Behavioral Economics

Authors: Felix Kersting und Daniel Obst | 10th of April 2016
Academic review: Anonymous (Full Professor)

1. Core Elements

Behavioural economics is a rather recent field of mainstream economics; it predominantly deals with human behaviour’s deviations from the model of the homo economicus or rational man. These deviations from rational calculation are introduced as “non-standard” (the standard being neoclassical economics) or reflections of “bias”. Behavioural research explains human behaviour through the lens of social preferences, heuristics and norms, from which new behavioural models are constructed. Scientific findings are mainly taken from field or laboratory experiments. Furthermore, findings from neighbouring disciplines (psychology, social sciences, neuroscience, cognitive science etc.) are used and transferred to the economic discipline in order to improve the reliability and precision of explaining human behaviour in the economic realm.

2. Terminology, analysis and conception of the economy

In general, behavioural economics does not have strong theoretical or normative assumptions about how an economic system works or should work. Instead, prominent (neoclassical) economic theories are analysed and reviewed with respect to human behaviour, flagging deviations from the neoclassical model in concrete economic contexts, e.g. markets or public goods (Weber and Dawes 2010, 91). Hence, behavioural economics focuses on the observable behaviour of humans. Central concepts particularly refer to humans and their decisions. Thereby, humans are described as behaving in accordance with ‘bounded rationality’.

There are different explanations for the causes. A prominent idea is the dual process theory: According to Daniel Kahneman (2011), there are two different ways of thinking based on the systems involved in decision making, depending on the situation: One, the intuitive system, is described as being fast, effortless and volatile with respect to its performance, while the other, the reasoning system is more elaborate, reliable and slow. Since the intuitive system deviates from predictions of the rational behavioural model, humans are considered as behaving with bounded rationality.

Based on neoclassical decision theory, the behavioural economist Matthew Rabin (2002) developed three deviations from neoclassical economics’ ‘expected utility theory’; these have become vital differentiations in behavioural economics research. Rabin developed ‘non-standard preferences’, ‘non-standard beliefs’ and ‘non-standard decision making’ (the three respectively refer to one part of the mathematical function in the neoclassical expected utility theory). These are described in the following, with two examples presented for each case (for further examples see DellaVigna 2009):
 

  • Non-standard preferences refer to elements that form part of the utility function:
     
    • Social preferences: These include evidence for altruism and reciprocity. Example: Humans do not only care for their own share, but also care for the distribution (Rabin 1993, Levine 1998, Fehr and Schmidt 1999, Bolton and Ockenfels 2000).
       
    • Time preferences: Humans do not consistently discount over time, but do often have a preference for the present. As a result decisions concerning future investments and savings deviate from neoclassical predictions (Frederick, Loewenstein and O'Donoghue 2002).
       
  • Non-standard beliefs concerns the part of the decision making process in which probabilities need to be taken into account:
     
    • Overconfidence: Humans tend to overestimate their own capabilities. For instance, 93% of all drivers in the U.S.A. assume they drive better than the average driver (Svenson 1981). Similarly, managers of big companies overestimate their capabilities (Malmendier and Tate 2005).
       
    • The law of small numbers: Humans tend to extrapolate from a small sample to the whole statistical population. For example, even if a fund manager works better than the market average for three years, this does not imply that high performance will necessarily continue for years to come.
       
  • Non-standard decision-making concerns the guideline of decisions, maximization being the normal case:
     
    • Framing: Decisions do not only depend on the expected results but also on the way the result is presented. Doctors rather tend to use a risky medication if it is promoted using the phrase ‘saves 90 out of 100’ rather than ‘kills 10 out of 100’ (Tversky and Kahneman 1981).
       
    • Heuristics: Humans use a variety of rules of thumb in order to reach a decision more quickly. The Availability Heuristic describes the overestimation of probabilities if an event is cognitively available. For example, after a plane crash that has been covered by the media worldwide, humans overestimate the probability of a plane crash in comparison to periods of time in which no accidents occur (Thaler and Sunstein 2008).
       

The use of the term ‘non-standard’ in Rabin’s classification clearly illustrates the orientation towards mainstream economics. While doing so, this version of behavioural economics claims to, first, generate better theories, second, make better predictions and, third, present better policy recommendations (Camerer and Loewenstein 2004).

