory is based on the concept of the economic man, or homo economicus. The economic man was assumed to make economic and financial decisions based on logic. If aware of all the pertinent facts, the economic man would take the actions that led to the most profitable outcome. The economic man was assumed to be self-aware, self-disciplined, analytical, self-centered, and able to delay gratification for a greater gain or good. The reasoning of such a person is in this way “unbounded.”

Traditional economics has a great deal of theoretical robustness. Intellectually, deductive economic theories and models make sense. They work on paper and in statistical software. Academics in general, and economists in particular, believed the theories were solid, and if the theories failed to explain observed behavior, the problem was assumed to lie in people’s not having enough pertinent data on which to base their decisions. The underlying mathematics and the theories conceptually made sense. However, the economic theories often failed to predict actual behavior. People, companies, or countries did not operate the way the theories said they would. What was so clear conceptually was rarely seen practically.

By the 1950s, economist Herbert Simon of Carnegie Mellon University had begun to advocate an economic theory that included the observation that rationality accounts for only part of the human mind, that rationality was in fact “bounded.” He reasoned that rationality, logic, and mathematics are important but have inherent limitations in their ability to explain people’s behavior and choices. Rational thought by itself does not account for how people make economic, or any other, decisions. Individual cognition includes emotion, feelings, memory, intuition, and undisciplined needs, passions, and drives. The concept of bounded rationality was unpopular when Simon first introduced it to professional economists in the 1940s, but it has become widely accepted.

Even as far back as the eighteenth century, preeminent economist Adam Smith described another factor present in economic activities, altruism, in which people care for the interests of others even at a cost to themselves. The “head” in theoretical economics was beginning to find the “heart” of psychological insight into human motivation and behavior. Behavioral economics studies not how people should act based on theory but how they really behave.

Impact on Economic Theory

Economics produced a series of theories that were intended to explain and predict economic behavior. Theories and concepts such as equilibrium, exponential discounting, expected utility (EU), and social utility were proposed to explain various types of commercial and trade behaviors. However, observed economic behaviors often have not been adequately explained or predicted by classical theories, forcing revisions of these theories that include social psychological, behavioral, and motivation psychology concepts. For example, in classical expected utility theory, people weigh possible outcomes by how likely they judge those outcomes to be. A man will loan his tools to a neighbor whom he believes can use them safely, will return them in a timely manner, and has the potential to loan him something of an approximately equivalent value. A fundamental, but flawed, assumption made by expected utility theory is that people consider such exchanges linearly—they do not. People make economic decisions not from the vantage of absolute net gains or losses, but gains or losses from a self-referred point.

Research shows that people mentally categorize sources and types of money differently even if the amounts are the same. Most schoolteachers who have the option to be paid their full annual salary over the ten-month school year or over the twelve-month calendar year choose the second option, even though the first option provides an economic advantage in the form of an investment opportunity. The ten-month option creates an opportunity to invest the portion that would be allocated to the eleventh and twelfth months, increasing the total amount of pay received. Yet few teachers take the ten-month option. Most teachers experience psychological tension and anxiety in the two months when they do not receive a paycheck (despite their having already been paid the money for the two months) and feel insecure about their fiscal self-discipline and budgeting practices. For the overwhelming majority, the ten-month option feels riskier.

How options are perceived has a lot to do with framing, the context in which an item, idea, statement, product, or other stimulus is presented. The classic example of framing involves presenting a glass of water that is filled to half of its capacity to a person. When the glass is presented as “half full,” the recipient will be more likely to believe that he or she is gaining something, a half glass of water. The emotional experience will probably be positive. When the glass is presented as “half empty,” the recipient will be more likely to believe that he or she is being short-changed. The recipient has not gained a half glass of water but is being cheated or deprived of the second half of the glass of water, the portion that is empty. The emotional experience in this case is probably negative, although the amount of water is identical in both cases.

Behavioral economics provides a psychological dimension of human decision making. It amplifies expected utility theory by blending it with prospect theory, which acknowledges that people adapt to their recent experiences and consider possibilities in nonlinear ways. Gains and losses are experienced psychologically, not rationally. Research in the social psychology of loss aversion shows that losses are experienced twice as negatively as gains are positively experienced, even when the absolute amounts are nearly identical. People also overvalue investing in low-probability events such as experiencing catastrophic home damage or buying a winning lottery ticket. Most are willing to secure the guaranteed loss of purchasing homeowner’s insurance or paying for a lottery ticket even though most will never experience the benefit of the purchase. Prospect theory explains the existence of an inner weighing of probabilities that is emotionally, nonlinearly driven. Expected utility theory on its own cannot easily explain these common behaviors.

