Behavioral Economics (business)

Behavioral economics draws upon the fields of economics and psychology to study how people make choices. Behavioral economists believe that the choices individuals make may be neither statistically predictable, nor always rational. This article explores concepts of behavioral economics; cites relevant findings; and summarizes some of the contemporary research in the field. The article concludes with a glossary of relevant terms.

Keywords: Behavioral Economics; Economics; Decision Making; Illusion of Validity; Intuitive Prediction; Judgment under Uncertainty; Prospect Theory

Behavioral Economics

Overview

Behavioral economics draws upon the fields of both economics and psychology to study how people make choices (Lambert, 2006, p. 50). According to Merriam-Webster's Collegiate Dictionary:

Because behavioral economics is concerned with how individuals make their choices rather than how statistical data or calculated notions predict what their choices should be, behavioral economic concepts are differentiated from two well-known economic theories. These theories are: The Bayesian theory, which relies upon statistics to draw conclusions about the future occurrence of a given parameter of a statistical distribution by calculating from prior data on its frequency of occurrence ("Bayesian theory," 2007) and the rational choice theory which assumes that an individual, using reason, will choose the option that yields maximum advantage or gain and minimizes disadvantage or loss ("Rational choice theory," 2009). In fact, behavioral economists believe that the choices individuals make may be neither statistically predictable, nor always rational. Rather, decisions are heavily influenced by other factors; it is these patterns of irrational choice that form the basis of study for behavioral economists (Fillion, 2008).

Psychology Melds with Economics

In 1982, Daniel Kahneman and Amos Tversky met psychologist Eric Wanner, who wanted to integrate the fields of psychology and economics. Under his presidency of the Russell Sage Foundation, Wanner awarded a grant to economist Richard Thaler to spend the 1984-85 academic year with Kahneman and explore the integration. During that year, psychologists Kahneman and Tversky, and economists Thaler and Jack Knetsch, conducted a series of research experiments that studied the nature and rules of fairness for a variety of transactions (Kahneman, 2002). In 1986, Richard Thaler, Daniel Kahneman, and Jack Knetsch published "Fairness as a Constraint on Profit Seeking: Entitlements in the Market," in the American Economic Review. The article described their analysis of a telephone survey which was conducted during the 1984-85 academic year. Among the findings, the survey respondents indicated that they thought it was fair for firms to raise prices or lower wages when profits are suffering but that it was unfair for firms to raise prices or lower wages for the purpose of exploiting market demand, such as when quantities of an item are temporarily limited, or when unemployment is high (Kahneman, Knetsch, & Thaler, 1986, p. 728). This research on the nature and perception of fairness among individuals provided psychological insight into economic factors in the marketplace: The public applies fairness concepts to their transactions with merchants, landlords, and employers. If the rules of fairness (what individuals have deemed acceptable or unacceptable according to their fairness reference points) are violated, the public will retaliate (Kahneman, 2002). For example, the retaliation may take the form of withholding business from a merchant who is considered unfair, or by paying more to transact with a merchant because he is deemed to be fair.

In 2002, Daniel Kahneman won half of the Sveriges Riksbank Prize in Economic Sciences — the Nobel Prize for Economic Sciences — "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty" ("The Sveriges Riksbank Prize," 2002). (The "other half" of the Prize was won by Vernon L. Smith, an experimental economist.) This prize brought the field of behavioral economics to the forefront as a legitimate and important area of study.

Further Insights

Concepts & Prospect Theory

Based upon the preliminary research and analysis mentioned above, as well as subsequent research and study, five prominent concepts within the field of behavioral economics have been identified:

• Judgment under Uncertainty
• Heuristics
• Illusion of Validity
• Intuitive Prediction
• Prospect Theory

Judgment under Uncertainty

Judgment under uncertainty refers to an individual's process for assessing probabilities and predicting values (Tversky & Kahneman, 1974, p. 1124) when choosing an option. As Sleeth-Keppler noted, judgment under uncertainty is not a rigid process and individuals will often rely upon heuristic strategies to aid their judgment (2007, p. 768).

Heuristics

Heuristics is a method for problem solving or decision making that arrives at solutions through exploratory means such as experimentation, trial and error, or evaluation ("Heuristics," 2007).