There is disagreement on how the mentioned findings should influence decision theory. Some researchers just extend neoclassical expected utility theory by adding findings from behavioural economics. For instance, Daniel Kahneman and Amos Tversky’s ‘prospect theory’ (1979) mostly maintains the concept of utility maximisation although in their model losses are weighted twice as much as gains. Alternatively, there are concepts that reject a vast part of the homo economicus concept, or which use other behavioural models as their basis. This includes research on social norms, where other people’s expectations directly influence an individual’s behaviour. Regarding theoretical approaches, apart from employing the neoclassical rational choice approach, behavioural economics also brings concepts into play from an array of fields including sociology and social psychology, which have different scientific assumptions (Bicchieri and Muldoon 2011). In some studies, the impact of social norms is used to induce a behavioural change, for instance in order to save energy (Allcott 2011).

3. Ontology

Behavioural economics’ focus on human behaviour makes the individual the central unit of analysis. Nevertheless, in contrast to mainstream economics, human behaviour is conceptualised in a more complex manner at the ontological level. Neoclassical economics assumes a reductionist ideal type of homo economicus, characterised by a stable set of preferences with regards to a bundle of goods. Meanwhile in behavioural economics, for modelling purposes, individual behaviour is determined by rules, heuristics, desires, moods, emotions, and other things (Anger 2014). As neoclassical theory does not correspond to real behaviour, behavioural economics has historically and continues to develop new behavioural models that are more accurate.

In the first instance it is not clear what causes deviations from the model of homo economicus at the ontological level. In the scientific discourse there are competing and complementary theoretical explanations which see the root cause arising from a reductionist focus on the individual in isolation rather than the individual in a group or decision making context. An example of the reductionist approach is the analysis of cognitive capacities. The authors Sendhil Mullainathan and Eldar Sharif (2013) describe that each individual has what they call a cognitive scarcity. Hence, decisions are boundedly rational due to the limitation of human thought. Examples of theories in line with the contextual approach include publications on social norms, which emphasise the influence of context on individual decisions (for a theoretical overview c.f. Bicchieri, Muldoon 2011).

Behavioural economic research does not present a universal answer to the question of whether reductionist or contextual approaches are more adequate for yielding trustworthy results. Another still contested question that figures as an issue of ongoing debate is whether preferences are rooted inside human beings (methodological individualism with stable preferences and reactions to results) or whether they are influenced by external factors and thus considered endogenous (see section 7).

Moreover, scarcity of resources is often understood as the central economic problem in behavioural economics. Derived from this understanding, the question arises as to which external conditions must be present in order for people to behave in line with the assumptions of homo economicus, since this would result in an efficient outcome (Frank and Bernanke 2004, 4). The central economic problem of scarcity can be derived from applied behavioural research in the discipline “market design”. Market design deals with the architecture of markets while accounting for certain aims. In the economic encyclopedia Gabler Wirtschaftslexikon “the maximization of returns, efficiency or liquidity, the minimization of costs, the revelation of information” (own translation, Springer Gabler Verlag 2017) are named as market design’s principal aims.

Additionally, uncertainty is a factor in behavioural economics. People in an uncertain environment are assumed not to calculate the optimal choice rationally in order to arrive at a decision. Instead, they make use of decision making heuristics. As opposed to neoclassical economics, behavioural economics sets out to analyse decisions taken under fundamental uncertainty, where the level of risk remains unknown (Tyszka 2015, 12). But heuristics are not limited to decisions under uncertainty and can be applied in manifold situations in which decisions are made. In comparison to other schools of thought, such as Austrian economics or Post-Keynesian economics, uncertainty is only a subordinate role and is only relevant to a subfield of behavioural economics.

How does behavioural economics deal with temporal successions on an ontological level? In most theories and models they are treated as being static. This means that models aim at predicting future events in grouped time periods. Time inconsistent preferences display a certain degree of dynamics, yet the results of such dynamics are not open or undetermined (e.g. Frederick, Loewenstein and O‘Donoghue 2002). Also, other approaches such as the prospect theory (Kahneman, Tversky 1979) commit themselves to an understanding in which past points of reference dynamically influence future behaviour, but not in an open and undetermined way.