Applied Behavioral Economics

Real world, observed economic activities are not the result of careful cognitive calculation and reasoning. Choice is not always economically purposeful. For example, economists and policy makers promote the importance of long-term investing for retirement, which most people would agree is a good thing. However, people are more likely to save for retirement if they are automatically enrolled in a plan than if they have to take deliberate steps to save money. Even the way the investment form is designed has an impact on whether employees choose to invest. Complicated, cluttered forms are generally not read in their entirety, and the boxes they frequently contain often remain unchecked.

Harvard professor of economics Sendhil Mullainathan conducted an illuminating study of how conditions at the moment of decision making are more influential than the objectively derived numbers associated with economic activity. He worked with a South African bank that had a mission of improving the general economic conditions of the country. The bank sought to accomplish this by making loans more readily available. Under Mullainathan’s guidance, the bank marketed the loans while simultaneously investigating whether other, unrelated variables would affect customers’ decisions to apply for a loan. The bank targeted previous borrowers, 70,000 in all, and informed the recipients that they had automatically qualified for a new loan. The bank randomized multiple versions of the letter. Some customers received a desirable low rate and others an undesirable high rate. All letters contained a photograph of a bank employee, with those depicted of various races and both genders. Some letters featured complex tables intended to illustrate how the loan would operate; others had simple tables. Some letters contained deadlines, and some offered to enroll customers in a lottery to win a free cell phone if they came into the local branch just to talk about getting a loan. Because Mullainathan randomized the sending of the letters, he was able to correlate which factors, in addition to the interest rate, influenced customers’ loan application behavior. Using a photograph of a woman rather than a man was as likely to generate an application as offering a rate that was lower by 5 percentage points. The level of complexity of the tables, the chance of getting into the cell phone lottery, and the presence of a deadline all influenced customers’ behavior as much as the interest rates did.

Though his study is fascinating and informative, it is not well known outside the world of professional and academic economists. Still, it illustrates the critical, sometimes determinative role that psychological factors play in making important economic decisions. To a classical economist, Mullainathan’s work in South Africa had one singular variable of worth, the interest rate. A classical economist would argue that if the bank wants to increase its loan business, it should lower the interest rate offered. To a behavioral economist, Mullainathan’s work demonstrates that a comfortable social climate, the intelligibility of the letter and subsequent forms, and a chance to get something (the cell phone) for nothing are of equal importance to getting people to borrow money.

A Biological Basis

Neuroeconomics is a growing, though controversial, branch of behavioral economics that uses the premise that people never fully escape their biology. It uses imaging technologies such as functional magnetic resonance imaging (fMRI) to map and understand the brain cell’s (neuronal) pathways and brain blood flow that are activated as people feel motivation to do or not do something. It studies the parts of the brain responsible for emotion and intuition, the limbic and paralimbic systems. It compares and contrasts how these areas are activated with the activation of the reasoning-analytical parts of the brain, the frontal and parietal areas, when people are asked to make decisions about delaying gratification. It is the interaction of the limbic and reasoning centers that provide the basis for how people make decisions.

Future

Economists widely accept the premise that financial decisions and economic activities come out of a complex array of motivations, most having little to do with what makes purely rational economic sense. Applying behavioral economic principles in developing policies and initiatives is essential if they are to achieve their ends. People use reason but are not exclusively rational. Behavioral economics has proven to be a critical complement to classical economics in understanding and predicting human economic activity and decision making.

Bibliography

Ariely, Dan. Predictably Irrational: The Hidden Forces That Shape Our Decisions. New York: Harper, 2008. Print.

Austin, Rob. "The Impact of Behavioral Economics on Retirement Plans." Benefits Quarterly 29.3 (2013): 25–32. Print.

Cartwright, Edward. Behavioral Economics. New York: Routledge, 2011. Print.

Cox, Donald. “Good News! Behavioral Economics Is Not Going Away Anytime Soon.” Journal of Product & Brand Management 14.6 (2005): 375–78. Print.

Diacon, Paula-Elena, Gabriel-Andrei Donici, and Liviu-George Maha. "Perspectives of Economics - Behavioural Economics." Theoretical & Applied Economics 20.7 (2013): 27–32. Print.

Heukelom, Floris. Behavioral Economics: A History. Cambridge: Cambridge UP, 2014. Print.

Lambert, Craig. “The Marketplace of Perceptions.” Harvard Magazine 108.4 (March/April 2006): 50–95. Print.

Mancio, Lisa. “Insidious Consumption: Surprising Factors That Influence What We Eat and How Much.” Amber Waves 5.3 (June 2007): 10–15. Print.

Mir, On, et al. “Psychology, Behavioral Economics, and Public Policy.” Marketing Letters 16.3/4 (2005): 443–54. Print.

Thaler, Richard H. The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton: Princeton UP, 1994. Print.

Thaler, Richard H., and Cass R. Sunstein. Nudge: Improving Decisions About Health, Wealth, and Happiness. Chicago: U of Chicago P, 2008. Print.