In 1974, Daniel Kahneman and his long-time collaborator Amos Tversky published an influential paper in Science, "Judgment under Uncertainty: Heuristics and Biases." The paper defined three heuristic methods which encompass multiple biases that individuals rely upon to assess the probability of an uncertain event or the value of an uncertain quantity (Tversky & Kahneman, 1974).

These three heuristics include:

• Judgment by Representativeness
• Judgment by Availability
• Judgment by Adjustment and Anchoring

Judgment by Representativeness

Judgment by representativeness is a determination of the probability that object A belongs to class B, or that event A originates from process B, or that the probability that process B will generate event A (Tversky & Kahneman, 1974, p. 1124).

For example, in the "object A belongs to class B" scenario, an individual is provided with a personality description of a man and then asked to guess the man's occupation from a list of possibilities. The individual, relying upon judgment by representation, will guess the man's occupation to be the one that fits his personality most stereotypically (Tversky & Kahneman, 1974, p. 1124). This practice is referred to as stereotyping. Bodenhausen (1990, p. 319) argues that while stereotyping is convenient and common, it is a less likely strategy when individuals are motivated by personal involvement or are at their peak energy levels.

Judgment by Availability

Judgment by availability is an assessment of the frequency of a class or the probability of an event by the ease with which instances or occurrences can be recalled (Tversky & Kahneman, 1974, p. 1127).

For example, a person may suppose that a new pizza restaurant will fail because three other pizza restaurants in the same neighborhood failed.

Judgment by Adjustment & Anchoring

In judgment by adjustment & anchoring, adjustment involves estimating using a base number that is then altered to garner the final value. Anchoring refers to the phenomenon that different starting points will yield different estimates that are biased toward the initial values (Tversky & Kahneman, 1974, p. 1128). When using adjustment and anchoring to estimate an unknown quantity, an individual uses information he already knows (the anchor) and then makes adjustments from that point to arrive at an acceptable answer (the adjustment) (Epley & Gilovich, 2006, p. 311).

For example, groups of research subjects were asked to estimate the percentage of African countries in the United Nations by adjusting their numbers up or down from a number obtained by spinning a wheel of fortune (the anchor or starting point). Despite the relevance, or lack thereof, the arbitrary anchor numbers represented, subject answers varied according to them (the adjustment) (Tversky & Kahneman, 1974, p. 1128).

Illusion of Validity

Illusion of validity refers to a "complete lack of connection between the statistical information and the compelling experience of insight" (Kahneman, 2002).

Intuitive Prediction

Intuitive prediction refers to a "willingness to make extreme predictions about future performance on the basis of a small sample of behavior" (Kahneman, 2002).

The terms "illusion of validity" and "intuitive prediction" were created by Daniel Kahneman when he first began developing his behavioral viewpoints of individual choice as a psychologist in the Israeli army. After comparing the results of an exercise designed to identify which soldiers showed the best potential to be officers, to the actual success of the same soldiers in officer training, Kahneman deduced that the correlation was minimal. The term he created for this disconnect between statistical information and the experience of insight is the "illusion of validity" (Kahneman, 2002). Kahneman also noted that there was an "intuitive prediction" factor to this method of identifying officers: It resulted in making extreme predictions about future performance based on a small sample of behavior (Kahneman, 2002).

Prospect Theory

Prospect Theory "attempts to explain why individuals make decisions that deviate from rational decision making by examining how the expected outcomes of alternative choices are perceived" ("Prospect theory," 2007).

The term "Prospect Theory" was created by Daniel Kahneman and Amos Tversky. As they were delving into the intricacies of decision-making, they constructed a theory for risky choice, which they called value theory. They eventually renamed it "Prospect Theory" when they published their article, "Prospect Theory: An Analysis of Decisions under Risk" in Econometrica in 1979. The significance of Prospect Theory was that it established that "objects of choice are mental representations, not objective states of the world." The publication of the article in Econometrica — rather than in a psychology journal — positioned Prospect Theory to be a strong influence in the field of economics (Kahneman, 2002).