4. Epistemology

Behavioural economics assumes that the behaviour that is assigned to the homo economicus is not adequate for describing human (decision) behaviour. This is the central topic of behavioural economics. Instead, behavioural economics’ point of departure is the real world in which theories and hypotheses are tested by means of experiments (see section 5). This descriptive orientation corresponds to an epistemological realism by assuming that scientists can observe and describe human behaviour relatively easily. Questions concerning knowledge production and the self-referential dynamics of science and scientific concepts, which are addressed by constructivist approaches, do not play an important role in behavioural economics, even if the application of behavioural findings is promoted by scientists of this field (see section 6).

Concerning the classification of empirical findings, the assumed behaviour of the homo economicus is taken as a benchmark for measuring observable behaviour. This becomes, for instance, apparent in the speech of Kahneman (2003, 1449), winner of the Nobel memorial prize, where he explains that in his research he intends to explore ‘the systematic biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models’. By this kind of proceeding, it can be determined whether a person behaves in line with the assumptions of homo economicus and to what extent behaviour deviates from the concept (Angner 2014). For some researchers, the neoclassical benchmark is at the same time a normative ideal. Thus, Richard Thaler (2016a, p. 1591) writes: “Expected utility theory remains the gold standard for how decisions should be made in the face of risk.” This position is formulated even more drastically by Colin Camerer et al. (2003): “The challenge is figuring out what sorts of ‘idiotic’ behaviours are likely to arise routinely and how to prevent them, while imposing minimal restrictions on those who behave rationally.” The aspiration to reduce the difference between observable behaviour and the benchmark by means of prescriptive theories, includes constructivist elements (compare e.g. nudging by Thaler and Sunstein 2008).

Concerning epistemology, behavioural economics focuses on human behaviour in economic (decision-making) situations (object-driven, i.e. a specific issue or phenomena is considered to be very important), and at the same time hypotheses are derived from a generalized theoretical framework and applied to many aspects of the economy (perspective-driven). This distinguishes behavioural economics from other theory schools, which are usually clearly object-oriented or perspective-driven. Thus, the focus lies in the analysis of human behaviour in economic (decision) situations on the one hand, and the theoretical affiliation to (neoclassical) economic theories on the other hand. Behavioural economics faces this tension as a perspective that follows certain interests and at the same time follows theoretical considerations (see section 8).

5. Methodology

The methodological focus of behavioural economics is on experiments. A distinction is made between laboratory and field experiments. In the experimental research design, only the measured behaviour is used as a basis for the analysis.

Vernon Smith laid the foundation of standardised economic experiments. His goal was to set up an experimental situation similar to a theoretical agent-principal situation, with a fixed set of choices in order to reveal the preferences of the participants. All other influencing factors are eliminated in order to compare model predictions with observed behaviour. He developed this approach to the Induced-Value Theory (Smith 1976). For this, he received the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Smith describes certain methodological conditions that have to hold to deliver unbiased results. For instance, different choices must have different rewards. This requires a rewarding medium with certain properties. For example, the participant must always prefer having more of it (monotonicity) and other factors must be rather irrelevant compared to the medium (dominance).

While laboratory experiments were dominant in the early days of behavioural economics, field experiments have become increasingly important (for an overview, see DellaVigna 2009). In addition to this, the application of neuro-scientific measurements has proliferated. Often, the goal of the methodology is to determine causal effects. The frequently used experimental design, with a randomized treatment and control group, is intended to simulate a counterfactual situation as closely as possible, in order to isolate the effect of a single measure or situation change. The methodological orientation focuses on the ideal of the natural sciences.

Qualitative research is a rare exception and its methodology is clearly different from standardised experiments. For instance, Truman F. Bewley (2002) conducted 300 interviews with business people asking why wages don’t fall during a recession. Instead of measuring observed behaviour, Bewley investigated individual motives.

Hypothesis generation does not follow a uniform pattern in the branch of behavioural economics. The empirical orientation towards observable behaviour implies an inductive approach (which is also postulated in some cases as evidenced by statements such as: “Let the data tell you what is going on, both in empirical work and in theory development” Thaler 2016b). But, usually, hypotheses are derived from the deductive construct of homo economicus and its altered forms. Moreover, experiments are conducted if theory does not suggest distinct predictions, or any predictions whatsoever.

