Behavioral Economics: Definition, Examples & Principles (2023)

Behavioral Economics Definition

Studies of how humans think and behave are generally rooted in the field of psychology but, in the 70s, Israeli psychologists Daniel Kahneman and Amos Tversky revealed new insights into how people think and behave when it comes to money. One of the earliest applications of their work, called Prospect Theory, was in the field of economics. American economists Richard Thaler and Robert Shiller helped to introduce behavioral theories into mainstream economic teachings, with the resulting body of knowledge referred to by the hybrid name “Behavioral Economics”.

Note: Thaler, Shiller, and Kahneman were each awarded Nobel Prizes for their pioneering work. For his part, Kahneman was the first psychologist ever to be awarded a Nobel Prize in economics.

See Also

What Is Behavioral Economics? Theories, Goals, and ApplicationsBehavioral EconomicsBehavioral Economics - learn & understand it online

Behavioral science brought valuable new insights not only to the world of economics and finance but into other industries as well, such as technology and professional sports.

Classic Economics vs. Behavioral Economics Theory

Classic economic theories coalesced during the 18^th century around concepts like supply and demand equilibrium, free markets, and the “invisible hand”, a metaphor for the unseen forces of a collective marketplace. This thinking fed into the development in the mid-20^th century of the Rational Utility Principle, the Efficient Market Hypothesis, and the Capital Asset Pricing Model, which form the basis of how financial markets are assumed to operate and are used throughout the financial industry today.

One of the key underlying assumptions that drove these theories is that people always behave “rationally”. The term is defined by the Rational Utility Principle to mean that people will always act in their own self-interests, always use all information available and will never let emotion sway them from a logical decision. Behavioral economics, however, provides evidence that people are not always rational and that emotions can often play a substantial role in their behavior.

Behavioral economics has identified numerous economic instances where people deviate from rational thinking, such as when we pay higher interest to borrow money than we currently earn on money saved, take more risk with money received as a gift than money earned, or ignore the guaranteed benefits of a 401k plan from our employer. A major objective of economists such as Thaler and Shiller is to suggest ways in which the government or employers can “nudge” the public into making better decisions along these lines.

Behavioral Biases & Decision-Making

The core findings in behavioral science point to various heuristics that the human brain employs to deal effectively with information. These heuristics can be thought of as shortcuts that speed up the way we process information which, in turn, leads to faster decision-making, which was critical to survival in early humans. Faster-thinking humans survived longer, reproduced at a higher rate, and handed those traits down through thousands of generations.

To make speedier decisions, our brains evolved to employ a variety of shortcuts, like estimating things, ignoring information, or using information only from recent memory. So, while fast decision-making was important to survival, it often sacrificed accuracy and that tradeoff carried forward through our DNA into current times. Humans only began making complex financial decisions a short time ago in the lengthy history of our presence on earth and what behavioral science determined was that we don’t always do it as accurately as we think.

Humans also found that they could utilize emotions to speed up decisions and that, too, became part of our mental fabric. Now, when we make decisions that require a logical rather than emotional response, we are unable to separate the two and we are helpless to prevent emotions from having an undue influence on our decisions. Even when unintentional, it happens subconsciously, rendering us incapable of completely eliminating the impact of emotions on our behavior.

Note: Studies of patients with injuries to the emotional center of their brains indicate that without emotions, our brains are unable to make almost any decisions at all.

The impact of heuristics and emotions on our decisions results in biases, which are part of our basic wiring as human beings. The importance of the biases to economics and finance is that they demonstrate how we are, in many ways, not the totally rational beings that classic economic theories assume.

Tip: Kahneman’s book “Thinking Fast and Slow” discusses many facets of his research on how people think and is among the most popular on the subject.

Principles of Behavioral Economics

Overall, behavioral economics tells us that our thinking process can lead us to make decisions that are not necessarily aligned with our best interests. Unfortunately, the biases behind these decisions are the result of how our brains work and they are not easily avoided, even after we have become aware of them. Furthermore, the biases result in actions that we are prone to repeat under similar circumstances again and again.

Depending on how you define the biases, there can be hundreds of them, but a high-level approach can boil that down to about a dozen or so. Biases are not just anecdotal—they have been researched and are known to be pervasive throughout the population. Some studies have even explored the different biases among generations, cultures, and genders. They are also systematic, meaning people are all biased in the same direction.

Some of the more prominent biases include:

• Availability bias: Giving a strong preference to information we can recall from short term memory.
• Framing: Being influenced by the way the choices are presented to us.
• Herding: Relying heavily upon what other people think and do, regardless of how relevant or accurate it is.
• Mental accounting: Compartmentalizing money into different mental “buckets” and attaching different values and priorities to each one.

Biases are deeply embedded in our mental framework and originate within our subconscious brain. Psychologists commonly use the phrase “hard-wired” when describing them. What makes the biases so challenging for us to overcome is that they work completely in the background such that we don’t even realize when our decisions are being influenced by them. Nonetheless, they can often have a significant impact on our decisions and actions.

Behavioral Economics Examples

One of the more prominent examples of a bias that was not in people’s best interests was related to 401k plans. Economist Richard Thaler studied why people were reluctant to sign up for their company 401k plan. Such plans offer workers the opportunity to save part of their pay in a tax-deferred retirement account. There is no obligation to contribute and no cost to workers. They also receive a tax deferral and many employers will match funds contributed up to a certain amount. All in all, the plans represent a clear benefit to workers with no cost or obligation, yet sign-up rates were found to be disappointingly low in many companies.

Studying the problem, Thaler discovered that the plan itself wasn't the cause of hesitation, but moreso a hesitation to sign up for anything. People could not offer a clear reason why they might not want to participate in the plan, so Thaler knew that wasn’t the issue. People may have been mistrustful, or simply afraid to commit to the responsibility of managing their own retirement assets.

Thaler’s solution was to change the process from an opt-in sign-up requirement to an opt-out process. In other words, people would automatically be put into the plan once they became eligible and they could decline by opting out. Very few elected to opt out and a good portion of the new signups began contributing as well. The result was a dramatic increase in plan participation (and a Nobel Prize for Thaler). Other companies quickly followed suit and now opt-out programs are the norm.

Tip: For those who are interested in reading more on the subject, consider Thaler’s book with Cass Sunstein called “Nudge: The Final Edition: Improving Decisions About Money, Health, and the Environment”.

Why It Matters To Investors

Behavioral Economics tells us that we are sometimes unknowingly sidetracked by our own emotions from making decisions that are in our best interests. Becoming aware of this is the first step toward recognizing when it happens and to taking steps to avoid it.

Research shows time and again that individual investors tend to underperform the markets and the most suspected reasons for this are biases like herding and overconfidence. Herding has us often following the crowd, which all but ensures that we will have lower returns and overconfidence causes people to believe that they can time the market, do better with highly concentrated portfolios, or trade frequently to catch all the swings, all of which generally results in lower rather than higher performance.

Bottom Line

Behavioral economics reveals how people think and make economic and financial decisions. Understanding it can help people avoid the psychological biases that sometimes prevent us from being better consumers, investors, and savers. It can lead to a better understanding of market behavior as well.