Behavioral Economics: Past, Present, Future PDF

Behavioral Economics: Past, Present, Future by Colin F. Camerer and George Loewenstein Behavioral Economics is a branch of economics that studies the psychological, emotional, and social factors behind economic decisions. Unlike traditional economics, behavioral economics recognizes that peop...

Behavioral Economics: Past, Present, Future by Colin F. Camerer and George Loewenstein Behavioral Economics is a branch of economics that studies the psychological, emotional, and social factors behind economic decisions. Unlike traditional economics, behavioral economics recognizes that people do not make rational, logical decisions and suggests that their decisions are often based on irrational behavior. At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve the field of economics on its own terms: 1.generating theoretical insights, 2.making better predictions of field phenomena, 3.suggesting better policy  The Historical Context of Behavioral Economics 1. Adam Smith, wrote a less well-known book, The Theory of Moral Sentiments, which laid out psychological principles of individual behavior that are arguably as profound as his economic observations. 2. Jeremy Bentham, whose utility concept formed the foundation of neoclassical economics, wrote extensively about the psychological underpinnings of utility 3. Francis Edgeworth’s Theory of Mathematical Psychics introduced his famous “box” diagram showing two-person bargaining outcomes and included a simple model of social utility, in which one person’s utility was affected by another person’s payoff. 4. The formal development of Behavioral Economics began with psychologists like Daniel Kahneman and Amos Tversky, who introduced Prospect Theory in 1979. They demonstrated that people’s decisions are heavily influenced by how choices are framed and that losses loom larger than gains (loss aversion). What are the origins of Behavioral Economics? Behavioral Economics has been shaped by studies that have blurred the boundaries between psychology and economics, especially since the mid-20th century. Important names: Daniel Kahneman and Amos Tversky: Their "Heuristics and Biases" studies revealed biases and errors in people's decision-making processes. Herbert Simon: He developed the concept of "Bounded Rationality", which suggests that people make decisions with limited information and limited cognitive capacities 1  Key Difference from Traditional Economics Traditional Economics (Neoclassical Economics): Assumes that people are rational agents (homo economicus) who make decisions that maximize their self-interest with all available information. Behavioral Economics: Suggests that human behavior often deviates from these assumptions, as people make decisions based on heuristics (mental shortcuts), emotional states, and biases. 1  Rational decision making means that individuals make choices in a logical and calculated manner to provide the highest benefit. According to classical economic What is rational theory, people evaluate all available information, decision making? calculate the consequences of options, and choose the option that provides the highest personal benefit. This assumption represents a completely rational individual called “homo economicus.” However, in the real world, such rationality is not always the case. 3  People don’t always act rationally for a variety of reasons. These reasons include: Limited Cognitive Capacity: People have a limited cognitive capacity and therefore cannot evaluate all information. This is explained by the concept of Why don’t people “bounded rationality.” always act rationally? Cognitive Biases: People can make systematic biases and errors that affect their decisions. For example, “confirmation bias” can cause a person to only pay attention to information that confirms their existing beliefs. Emotional Influences: Emotions can affect decisions. Fear, sadness, or excitement can make it difficult for individuals to make rational 4 decisions.  Why Behavioral Economics Matters Real-World Decision-Making: Behavioral Economics provides a more realistic view of how people make decisions in everyday life. From personal finance to consumer choices, it accounts for factors like procrastination, overconfidence, and emotional reactions. Policy and Business Applications: The field has become increasingly important in areas such as public policy (e.g., using "nudges" to promote better behavior) and business strategy (e.g., designing products and services that account for consumer biases).  