Contemporary Research in Behavioral Economics

Behavioral economists are interested in the benefits of behavioral economics to society. Here are some suggestions from two prominent behavioral economists Richard H. Thaler and Dan Ariely:

Richard H. Thaler

Richard H. Thaler studies the relationships among behavioral economics, finance, and the psychology of decision-making. He discounts the assumption that the economy is totally based on rational and selfish behavior and explores the possibility that human factors are a strong influence. Much of his work focuses on the role of behavioral economics in finance and financial decision-making (University of Chicago Booth School of Business, 2009).

Thaler believes that it is naïve to think that high school students are prepared to be astute consumers. He suggests that financial institutions should be more transparent upfront and teach individuals to be smart consumers by educating them about the costs of their options without limiting them. Thaler calls this approach to teaching financial literacy "libertarian paternalism" (Thaler & Sundstein, 2008).

Thaler's work on retirement savings was influential in the creation of the 2006 Pension Protection Act. In 2008, Thaler described his findings in Nudge: Improving Decision About Health, Wealth, and Happiness, which compared automatic enrollment in retirement plans with opt-in plans and found that people were likely to accept a default decision made on their behalf. That is, people were unlikely to either opt out of automatic enrollment plans or opt in to freely offered plans (Burstyn, 2011). After moves by the Obama Administration to make government data more available to the public, Thaler argued that the response of individuals to such data depended less on actual self-interest than on perceived self-interest, which could be controlled merely by presentation (Thaler & Tucker, 2013).

Dan Ariely

In an article titled, "The Dishonesty of Honest People: A Theory of Self-concept Maintenance," Ariely and two co-authors analyzed the results of six experiments with university students and concluded that they valued honesty and wanted to feel like they were honest. However, they did choose to cheat a little bit if they benefited by it, but did not cheat enough to convince themselves that they were dishonest (Mazar, Amir, & Ariely, 2008). This has clear implications for behavior theory in general and specifically in determining how people balance their ethical beliefs with their needs.

In 2008, Ariely published his book, "Predictably Irrational," in which he attempts to describe research findings from behavioral economics and decision-making in non academic terms so that a broader audience may use the research to improve their lives (Ariely, 2007, p. 5). The book tackles such issues as why a commitment to dieting dissolves when we see a tempting dessert; why we buy items that we don't need; why an expensive aspirin cures a headache better than a cheaper aspirin; and why honor codes reduce dishonesty in the workplace (Ariely, 2007, p. 6).

Homo Economicus vs. Homo Communitatis

H. Joel Jeffrey and Anthony O. Putnam declared in their 2013 article "The Irrationality Illusion: A New Paradigm for Economics and Behavioral Economics" that the old paradigm supported by Kahneman, Ariely, and others of human irrationality in financial decision making —homo economicus— was a mere grafting onto the classical model to explain anomalous decision making that deviates from utilitarian predictions of human behavior. Jeffrey and Putnam put forward their homo communitatis paradigm, which calls for a framework of principles that asserts that "[b]ehavior choices are made in light of the individual's reasons to engage in one behavior or another" and that "[e]very behavior is an instance of engaging in a social practice of a community" (Jeffrey & Putnam, 2013).

Conclusion

Behavioral economics gathers insight from the fields of psychology and economics to try to analyze why people make choices. Behavioral economists do not subscribe to the fact that individual choice always follows rational guidelines or is statistically predictable, but believe that individual choice is heavily-influenced by other factors. The importance of behavioral economics as a significant field of study is evidenced by the fact that leading behavioral economist Daniel Kahneman shared the 2002 Nobel Prize in Economic Sciences "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty" ( "The Sveriges Riksbank Prize," 2002).

Terms & Concepts

Bayesian Theory: A statistical theory and method for drawing conclusions about the future occurrence of a given statistical distribution parameter by calculating from prior data on its frequency of occurrence ("Bayesian theory," 2007, p. 757).

Behavioral Economics: "The study of how real people actually make choices, which draws on insights from both psychology and economics" (Lambert, 2006, p. 50).

Decision Making: "The process of choosing between alternative courses of action. Decision making may take place at an individual or organizational level. The process may involve establishing objectives, gathering relevant information, identifying alternatives, setting criteria for the decision, and selecting the best option" ("Decision making," 2007, p. 2285).

Decision Theory: A branch of statistical theory concerned with quantifying the process of making choices between alternatives ("Decision theory," 2000, p. 298).

