behavioral economics

DEFINITION: “Behavioral economics” is a subfield of economics which augments the traditional view of human beings as utility-maximizing rational actors with a psychologically more-realistic view of people as motivated by a wide assortment of emotional (“affective”) factors in addition to pure reason.

Sub-subfields of behavioral economics include such theoretical perspectives as “bounded rationality” and “prospect theory” (see below).

ETYMOLOGY: The adjective “behavioral,” as well as the related noun “behavior” and verb “behave,” derive from the Middle English verb behaven, meaning “to conduct oneself,” “to comport oneself,” or “to behave.”

The word behaven is attested beginning in the fifteenth century.

For the etymology of the word “economics,” see the Glossary article “economics.”

USAGE: The simplest way to understand behavioral economics is as an attempt to make mainstream economics less ideal (i.e., theoretical), and more realistic (meaning grounded in the empirical study of human nature).

The origins of behavioral economics may be traced to the transition from the old behaviorist (“stimulus-response”) orientation, which dominated academic psychology from the 1920s through the 1950s, to the new cognitive science–based approach.

The new cognitive-science approach redirected the energies of psychology as an academic discipline towards the effort to get inside the mind of the human subject as the best way of constructing a theoretical framework for the explanation of human behavior.

One of the first psychologists following the new approach, whose work proved to be foundational for the later development of behavioral economics, was Herbert A. Simon.

During the late 1950s and early 1960s, Simon published a series of studies on the concept of “bounded rationality.”

Bounded rationality, in a nutshell, is the name for a set of empirical observations of human decision-making. More specifically, it refers to a cluster of the several different ways in which human beings depart from perfect rationality, particularly in relation to behavior under conditions of uncertainty.

It is a well-established fact that human reasoning relies upon several rules of thumb, which under real-world conditions usually result in successful action, but which do not necessarily conform to the formal requirements of probability theory. For this reason, many investigators condemn human beings as fundamentally “irrational.”

This is, of course, absurd, seeing that it is human beings who discovered and who recognize the forms laws of logic and probability in the first place.

Rather, it is the idea that early human beingsfaced with quickly identifying potential threats to their survival—ought to have stopped to consider their Bayesian priors before acting that is truly irrational, not to say absurd.

Beginning in the 1960s, two Israeli psychologists, Daniel Kahneman and Amos Tversky, brought a large number of novel psychological considerations to bear on the problem of understanding human behavior, which reached far beyond the limits of bounded rationality.

More specifically, Kahneman and Tversky applied the expanded bounded-rationality theoretical framework to the reformation of the discipline of economics.

Kahneman and Tversky’s reformulation of economic theory is sometimes referred to as “prospect theory,” because it focused on prospective (future-oriented) decision-making under conditions of uncertainty.

The supplementary factors identified by Kahneman and Tversky to explain economic action include such phenomena as the following, among others:

  • loss aversion—the greater negative affect associated with a loss compared to the positive affect associated with a quantitatively equal gain
  • confirmation bias—the greater positive affect associated with confirming as opposed to disconfirming evidence
  • anchoring effects—the greater positive affect associated with events that conform to a prior expectation
  • framing effects—the dependency of the affect associated with a choice upon a framing narrative

Recently, behavioral economics has begun to have an impact on public policy.

Perhaps the best known of such policies is the explicit introduction of the notion of “nudge” into policy deliberations. The concept of “nudge” refers to the intentional use of behavioral economics to shape an economic actor’s perceptions.

The nudge policy is particularly associated with Cass R. Sunstein, who implemented it while serving as Administrator of the White House Office of Information and Regulatory Affairs during the Obama administration.