What’s it: Behavioral economics is a branch of economics on how psychological factors influence and explain economic decision making. It studies the cognitive, emotional, cultural, and social effects on decisions made by economic actors.
Behavioral economics emerged in the 20th century along with advances in psychology and neuroscience. In the book The Economic Approach to Human Behavior in 1976, economist Gary S. Becker describes the rational choice theory. The theory tells you that economic actors have stable preferences and seek to maximize behavior. He uses an economic approach to understand all human behavior, including related social interactions, crime and punishment, and irrational behavior. Some of the notable contributors to behavioral economics are Herbert Simon, Daniel Kahneman, George Akerlof, Robert J. Shiller, and Richard Thaler.
Importance of behavioral economics
Behavioral economics is a relatively modern economic theory. It is important to understand economic behavior and understand the reasons why economic actors take specific actions. Then, behavioral economists use social, moral, and psychological factors to study them.
In textbooks, in general, economic actors are assumed to be rational. Individuals try to maximize satisfaction when consuming goods and services. And, businesses maximize profits in providing goods and services.
In particular, behavioral economics questions these assumptions. Is it true that individuals are rational decision-makers? Does it apply to every situation? After all, people may not behave as traditional economics textbooks suggest.
Insights into behavioral economics theory are essential. One of them is in policymaking. It can help governments and other institutions formulate more effective economic policies. They seek to understand the reasons why economic actors take specific actions. Thus, they can find more effective ways to frame individual choices and be directed toward more desirable actions.
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Behavioral economics concepts
As I mentioned earlier, behavioral economics explains economic decision-making motives, especially related to human psychology. In economics, individuals will try to maximize their satisfaction when faced with several choices. This choice arises because they are faced with limited resources, while their wants and needs are unlimited. Traditional economics assumes human beings are the economic man and make rational decisions.
However, are humans always rational in every situation? For example, why do some people consciously drive over the speed limit? Why do people consume so much junk food if it is harmful to their health? Questions like that then question the assumption that humans are homo economicus.
Behavioral economics asserts that economic actors are not always rational in every decision, as assumed in traditional economics. Some of them may make irrational choices. Economists then added a psychological element to traditional models to better understand their decision-making motives and behavior.
Some of the topics in behavioral economics are:
- Bounded rationality
- Limited self-control
- Social preferences
- Faulty heuristics
- Mental fatigue
- Loss aversion
- Situational framing
Unlike traditional economics, behavioral economists rarely rely on mathematical models to predict outcomes. Humans are always developing and changing when faced with different situations. Thus, the results of decisions are difficult to predict. Instead, they only studied the past behavior of economic actors. They then conducted several experiments to examine how economic actors might behave in the situations they developed.
Many modern economic approaches use the concept of behavioral economics. One example of its application is in ethical economics. In this case, economic actors consider their decisions’ social and environmental impacts rather than just the profit motive.
Economic actors act and make rational decisions. They effectively weigh the costs and benefits of each option available to them. The final decision is the best choice for them.
However, the rationality of economic actors is bounded. It depends on the situation and when they make a decision or choice. For example, you might consider everything you think is most relevant to your situation. However, your consideration may be a fraction of the possibilities. Your friends or family members may have different rationalities.
Long story short, you may be rational. However, your rationality is bounded because you do not have all the information necessary to solve the problem. Herbert Simon introduced the bounded rationality as a critic to the perfect rationality assumption.
Perfect rationality assumes individuals have self-control and are not affected by emotions and external factors. Unfortunately, this assumption does not apply to all situations because of limited self-control.
Individuals are often unable to make the right decisions because they tend to be emotional. Their attention is easily distracted by external factors.
For example, you may experience weight problems because you often eat fast food. You then decide to lose weight and eat only low-calorie and healthy food products. Within a few days, you managed to stop buying fast food.
But, then, you see a commercial on television about a significant discount on the fast-food you love. You are tempted and ignore your commitments. After eating it, you may regret it and will not repeat it again.
Again, the next time your friend gives you a bunch of fast food vouchers, a bonus from his company. You find it attractive and a pity to miss. Once again, your commitment wavered, and you finally decided to buy it.
Due to a lack of self-control, you end up buying fast food, not once, but several times. Thus, you become irrational because you are tempted by external factors (advertisements and vouchers).