1. Chapter 8 Behavioral Economics
This chapter will define behavioral economics and explain how it contrasts with neoclassical economics. It will relate how prospect theory helps explain many consumer behaviors and how time inconsistency and myopia cause people to make suboptimal long-run decisions. It will also define fairness and give examples of how it affects behavior in the economy. The Last Word is about how researchers in the UK found ways to nudge people toward making different choices.
Behavioral Economics

2. The Origin of Behavioral Economics
Neoclassical economics
Believe our decisions are rational
But evidence shows we make systematic errors
Behavioral economics
Developed to explain these errors
Neoclassical economists have always believed that people act rationally when making decisions. But evidence shows that is not always the case; we find that people make systematic errors which means they make the same errors over and over again. Neoclassicalists answered back that consumers were ignorant about the situation and just needed to be educated on the matter; but they found that people persisted in making errors even when it was pointed out to them that they were acting against their own best interests. Behavioral economics was developed in order to make more accurate predictions about human behavior.
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3. Comparing Economic Theories
Neoclassical economics
People have stable preferences that aren’t affected by context
People are eager and accurate calculating machines
People are good planners who possess plenty of willpower
People are almost entirely selfish and self-interested
Rationality is the most fundamental point of disagreement between behavioral economics and neoclassical economics. Behavioral economics contends that neoclassical economics makes a number of highly unrealistic assumptions about human capabilities and motivations.
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4. Comparing Economic Theories Continued
Behavioral economics
Focusing on the mental process behind decisions
Improving outcomes by improving decision making
Behavioral economics puts significant emphasis on the mental process driving behavior. Improving outcomes by improving decisions is one of the distinguishing characteristics of behavioral economics.
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5. Combining Economic Theories
Viewing behavioral economics and neoclassical economics as complements
Neoclassical economics at the supermarket
Behavioral economics at the supermarket
Complementary explanations at the supermarket
Many economists prefer to think of neoclassical and behavioral economics as complementary approaches that can be used in conjunction to help improve our understanding of human behavior.
“Incentives matter!” Neoclassical economics believe that consumers care a great deal about prices. They cannot explain “impulse buying” very well, however. Behavioral economics explains impulse buying and other irrational behaviors as the result of a wide variety of underlying factors.
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6. Contrasting Economic Theories
This table summarizes how the two approaches differ in several areas.
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7. Our Efficient, Error-Prone Brains
Heuristics are energy savers
Riding a bicycle with steering heuristics
Guesstimating ranks with recognition heuristics
The implications of hardwired heuristics
The brain evolved many low-energy mental shortcuts, called heuristics. These shortcuts are not the most accurate mental-processing options but used because the opportunity cost of perfection is high. Since heuristics are hardwired in our brains it may be difficult for people to alter their behaviors and people may be easy prey for those who understand their hardwired tendencies.
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8. Our Efficient, Error-prone Brains Continued
Brain modularity
System 1 and System 2
Cognitive biases
Confirmation bias
Self-Serving bias
Overconfidence effect
Hindsight bias
Availability heuristic
Planning fallacy
Framing effects
The brain is modular which means specific areas of our brain deal with specific sensations like vision, breathing, and anger. The brain’s decision-making system has two parts: System 1 and System 2. System 1 uses a lot of heuristics in the older parts of the brain and System 2 uses newer parts of the brain to undertake slow, deliberate, and conscious calculations of costs and benefits. The unconscious mental processes suffer from a variety of cognitive biases which are misperceptions that cause systematic errors. Psychologists have identified a number of cognitive biases; here are a few that are relevant to economics and decision-making. Confirmation bias refers to the human tendency to only pay attention to information that agrees with one’s preconceptions. Overconfidence effect refers to people’s tendency to be overly confident about how likely their judgments are to be correct. Hindsight bias is when people retroactively believe that they were able to predict past events. Availability heuristic causes people to base their estimates about the likelihood of an event happening, not on objective facts but on whether or not similar events come to mind. The planning fallacy is the tendency people have to massively underestimate the time needed to complete a task. Framing effects occur when a change in the context causes people to react differently to a particular piece of information.
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9. Prospect Theory
People judge good things and bad things in relative terms, as gains and losses to their status quo
People experience both diminishing marginal utility for gains as well as diminishing marginal disutility for losses
People experience loss aversion, in that they feel losses much more intensely than gains
How people cope with negative possibilities is a central focus of behavioral economics. Many observations have been catalogued as to how people actually deal with the prospect of bad things as well as good things. Three very interesting facts summarize how people deal with good and bad.
