Chapter 1
Decoding Behavioral Economics
In This Chapter
Understanding the importance of assumptions for economic analysis
Looking at how real people make choices in the real world
Identifying the non-monetary variables that grow the economic pie
Blowing bubbles and weathering bumps
Seeing what makes people happy
Behavioral economics is all about developing economic analyses for real people in the real world. Itās about making economic models more robust, more accurate, and more practical. But behavioral economics, like its conventional bedfellow, is very much concerned with incentives, costs and benefits, cause and effect, and economic efficiency.
Behavioral economics enriches the conventional economics toolbox by incorporating insights from psychology, neuroscience, sociology, politics, and the law. We end up with more vibrant and revealing economic analyses based on more realistic assumptions about how individuals behave in the real world and the real-world circumstances that influence the decisions they make. In behavioral economics, people arenāt calculating machines. Instead, theyāre decision makers driven by both passion and reason. This type of enriched economics provides us with a better understanding of individualsā economic behavior and their societies.
Making Wise Assumptions
All economists ā conventional or not ā make assumptions about people in order to do their economic analyses. But in conventional economics, the realism of assumptions doesnāt count for much. Assumptions are supposed to be all about prediction, and building models requires economists to simplify reality. Conventional economists figure they just need to get the basics down pat ā they donāt need to describe in detail the apple market to build a model of the apple market.
Behavioral economists, on the other hand, believe that too many of the assumptions in conventional economics are not only simplifications of reality, but also simple-minded and often downright wrong. Behavioral economics says that these unrealistic assumptions often lead to weak and sometimes inaccurate economic analyses and are misleading guides for public policy and private practice.
Why reality matters
One of the originators of behavioral economics, Nobel Laureate Herbert Simon, argued that economic models require realistic simplifying assumptions. Realistic assumptions are necessary in order for economists to build models that help explain not only the causes of actual human behavior but also the institutional framework in which real people make decisions. We need models that not only predict well but also explain well, models that tell us something about cause and effect.
For example, if we start with the assumption that all economic outcomes are efficient (which conventional economics assumes), weāll never notice any inefficiencies, and weāll assume that peopleās choices are producing efficient outcomes. Our assumptions can blind us from engaging in rigorous economic analysis.
To construct rigorous and meaningful scientific models, our simplifying assumptions have to capture important, realistic elements of how people behave and the decision-making environment theyāre in. We have to get our psychology right in order to construct rigorous models that tell a plausible story. But behavioral economics is much more than psychology. Models also need to make assumptions that take into account norms, peer pressure, culture, religion, differences in tastes and preferences, power relationships, gender, and past behaviors. Plus, assumptions need to capture the reality of the legal and overall incentive environment, which can differ across communities and societies.
Why incentives matter ā even in behavioral economics
Conventional economics focuses on the effect of economic incentives like prices and income on peopleās decisions.
Itās true that behavioral economics is fixated on the psychological, sociological, and institutional underpinnings of modeling assumptions, but behavioral economics doesnāt dismiss the importance of economic incentives. Incentives do affect peopleās decisions. Itās just that, often, incentives arenāt enough to tell a good story about economic phenomena.
When behavioral elements are left out of standard models, choices can end up going in the opposite direction of what the standard theory predicts. For example, people sometimes do buy more when the price is high or do less work when new monetary payoffs are introduced. Economists need to enrich the traditional economics toolbox ā but we canāt ignore the importance of economic incentives to the decisions people make.
Making Sense of Choice
Conventional economics assumes that people are calculating, omniscient, self-interested, and focused on maximizing their wealth or income. Behavioral economics is unapologetic about expanding on this conventional decision-making toolkit.
Conventional economics offers us a model that prescribes how people should behave to get ideal results. The conventional model also tells us (or so itās assumed) how people behave, on average.
For behavioral economics, itās important that we be able to not only describe but explain how people make choices. Itās also important for us to get a handle on how most people will behave, and how they make particular decisions given particular circumstances.
Maximizing versus satisficing
Almost no one maximizes, carefully calculates cost versus benefit, operates with perfect information, or carefully forecasts into the future the implications of current decisions, especially with any degree of certainty. People engage in what behavioral economists refer to as satisficing ā they do the best they can to get the best possible results they can, given the psychological, physiological, and environmental constraints they face.
If conventional behavior is considered to be rational, then behavioral economists refer to the way in which people actually do behave as boundedly rational. Being boundedly rational often involves decision-making shortcuts, or heuristics. Some behavioral economists argue that using heuristics typically results in errors and biases in decision making. Others argue that heuristics often generate superior results, given that people are human, not machinelike decision makers.
The effect of emotions
Emotions play an important role in peopleās decision making, and behavioral economics incorporates this important fact of life into its decision theory. Emotions are assumed to be unimportant for decision making in the conventional economic model.
Some behavioral economists believe that emotions interfere with peopleās capacity to make smart decisions. But other behavioral economists believe that emotions and intuition can play an important positive role in the decisions people make, with emotions and intuition building on memories of past experience and understandings. Emotions and intuition have their upsides and downsides ā but theyāre definitely part of the decision-making process (despite what conventional economics says).
The avoidance of loss
In conventional economics, people are particularly concerned with maximizing income and wealth. But behavioral economics recognizes that people arenāt only willing to trade off some income to reduce the risk of making money. On average, people tend to really despise losses and even despise giving up on lost causes. And people often are willing to sacrifice some income and wealth to avoid losses, to stick with what appears to be a lost cause, to gain some certainty, and to avoid ambiguous outcomes. This all is referred to as loss aversion. People do what it takes to make themselves more satisfied ā but however important money is to them, maximizing money and wealth given the risk involved doesnāt appear to be the only thing that matters.
Most people will also gladly sacrifice some income and wealth to help others or to punish people they consider to be cheats and free riders. They get a happiness spike by being nice to good people and by punishing the ābad guys.ā This isnāt to say that people are willing to sacrifice everything ā but when you go with the conventional assumption that people are focused solely on maximizing their income and wealth, youāre overlooking a key part of human behavior.
How options are framed
Conventional economics says that people arenāt influenced by trivial changes in the manner in which options are framed. For example, conventional economics says that if people want to donate their organs after they die, theyāll arrange for that to happen no matter what ā and if they donāt become organ donors, itās because they didnāt really want to.
But the fact of the matter is that people are affected by how options are framed. For example, if the default option for organ donation is to not donate at death (in other words, if you have to make some kind of effort to become an organ donor), most people wonāt. If the default option is to donate (for example, if organ donation is the rule, and you have to make an effort to indicate that you donāt want to donate), most people will donate.
Very often, opting for the default is just one less obstacle to cross when making decisions. In a world of uncertainty, defaults also signal what is the right thing to do.
However you look at the issue, framing is important. And because of its importance, how options are framed becomes very important to the choices people make and to economic outcomes that can have considerable implications for society at large, such as retirement savings.
Paternalism versus free choice
In conventional economics, peopleās choices are always the best choices, and we should leave well enough alone, unless peopleās c...