Economics: "A social science concerned chiefly with description and analysis of the production, distribution, and consumption of goods and services" ("Economics," 2000, p. 365).

Heuristics: A method for problem solving or decision making that arrives at solutions through exploratory means such as experimentation, trial and error, or evaluation ("Heuristics," 2007, p. 3609).

Illusion of Validity: "A complete lack of connection between the statistical information and the compelling experience of insight" (Kahneman, 2002).

Intuitive Prediction: "A willingness to make extreme predictions about future performance on the basis of a small sample of behavior" (Kahneman, 2002).

Irrational: "Not endowed with reason or understanding; lacking usual or normal mental clarity or coherence; not governed by or according to reason" ("Irrational," 2000, p. 618).

Judgment: "The process of forming an opinion or evaluation by discerning and comparing; the capacity for judging" ("Judgment," 2000, p. 632).

Judgment by Adjustment & Anchoring: Adjustment involves estimating using a base number that is then altered to garner the final value. Anchoring refers to the phenomenon that "different starting points will yield different estimates that are biased toward the initial values" (Tversky & Kahneman, 1974, p. 1128).

Judgment by Availability: An assessment of "the frequency of a class or the probability of an event by the ease with which instances or occurrences can be recalled" (Tversky & Kahneman, 1974, p. 1127).

Judgment by Representativeness: A determination of "the probability that object A belongs to class B, or that event A originates from process B, or that the probability that process B will generate event A" (Tversky & Kahneman, 1974, p. 1124).

Judgment under Uncertainty: The assessing of probabilities and the predicting of values (Tversky & Kahneman, 1974, p. 1124). Tversky & Kahneman identified three heuristics that individuals employ in order to predict values in judgments under uncertainty: Judgment by representativeness, judgment by availability, and judgment by adjustment & anchoring (1974, p. 1124, 1127, 1128).

Libertarian Paternalism: Programs that provide guidance in a way that allows individuals to make the best choices without limiting them. This is a term invented by Richard Thaler and Cass Sundstein to describe a suggested consumer financial literacy technique by financial institutions (Thaler & Sundstein, 2008).

Prospect Theory: "A branch of decision theory which attempts to explain why individuals make decisions that deviate from rational decision making by examining how the expected outcomes of alternative choices are perceived" ("Prospect theory," 2007, p. 6032).

Psychology: "The science of mind and behavior; the mental or behavioral characteristics of an individual or group; the study of mind and behavior in relation to a particular field of knowledge or activity" ("Psychology," 2000, p. 940).

Rational Choice Theory: "Attempts to explain all conforming and deviant social phenomenon in terms of how self-interested individuals make choices under the influence of their preferences. It treats social exchange as similar to economic exchange — where all parties try to maximize their advantage or gain, and to minimize their disadvantage or loss. It's basic premises are that human beings base their behavior on rational calculations, they act with rationality when making choices, their choices are aimed at optimization of their pleasure or profit" ("Rational choice theory," 2009).

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Suggested Reading

Electronic copy available at: http://ssrn.com/abstract=1592456 Electronic copy available at: http://ssrn.com/abstract=1592456 Assem, M.J. van den, Dolder D. van, & Thaler, R.H. (2012). Split or steal? Cooperative behavior when the stakes are large. Management Science, 58, 2-20.

Bodenhausen, G.V. (1990). Stereotypes as judgmental heuristics: Evidence of circadian variations in discrimination. Psychological Science, 1, 319-322. Retrieved February 6, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=8559771&site=ehost-live

Driscoll, J. C., & Holden, S. (2014). Behavioral economics and macroeconomic models. Journal Of Macroeconomics, 41,133-147. Retrieved November 4, 2014 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=plh&AN=97335499&site=ehost-live

Gandel, S. (2008). The campaign to make you behave. Money, 37, 126-130. Retrieved February 19, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=33259960&site=ehost-live

Goldsmith, M. (2009, January 21). Human nature: The X factor in economic theory. Business Week Online, 13. Retrieved February 4, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36276213&site=ehost-live

The way the brain buys. (2009). The Economist, 389(8611), 105-107. Retrieved February 11, 2009, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=35855501&site=ehost-live