Behavioral Economics

decoy effect


Behavioral economics is a smaller part of economics that combines what we know about psychology with what we know about economics. Normally, economics does not consider the way humans actually think, but instead, abstracts complex decision-making into comparatively simple mathematical models.

Normally, economists assume people are rational, meaning they make good decisions at the right times using all information. In reality, people are subject to problems with self-control, limitations of time and physical resources, and make different choices depending on how decisions are presented to them.

The first major paper in behavioral economics was written in 1979 by psychologists Amos Tversky and Daniel Kahneman. ‘Prospect Theory’ argued that way choices are presented to somebody are just as important as the choices themselves when an individual is making a decision. Later, economist Richard Thaler created a savings model which suggested that people do not figure out how much to save and spend to stay at a constant level. People would rather spend more now, because they prefer gratification in the near future. Behavioral economics can explain many different kinds of human actions such a ‘loss aversion,’ the irrational tendency to be more upset over losses than happy about gains of the same amount. This is important for how people think about taking risks. Related is the ‘disposition effect,’ the tendency for investors to hold onto losing stocks too long, and sell winning ones too soon. The investors are putting off making their losses a reality. Also related is the behavioral economic concept of ‘status quo bias,’ which explains that, against what economics would expect, people seem to like their current state more than any other state they see as different.

Behavioral economics has increasing relevance to public policy design. If framing a choice a certain way will ‘nudge,’ or push, someone to make a better decision, those who are in charge of creating options can use this to produce a better outcome. These outcomes can range from increasing physical activity to decreasing obesity and changing eating habits, to lessening energy use or to reshaping government policies. In the future, the hope is that through small changes, the public will receive large-scale benefits. In Denmark, the government is employing the concept of anchoring (the tendency to rely too heavily on the first piece of information offered) to increase the amount of drivers who are organ donors. In the US, the White House has hired Cass Sunstein, a behavioral economist, to help guide policymakers. Richard Thaler also works in the US Cabinet on the new Behavioral Insight Team. Great Britain, has considered the idea of default options helping increase retirement savings (i.e. requiring people to opt-out of the program rather than in).

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