Behavioral Economics: Importance, Concept Examples

General Article

What it is: Behavioral economics is the branch of economics that studies how the effects of 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 from the fields of psychology and neuroscience. Through his book The Economic Approach to Human Behavior in 1976, economist Gary S. Becker describes 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 those related to social interactions, crime and punishment and irrational behavior. Some of the leading contributors to the study of behavioral economics are Herbert Simon, Daniel Kahneman, George Akerlof, Robert J. Shiller, and Richard Thaler.

The 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 perform certain 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 seek to maximize satisfaction when consuming goods and services. And, businesses maximize profits in providing goods and services.

In particular, behavioral economics questions this assumption. Is it true that individuals are rational decision makers? does it apply to every situation? After all, people may not behave the way traditional economics textbooks demand.

Insight into behavioral economic theory is important. One of them is in policy making. It can help governments and other agencies develop more effective economic policies. They seek to understand the reasons why economic actors perform certain actions. Thus, they can find more effective ways in which individual choices are framed and directed toward more desirable actions.

Behavioral economics concept

As I mentioned earlier, behavioral economics explains the motives for making economic decisions, particularly with regard to human psychology. In economics, individuals will try to maximize their satisfaction when faced with a number of choices. These choices arise because they are faced with limited resources, while their wants and needs are unlimited. Traditional economics assumes that humans are economic people and make rational decisions.

However, are humans always rational for every situation? For example, why do some people consciously drive over the speed limit? Why do people consume a lot of junk food, if it is harmful to their health? Such questions then question the assumption that humans are homo economicus.

Behavioral economics emphasizes that economic actors are not always rational in every decision as assumptions in traditional economics. Some of them may make irrational choices. Economists then added elements of psychology to traditional models in an attempt to better understand the motives of decision-making and their behavior.

Some behavioral economics topics are:

  • Bounded rationality
  • Biases
  • 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 evolving and changing when faced with different situations. Thus, the outcome of the decision is difficult to predict. Instead, they only study the behavior of economic actors in the past. They then conduct several experiments to examine how economic actors might behave in the situations they develop.

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 the social and environmental impacts of their decisions rather than only on the profit factor.

Limited rationale

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 limited. It depends on the situation and when they make a decision or choice. For example, you might consider everything that you think best fits your situation. However, your judgment is probably a small part of the possibilities. Your friends or family members may have a different rationale.

Long story short, you are probably rational. However, your rationality is limited because you don’t have all the information needed to solve the problem. Herbert Simon introduced the concept of finite rationality to replace the assumption of perfect rationality as in neoclassical economics.

Limited self-control

Perfect rationality assumes the individual has self-control and is not moved by emotions and external factors. Unfortunately, this assumption does not apply to all situations due to limited self-control.

Individuals are often unable to make good decisions because they tend to be emotional. Their attention is easily distracted by external factors.

For example, you have weight problems because you often eat fast food. You then decide to lose weight and consume only low-calorie food products and healthy foods. Within a few days, you managed to stop buying fast food.

But, then, you see an ad on television about a big discount on the fast food you love. You are tempted and neglect your commitments. After eating it, you may regret it and won’t do it again.

Again, another time, your friend gives you lots of fast food vouchers, a bonus from his company. You find it interesting and it’s a shame to miss it. Once again your commitment wavered and 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 (ads and vouchers).