Behavioral Economics 101: Basics of Behavioral Economics

Behavioral economics is a branch of economics that incorporates insights from other social sciences, such as psychology and behavioral science. In order to better understand people’s real-world economic decision-making, behavioral economists conduct field experiments and surveys to study how people behave under certain constraints. This helps economists understand how human psychology affects the choices consumers make with their money.

The modern practice of behavioral economics traces back to the early 1900s when academics at the University of Chicago emphasized the need for more advanced models linking human behavior to the discipline of economics. Previous economic modeling mainly relied on the assumption of rational choice and exclusive self-interest, creating a model of the so-called Homo economicus—a human whose rational mind governed their economic decisions. The Chicago researchers challenged this notion; they sought new links between human emotion and financial decisions.

In the ensuing years, many academics have contributed to the understanding of behavioral economics. With the rise of cognitive psychology in the 1960s, economists Amos Tversky and Nobel Prize–winner Daniel Kahneman applied their own insights to behavioral economics, offering particular emphasis on economic decisions made with respect to risk (often called loss aversion). Duke University professor Daniel Ariely brought behavioral economics to mainstream audiences with his 2008 book Predictably Irrational: The Hidden Forces That Shape Our Decisions, and the field remains as relevant as ever.

Behavioral economics has grown into a sizable field of inquiry, with various subfields and specializations. Many academic and professional journals dedicate space to behavioral economics, including The Journal of Political Economy, American Economic Review, Journal of Economic Perspectives, and the Quarterly Journal of Economics. These journals touch on key behavioral economics principles, including:

1. 1. Heuristics: Heuristics refer to mental shortcuts or rules of thumb that people use in their decision-making process. Behavioral economists study heuristics like the availability heuristic, which illustrates the tendency to favor easily recalled information over more comprehensive data that may be harder to recall instantly.
2. 2. Prospect theory: Economists Amos Tversky and Daniel Kahneman articulated a concept they called “prospect theory” in 1979. This theory unites three basic observations: People treat gains differently than losses (known as loss aversion); people place unequal weight on outcomes with certainty compared to those with uncertainty; the structure of a problem itself may affect the choices made.
3. 3. Bounded rationality: In 1957, Nobel Prize–winner Herbert Simon explored the concept of bounded rationality, which looks at how both inner and outer circumstances hamper human decision-making. While classical economic models presume strict rationality in people’s behavior, bounded rationality seeks to show the limits of that rationality. These limits come in the form of external pressures, limited self-control, poor data collection, and more. Daniel Kahneman helped articulate this concept to mass audiences in his book Thinking, Fast and Slow (2011).
4. 4. Mental accounting: This type of cognitive bias explains how people divide their money based on where it came from or what it will be used for. Research indicates people may value the same amount of money differently if they won it at a casino versus earning it through work.

Contemporary behavioral economics bridges gaps between the related fields of classical economics, sociology, and psychology. Here are five ways that behavioral economics manifests in everyday life.

1. 1. Nudge theory: Brought to wide public attention by 2008’s Nudge: Improving Decisions About Health, Wealth, and Happiness by Cass Sunstein and Richard Thaler, Nudge theory examines how “choice architecture” shapes human behavior. For instance, supermarkets can nudge consumers to make better decisions about their eating by placing healthy food options in prominent displays.
2. 2. Game theory: Game theory is a mathematical model of strategic interactions that informs everything from public policy to military strategy. Economists have developed behavioral game theory, which seeks to further refine classical choice-making models. These economists emphasize the ways that interactive learning and social norms shape economic behavior.
3. 3. Behavioral finance: This economic subfield studies decision-makers in financial markets. Much like everyday consumers, highly paid professionals can make irrational choices, some of which run counter to their own companies’ interests. Behavioral economics attempts to help anticipate and correct these emotionally-charged errors, leading to greater overall efficiency.
4. 4. Overconfidence effect: The overconfidence effect stems from psychology, but it also resonates in the field of economic theory. The theory is rooted in the notion that people take inflated stock of their abilities, going far beyond what an objective assessment would indicate. This can lead people to make poor economic decisions. Overconfidence bias notably plagues people who work in the finance industry, leading to poor investment decisions.
5. 5. Time discounting: Time plays a role in economic decisions. Studies show that human beings often favor receiving smaller amounts of money in the present (or near future) instead of larger amounts in the distant future. Among other things, this produces deleterious effects on societal retirement savings. Behavioral economists call this “intertemporal choice.

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