6. Ideology and Political Goals

The aim of behavioural economic research is to gain more knowledge about human decision making behaviour and also to better inform and politically shape social phenomena (such as investment in private pensions, health care, decisions on finance and education), mostly in accordance with the normative ideal of rational choice. This means that behavior which is considered not to be economically rational should be incrementally reduced. Nudges (such as default settings in pension systems, the arrangement of vegetables in a cafeteria or the presentation of information) are seen as an appropriate instruments (Thaler and Sunstein 2008) to lead humans to decide as if there was no bounded rationality, e.g. due to lack of self-control. It is assumed that humans themselves prefer these devices and these decisions in comparison to those driven by bounded rationality. Richard Thaler and Cass Sunstein (2008) understand such approaches as liberal paternalism. Liberal paternalism differs from a pure paternalism insofar that the opportunities are not restricted. Instead, the choice architecture is changed in favor of the prefered outcome. Concerning the debate within Philosophy of Economics see Robert Lepenies and Magdalena Malecka (2015).

Furthermore, the findings of behavioural economics are used to test the effectiveness of an envisaged policy toward a certain goal. For behavioural economists, experiments are an adequate method in order to compare different options in politics. The Behavioural Insights Team in the UK, which works for the government, developed instructions for public authorities in order to carry out experiments locally. This implies a shift towards concrete situations as a point of departure for policies. This approach is also applied in development economics by Abhijit Banerjee and Esther Duflo (2012), who also take up the idea of a liberal paternalism.

7. Current debates and analyses

A recurring debate in behavioural economics literature discusses the question of whether preferences are endogenous or exogenous. A well-known study by Joseph Henrich et al. (2001, 77) draws the following conclusion: ‘preferences over economic choices are not exogenous as the canonical model would have it, but rather are shaped by the economic and social interactions of everyday life’. A large survey by Armin Falk et al. (2015) delivered similar results. This is connected to a debate in welfare economics, a field of mainstream economics which permits normative statements. However, if preferences are considered endogenous, normative statements are no longer possible because welfare economics assumes stable and exogenous preferences. Therefore, a debate in the field of the Philosophy of Economics on ‘preference purification’ discusses if assumptions on true statements are still possible in welfare economics (cf. Infante et al. 2016).

Further current research deals with the reconception of ideas about the individual. This seems necessary since behavioural economics rejects homo economicus as the agent of economic models. In this context, George Akerlof and Rachel Kronton (2000) established identity, mainly understood as a preference to conform to norms, as part of economic research. (Another identity concept can be found in the work of Bénabou and Tirole 2011). The current state of the debate is summarised by Rachel Kranton (2016), and for a critical analysis compare John Davis (2011).

Test persons in laboratory experiments are also an object of debate (for an overview cf. Levitt and List 2007 and for a reply Camerer 2015). In an article that received much attention, Henrich et al. (2010) characterised test persons as the ‘weirdest people in the world’. In this context, ‘weird’ stands for ‘Western, Educated, Industrialised, Rich, and Democratic’. According to the authors of the studies, even if the results of economic laboratory experiments do not show average or usual behaviour, general conclusions are still drawn from those experiments. Hence, the external validity of those experiments is questioned. In contrast, Armin Falk and James Heckman (2009) consider those problems less severe and point to the high internal validity, the possibility to identify causal effects as well as the possibility of combining experimental proceedings with survey data in order to improve the external validity.

Concerning the political implications of behavioural economics, the works of Thaler and Sunstein on nudging and liberal paternalism are often debated, especially in other social sciences than economics. The basic theses of the authors are that boundedly rational behaviour leads to ‘behavioural market failures’ and that persons often unconsciously act to his/her detriment. In those cases, institutions or the state have to ‘nudge’ persons in the right direction, since otherwise he/she will be nudged in a direction by other persons, firms or institutions which entirely lack democratic accountability. In Germany, the psychologist Gerd Gigerenzer (2015) rejects nudging since it mainly relies on rational choice as the normative ideal and does not operate through better educational offers concerning, for example, financial decisions.

