Behavioral Economics For Dummies
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Behavioral economics is about bringing reality into economic analysis. It borrows from psychology, sociology, politics, and institutional economics (which focuses on the rules of the economic game) to describe and explain human behavior and economic phenomena.

Behavioral economics builds upon conventional economics, offering more tools for understanding why people behave the way they do when it comes to income, wealth, ethics, and fairness. It uses prospect theory to describe the choices that the typical person makes.

Behavioral economics vs. conventional economics

Behavioral economics enriches the conventional economics toolbox by incorporating insights from psychology, neuroscience, sociology, politics, and the law. The result: more vibrant and revealing economic analyses based on more realistic assumptions about how individuals behave in the real world and the real-world circumstances that influence the decisions they make.

Conventional Economics Says . . . Behavioral Economics Says . . .
For economic analysis, the assumptions made about people
don’t have to be realistic.
For economic analysis, the assumptions made about people must
be realistic.
People are endowed with the capacity to efficiently and
effectively acquire and process all relevant information.
People are not endowed with the capacity to efficiently and
effectively acquire and process all relevant information. People
are referred to as being boundedly rational — they do the
best they can, given the constraints they face.
People can figure out and factor in the future consequences of
current decisions.
People aren’t always able to figure out the future
consequences of current decisions, especially in a world of
uncertainty (in other words, the real world).
People always make smart decisions, ones that they don’t
People can and often do make decisions they end up
People always make decisions in an ideal decision-making
environment, where they have all the information they need and the
time to make the best possible decision.
People often face decision-making environments that prevent
them from making the best possible choices.
Wealth and income maximization are all that matter. Wealth and income maximization aren’t the only things
that matter. Being fair, doing the right thing, maintaining a good
reputation, and pleasing friends, neighbors, and partners are also
important, even if they come at the expense of some wealth or
Relative positioning isn’t important. It doesn’t
matter how much money your neighbor makes; all that matters is how
much you make.
Relative income can be as important to people’s happiness
as absolute income. People derive happiness from earning more than
other people do.
People aren’t influenced by anyone or anything else. People are influenced by their peers, by their past, and by
their circumstances.
People are narrowly self-interested, and this is the only
rational way to be.
Many people are narrowly self-interested, but altruism and
ethics also can be important motivators for behavior.
How hard and well people work is assumed to be fixed, usually
at some maximum point. Therefore, people don’t change how
hard they work and productivity can’t be affected by the work
How hard and well people work is determined by their work
environment and by their individual preferences. As a result,
productivity, costs, and prices can be affect by the work
People are pretty much all the same. People are different, with different tastes and
Markets are efficient, even if they appear to be inefficient.
Efficiency is everywhere.
Markets can be highly inefficient, and if they look
inefficient, they probably are.

What is prospect theory?

Prospect theory, a theory about how people make choices between different options or prospects, is designed to better describe, explain, and predict the choices that the typical person makes, especially in a world of uncertainty. Prospect theory is characterized by the following:

  • Certainty: People have a strong preference for certainty and are willing to sacrifice income to achieve more certainty. For example, if option A is a guaranteed win of $1,000, and option B is an 80 percent chance of winning $1,400 but a 20 percent chance of winning nothing, people tend to prefer option A.

  • Loss aversion: People tend to give losses more weight than gains — they’re loss averse. So, if you gain $100 and lose $80, it may be considered a net loss in terms of satisfaction, even though you came out $20 ahead, because you’ll tend to focus on how much you lost, not on how much you gained.

  • Relative positioning: People tend to be most interested in their relative gains and losses as opposed to their final income and wealth. If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramatically. In other words, if you get a 10 percent raise and your neighbor gets a 10 percent raise, you won’t feel better off. But if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.

  • Small probabilities: People tend to under-react to low-probability events. So, you may completely discount the probability of losing all your wealth if the probability is very small. This tendency can result in people making super-risky choices.

About This Article

This article is from the book:

About the book author:

Morris Altman, PhD, is a professor of behavioral economics at Victoria University of Wellington in New Zealand and a professor of economics at the University of Saskatchewan in Canada. He is on the board of the Society for the Advancement of Behavioral Economics and is a former president of that organization. He also edited the Handbook of Contemporary Behavioral Economics.

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