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10. Prospect Theory Continued
Losses and shrinking packages
Framing effects and advertising
Anchoring and credit card bills
Mental accounting and overpriced warranties
The endowment effect and market transactions
Status quo bias
Prospect theory helps us understand how consumers plan for and deal with life’s ups and downs. Businesses have to be very careful about increasing the price they charge for their products, because once consumers become used to a given price, they will view any increase as a loss relative to the status quo price they had been accustomed to.
Framing effects have major consequences for consumer behavior because any frame that alters whether consumers consider a situation to be a gain or a loss will affect their consumption decisions.
By showing such small minimum-payment amounts, credit card companies anchor many customers into the expensive habit of paying off their debts slowly rather than quickly.
The endowment effect is the tendency that people have to put a higher valuation on anything that they currently possess than on identical items that they do not own but might purchase.
Status quo bias is the tendency that people have to favor any opinion that is presented to them as being the default (status quo) opinion.
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11. Global Perspective
This table shows, for a selection of European countries, the percentages of their respective populations that have indicated their willingness to participate in organ-donation programs. People tend to stick with whatever option is presented as the default option. Thus, the seven countries with high percentages consenting to be organ donors have organ-donation programs in which the default option is participation. By contrast, the four countries with low percentages of organ donors have organ-donation programs where the default option is not participating.
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12. Myopia and Time Inconsistency
Fighting self-control problems with pre-commitments
Hiding the alarm clock
Automatic payroll deductions
Salary smoothing
Early withdrawal penalties
Weight-loss competitions
Economists use the word myopia to describe the fact that brains have a hard time conceptualizing the future. The primary consequence of myopia is that when people are faced to choose between something that will generate benefits quickly and something that won’t yield benefits for a long time, they will have a very strong tendency to favor the more immediate option.
Time inconsistency is the tendency to systematically misjudge at the present time what you will want to do at some future time. It is as if your future self ends up disagreeing with your present self. This is a major cause of self-control problems. The key to fighting time inconsistency and self-control problems is to have a good understanding of what your future self is likely to want. You can then make pre-commitments and take actions ahead of time to prevent your future self from doing much damage.
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13. Fairness and Self-Interest
Evidence for fairness exists
Giving to charity
Obeying the law
Fixing prices
Purchasing the “Fair-Trade” products
Neoclassical models assume that people are purely self-interested. What behavioral economists have discovered is that the human propensity to care about others extends into every type of economic behavior. While self-interest is always present, most people care deeply about others and how they are interacting with others. As a result, economic transactions are heavily influenced by moral and ethical factors.
Fairness is a person’s opinion as to whether a price, wage, or allocation is considered morally or ethically acceptable. Many everyday economic behaviors indicate that people care substantially about fairness.
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14. Fairness and Self-Interest Continued
Experimental evidence for fairness
The dictator game
The ultimatum game
The rules
How players behave
Why the threat of rejection increases cooperation
Implications for market efficiency
Our understanding of fairness and how it affects economic transactions has been reinforced and refined in recent decades by examining experimental games that were specifically designed to test people’s feelings about fairness. Outcomes suggest that people care about fairness and are not purely self-interested; it has been found that people share with others even when anonymity would allow them to be perfectly selfish and that people will reject deals that they consider unfair to themselves. This threat of rejection can be construed as that which drives markets to increased allocative efficiency and increased productive efficiency.
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15. Nudging People Toward Better Decisions
UK established a Behavioral Insight Team
Used to study “nudging” people towards choices that are better for themselves and others
Paying taxes
Attending adult literacy class
Increasing saving
Can be viewed as a form of manipulation
Now that behavioral economics has made significant headway in explaining many behaviors, some economists are suggesting that its insights be used to nudge people toward choices that are better for themselves and others. A key feature of “nudges” is that they are subtle and can cause large changes in behavior without making people feel bullied or coerced. And, without imposing stringent new rules or having to offer people big monetary incentives or disincentives to get them to do what you want. The BIT found the UK could substantially increase tax revenues paid in by mailing letters that said that the neighbors had already paid. Sending text messages to students on Sunday night that said we look forward to seeing you next week and to remember to plan how to get to class increased class attendance. Increased saving by 82 percent for a group in commitment saving accounts. The problem is that the people who are being nudged are completely unaware that they are being manipulated and some question whether this type of activity is ethical.