Principals of Behavioral Economics Cognitive biases are errors in thinking that systematically influence people's decisions: Bounded Rationality: People don’t always make optimal decisions because their cognitive abilities and the information they have are limited. They don't always make optimal decisions because they can't process all available information or anticipate future outcomes perfectly. Heuristics: Mental shortcuts that simplify decision-making but can lead to biases and errors (e.g., availability heuristic). For instance, people may rely on the "availability heuristic," where they assess the likelihood of events based on how easily they can recall similar instances. Biases like "loss aversion" show that people tend to feel the pain of losses more strongly than the pleasure of equivalent gains. Loss Aversion : The idea that people feel losses more strongly than equivalent gains. This can affect risk-taking behavior. Developed by Daniel Kahneman and Amos Tversky, this theory challenges the traditional notion of utility by showing that people value gains and losses differently. This has profound implications for understanding economic behavior, particularly in areas like risk aversion, investing, and consumer behavior. Framing Effects (Nudging) : Small changes in the way choices are presented can lead people to make better decisions without restricting their freedom of choice. For example, they might respond differently to a choice if it is framed as a potential loss rather than a gain, even if the outcome is identical.  Behavioral Economics integrates psychology into economic theories to understand individuals’ decision-making processes: How do psychology and economics combine? Cognitive Psychology: Used to understand people’s information processing processes and thinking styles. Emotional Psychology: Investigates how emotions affect decisions. For example, feelings of fear or excitement can affect consumer behavior. 3 PSYCHOLOGICAL BASIS OF OUR ECONOMIC BEHAVIORS Kahneman and Tversky (1974) state that people make many systematic errors and act with prejudice when making decisions under uncertainty and then explain three different mental shortcuts. These are; 1.representativeness, 2.availability and 3.anchoring  Individuals generally evaluate the probability that object x belongs to category y or that event x originates from process y according to Representativeness: representativeness. In other words, they look at how similar x is to y. If x resembles y, they find the probability that x originates from y high, if not, they find it low. 3 Example: A group of 100 engineers and lawyers were given short personality descriptions randomly sampled. The subjects were asked the probability that these descriptions belonged to an engineer rather than a lawyer. In the first experiment, subjects were told about a group of 70 engineers and 30 lawyers, and in the second experiment, a group of 30 engineers and 70 lawyers. Although the probability of a certain description belonging to an engineer was higher than that of a lawyer in the first experiment and the opposite was true in the second experiment (the ratio of the probabilities in question is 0.7/0.3 according to Bayes' rule), subjects ignored Bayes' rule. Subjects gave the same probability for both experiments. They looked at how much a description that was more likely to belong to an engineer than to a lawyer represented the image of an engineer,  Individuals sometimes evaluate the frequency of a category or the probability of an event according to the frequency or ease with which examples related to that Availability: category or event come to mind. This shortcut is called availability. It comes to mind more easily, especially if it is a big situation or occurs frequently. 3 Example: Subjects were asked to read a list of famous men and women and whether there were more men than women on the list. Different groups were presented with different lists. In some of the lists, men were more famous than women, while in others, the opposite was true. In each of the lists, subjects made the mistake of thinking that the category containing more famous people (in terms of gender) was more common.  In many cases, individuals determine a starting point, or anchor, in their minds before estimating an unknown Adjustment and quantity. Individuals adjust this anchor up or down as Anchoring: they visualize it. However, these adjustments can sometimes lead to errors and be biased, and in other cases they can be useful. 4 Example: When the value of an inherited antique chair is being determined by the heirs, they can determine the price of a similar chair found at an antique shop and compare this price to the condition of their own antique chair as an anchor. In this sense, using the mental shortcut of anchoring and correction provides benefits and saves extra effort. So, does the situation change when you watch an antique program on TV at the same time? For example, if an antique chair worth thousands of dollars made by a designer is considered to be evaluated, if issues such as the chair not having a designer are not correctly reflected in the anchor, then the anchor may be too high and biased. Example: In a study conducted on real estate valuation, 21 real estate agents were asked various questions such as the real value of the house they were taken to and how much they would sell it for if they were to sell it. After giving similar information about a house with a real list price of $74,900 to both groups, one group was told that the list price of the house was $65,900, and the other group was told that the list price was $83,900. The first group determined the home's real value to be $67,811 and its sales value to be $69,966, while the second group determined the home's real value to be $75,190 and its sales value to be $76,380. The real estate agents were then asked about the factors that influenced their decisions, and the real estate agents insisted that the list price had no effect on their answers, but the result was the opposite. THANK'S FOR WATCHING