8. Delineation: subschools, other economic theories, and other disciplines

It is not possible to consistently differentiate between different currents of behavioural economics. In economic textbooks (e.g. Beck 2014), behavioural economics research areas are often delineated by the following subjects (similar to the differentiation of Rabin, described in section 2):

  • Analysis of heuristics e.g. representativeness heuristic, availability heuristic
  • Discounting and time preferences
  • Altruism, fairness, reciprocity
  • Emotions
  • Happiness research

Further distinctions, in particular with respect to the practical application of theoretical findings, can be made between different areas such as behavioural finance, behavioural macroeconomics, social policy and liberal paternalism (cf. Beck 2014, a historical outline is presented by Heukelom 2014).

Moreover, there have been attempts to classify particular aspects of research in relation to who it was that undertook the substantial body of that research (Tomer 2007): one example is the Satisficing Theory of Herbert Simon (1955), according to which individuals do not maximize their utility but are satisfied as soon as their expectations are met. A further example is George Akerlof’s (2002) work to integrate the findings of behavioural economics into neoclassical macroeconomics. Another is Vernon Smith’s significant influence on experimental economics, derived from his analysis of the functioning and design of markets (for the history cf. Svorenčík 2015).

While the mainstream of behavioural economics tries to improve, not to revolutionise, neoclassical concepts, there are some authors who distance themselves from neoclassical concepts. Hermann Brandstätter and Werner Güth referred to much of the aforementioned brand of research programs as ‘neoclassical repair shop[s]’ (1994), since standard models are extended by behavioural economic findings but the assumptions on rational maximisation are maintained. Yet theories exist that reject the concept of utility maximisation. Examples of this rejection are the Satisficing Theory (Simon 1955), Aspiration Adaptation Theory (Selten 1998), Case-based Decision Making (Gilboa and Schmeidler 2001), as well as Fast and Frugal Heuristics (Gigerenzer and Goldstein 1996).

Finally, the area of neuro-economics, with its strong focus on medical research, is worth mentioning, the point of departure of these analyses being neuro-scientific findings. Often, behaviour is analysed here by means of functional magnetic resonance imaging (fMRI).

9. Delineation from the Mainstream

One main difference between behavioural economics and the core theories of the mainstream is the way in which human behaviour is classified. While the neoclassical mainstream considers the conception of behaviour in terms of homo economicus as descriptively and normatively adequate, in behavioural economics, behaviour in terms of homo economicus is a normative guideline (see Kahneman 2003 and Thaler 2016a). The descriptive foundation is observable human behaviour.

Apart from this difference, behavioural economics is an acknowledged field of mainstream economics. Acknowledgement and compatibility are due to the experimental methods that are also the standard in other empirical areas of mainstream economic research (cf. Angrist and Pischke 2014).

10. Institutions

Representatives:

  • former: Herbert Simon, Amon Tversky, Vernon Smith, Reinhart Selten
  • current: Daniel Kahneman, Colin Camerer, Matthew Rabin, David Laibson, George Loewenstein, Richard Thaler, Ernst Fehr

Journals:

  • Games and Economic Behavior
  • Experimental Economics
  • Journal of Economic Behavior & Organization
  • Also popular journals like American Economic Review, Quarterly Journal of Economics, Econometrica, Journal of Political Economy, Review of Economic Studies, Economic Journal, Journal of Economic Perspectives, Journal of Economic Literature

Think Tanks / Universities:

  • Universities: Bonn, Köln, Zürich, London School of Economics and Political Science, Warwick, Nottingham; For USA c.f. https://www.behavioraleconomics.com/be-grad-programs/
  • Research facilities: WZB Berlin, MPI für Bildungsforschung Berlin
  • Behavioral Economics Roundtable (associated with Russell Sage Foundation)

Online Platforms:

References

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Assigned course modules

Title Provider Start Level
Behavioral Economics in Action University of Toronto self paced beginner
Behavioral Investing Indian School of Business 2017-08-17 beginner
Complexity Economics - self paced advanced
The Challenges of Global Poverty Massachusetts Institute of Technology 2017-09-26 beginner
Behavioural Finance Lectures University of Western Sydney self paced advanced