There are two main motivations for research in behavioral economics. First, people sometimes make choices that are inconsistent or at least very difficult to reconcile with standard economic theory. Second, in some situations, standard economic theory leads to seemingly unreasonable conclusions about consumer welfare.
The main objective of behavioral economists is to modify, supplement, and enrich standard economic theory by adding insights from psychology. Usually they modify the theory either by making different assumptions about preferences or by assuming that certain actions are mistakes.
For the most part, behavioral economists employ the same tools as other economists, though they tend to rely more on experiments. Experiments offer several potential advantages and disadvantages over other methods.
Departures from perfect rationality
Some experiments call into question the assumption that people have coherent preferences. In some situations, subjects consistently violate the Ranking Principle: in others, their judgments appear to depend on patently irrelevant information.
In some situations, people exhibit a strong attachment to the status quo. For example, they tend to value something more highly when they own it than when they don't. Moreover, when confronted with a menu of alternatives, they sometimes avoid making a choice and end up with the default option. Default effects are apparent in decisions about retirement saving.
People tend to group related items into categories and to draw artificial boundaries around those categories. In making a choice, they tend to consider other items in the same category, and may ignore items in different categories.
Sometimes, people's choices seem to depend on the way the alternatives are presented. Different presentations may convey precisely the same objective information while calling attention to different facts.
When confronted with complex problems, people often rely on simple rules of thumb that have performed reasonably well in the past. Rules of thumb appear to play an important role in decisions concerning saving and portfolio allocation.
Choices involving time
Some people change their rankings of the alternatives available at some future time as that time approaches. This phenomenon reflects a bias toward immediate gratification, which creates problems involving self-control. That, in turn, leads people to restrict future choices.
People who suffer from present bias may have difficulty exercising the self-control required to save money. If they're aware of their tendencies, they may look for ways to save automatically and lock up funds for retirement—for example, through pension plans.
Though microeconomic theory tells us to ignore sunk costs, people sometimes have difficulty following that principle. For example, they may behave as if the value they attach to an object depends on the price they paid for it.
In some situations, people appear to have trouble accurately forecasting how they'll feel about different outcomes in the future. Instead of making reasonable forecasts, they tend to evaluate future consequences based on their tastes and needs at the moment of decision making.
Choices involving risk
People tend to make several types of errors in assessing probabilities. Some think that once an event has occurred several times in a row, it is more likely to repeat; others think it is less likely to repeat. Overconfidence causes people to overestimate their abilities and underestimate the uncertainty involved in decisions. This tendency may contribute to the high frequency of business failure.
In some situations, people seem to place disproportionate weight on low-probability events, and are noticeably risk averse, even toward gambles involving very low stakes. These and other puzzles have led to the development of prospect theory.
Prospect theory assumes, first, that people evaluate an outcome based on the change in total resources (rather than on the level of total resources); second, that a person's valuation of an outcome is more sensitive, per dollar, to small losses than to small gains; third, that the impact of enlarging a change on a valuation declines with the size of the change; and fourth, that the weight associated with each potential outcome is greater than its probability for small probabilities and smaller than its probability for large probabilities.
Choices involving strategy
Predictions of behavior that are based on game theory tend to become more accurate once players have gained some experience with a game, particularly if the rules are relatively simple. However, even experienced players of simple games sometimes appear to behave contrary to their own interests. Many of these failures may be attributable to assumptions about players' payoffs (in particular, that they care only about their own monetary rewards) rather than to problems with game theory itself.
An important objective of behavioral economists is to understand the ways in which social motives influence strategic choices. Results for the dictator game illustrate the potential importance of social motives such as altruism, fairness, egalitarianism, and status. Results for the ultimatum game suggest that emotions such as anger and indignation can also influence economic decisions. Results for the trust game help us to understand one reason why it's possible to conduct a great deal of business based on only handshakes and oral agreements.
Neuroeconomics: a new frontier
Some economists believe that they will eventually learn to build better models of economic behavior, and perhaps develop a new unified theory of decision making, by studying relevant aspects of the human neural system, including brain processes. For example, researchers have identified a plausible neurological source of dynamic inconsistency.
Neuroeconomics may help us determine whether particular behavioral patterns, such as the consumption of addictive substances, reflect preferences or mistakes.
