Behavioral economics

Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory.^[3][4] The study of behavioral economics includes how market decisions are made and the mechanisms that drive public opinion.


Behavioral economics began as a distinct field of study in the 1970s and '80s, but can be traced back to 18th-century economists, such as Adam Smith, who deliberated how the economic behavior of individuals could be influenced by their desires.^[5]


The status of behavioral economics as a subfield of economics is a fairly recent development; the breakthroughs that laid the foundation for it were published through the last three decades of the 20th century.^[6][7] Behavioral economics is still growing as a field, being used increasingly in research and in teaching.^[8]

In 1979, Kahneman and Tversky published Prospect Theory: An Analysis of Decision Under Risk, that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory.^[24] Kahneman and Tversky utilising prospect theory determined three generalisations; gains are treated differently than losses, outcomes received with certainty are overweighed relative to uncertain outcomes and the structure of the problem may affect choices. These arguments were supported in part by altering a survey question so that it was no longer a case of achieving gains but averting losses and the majority of respondents altered their answers accordingly. In essence proving that emotions such as fear of loss, or greed can alter decisions, indicating the presence of an irrational decision-making process. Prospect theory has two stages: an editing stage and an evaluation stage. In the editing stage, risky situations are simplified using various heuristics. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include:


In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave a revised account of prospect theory that they called cumulative prospect theory.^[25] The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggin's rank-dependent utility theory. Psychological traits such as overconfidence, projection bias and the effects of limited attention are now part of the theory. Other developments include a conference at the University of Chicago,^[26] a special behavioral economics edition of the Quarterly Journal of Economics ("In Memory of Amos Tversky"), and Kahneman's 2002 Nobel Prize for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."^[27]


A further argument of Behavioural Economics relates to the impact of the individual's cognitive limitations as a factor in limiting the rationality of people's decisions. Sloan first argued this in his paper 'Bounded Rationality' where he stated that our cognitive limitations are somewhat the consequence of our limited ability to foresee the future, hampering the rationality of decision.^[28] Daniel Kahneman further expanded upon the effect cognitive ability and processes have on decision making in his book Thinking, Fast and Slow Kahneman delved into two forms of thought, fast thinking which he considered "operates automatically and quickly, with little or no effort and no sense of voluntary control".^[29] Conversely, slow thinking is the allocation of cognitive ability, choice and concentration. Fast thinking utilises heuristics, which is a decision-making process that undertakes shortcuts, and rules of thumb to provide an immediate but often irrational and imperfect solution. Kahneman proposed that the result of the shortcuts is the occurrence of a number of biases such as hindsight bias, confirmation bias and outcome bias among others. A key example of fast thinking and the resultant irrational decisions is the 2008 financial crisis.