Behavioral Economics

Behavioral economics (also spelled behavioural economics) is the field of economics that uses insights and methods from psychology to study how people actually make decisions about money, work, saving and risk. It documents predictable ways in which choices depart from the fully rational, self-interested and consistent behavior assumed in standard neoclassical economics, and builds models that take those departures into account.

The field grew from Herbert Simon's idea of bounded rationality in the 1950s and from the experiments of psychologists Daniel Kahneman and Amos Tversky in the 1970s, and was brought into economics by Richard Thaler and others. It has since earned several Nobel prizes and is used by governments, regulators and firms. It is closely linked to behavioral finance, which applies the same ideas to markets, and to experimental economics.

Standard economics often pictures people as calm calculators who weigh every option perfectly. Real people are busier and more human: they put off joining a pension, keep a gym membership they never use, and feel losing $50 more sharply than finding $50. Behavioral economics takes these habits seriously and studies them like any other fact.

The useful discovery is that these slips are not random. Because they are predictable, small changes in how a choice is presented, such as which option is ticked by default, can change what large numbers of people do.

• Loss aversion. Losses weigh more heavily than equal gains (see loss aversion).
• Framing. The same choice described differently, for example as "90% survive" or "10% die", leads to different decisions (see framing effect).
• Endowment effect. People tend to value things more once they own them (see endowment effect).
• Present bias. People overweight the present, so they under-save and procrastinate even when they plan otherwise.
• Mental accounting. Money is treated differently depending on its source or label, such as a tax refund versus a salary.
• Sunk costs and money illusion. People often let past spending steer new decisions (see sunk cost) and judge values in nominal rather than real terms (see money illusion).
• Social preferences. In experiments people often share, punish unfairness and cooperate more than narrow self-interest predicts, findings that extend game theory.

Kahneman and Tversky's prospect theory (1979) replaced expected utility with a value function measured from a reference point. A common form, estimated by Tversky and Kahneman in 1992, is:

• $x$ is the gain or loss relative to the reference point.
• $\alpha$ and $\beta$ (both estimated at about 0.88) make each extra dollar matter a little less.
• $\lambda$ is the loss-aversion coefficient, estimated at about 2.25.

Example: a $100 gain is felt as $100^{0.88} \approx 57.5$ units, while a $100 loss is felt as $-2.25 \times 57.5 \approx -129$ units. That is why many people refuse a coin flip that wins $110 or loses $100, even though it has a positive expected value, a pattern also linked to risk aversion.

Thaler and Cass Sunstein's book Nudge (2008) argued that "choice architecture" can steer people towards better decisions without banning options. The UK government set up its Behavioural Insights Team in 2010, and the US created a Social and Behavioral Sciences Team in 2014. The best-known application is automatic enrolment in workplace pensions, which sharply raises participation: the US Pension Protection Act of 2006 encouraged it, and the UK made it a legal duty for employers from 2012. Financial regulators use behavioral evidence to design disclosures and protect consumers from manipulative sales practices, and economists draw on it to explain bubbles, herding and fear of missing out, themes that echo Keynes's animal spirits.

Key laureates include Simon (1978), Kahneman (2002, shared with experimental economist Vernon Smith; Tversky had died in 1996), Robert Shiller (2013, for asset-price research that challenged the efficient market hypothesis) and Thaler (2017). Researchers increasingly test ideas with a randomized controlled trial.

• Replication. Some well-known findings have failed to replicate in larger studies, and a 2012 study on honesty pledges was retracted in 2021 after evidence that its data had been fabricated.
• Size of effects. A 2022 analysis in the Proceedings of the National Academy of Sciences argued that, after correcting for publication bias, there was little evidence that nudges work on average; others replied that some nudges, such as defaults, are clearly effective.
• Markets correct errors. Defenders of standard theory, including many in the Chicago school, argue that competition and learning reduce the impact of individual biases, and that a list of biases is not a general theory.
• Paternalism. Libertarian critics warn that nudging lets governments steer citizens, while others argue that it is too weak to replace regulation.

• The Nobel Prize: Prize in Economic Sciences 2017 (Richard H. Thaler)
• The Nobel Prize: Prize in Economic Sciences 2002 (Kahneman and Smith)
• The Behavioural Insights Team