Behavioural Economics and Finance


What is behavioral economics?

With the award of the 2017 Nobel Prize in economics to behavioral economist Richard Thaler – one of the pioneers in developing behavioral public policy “nudging” behavioral economics is very much in the news.

There are, however, many misconceptions about behavioral economics, which raises the question: what is behavioral economics?

This is a question that many behavioral economists have worked on answering, for example see Hargreaves-Heap (2013) versus Thaler (2016) for some contrasting perspectives. To give a quick and simple answer: behavioral economics is a fascinating and fashionable subject, of increasing interest to policymakers and business, as well as to a range of academic researchers and teachers. But, because it is such a broad field, it can be difficult precisely to define. Some would argue that all economics is behavioral economics because economics is about behavior, albeit in a restricted context.

Others would define behavioral economics very narrowly as the study of observed behavior under controlled conditions, without inferring too much about the underlying, unobservable psychological processes that generate behavior.

Overall, the clearest way to describe it is as a subject that brings together economic insights about preferences and decision-making with broader principles of behavior from a range of other social, behavioral and biological sciences.

In this, behavioral economics relaxes economists’ standard assumptions to give models in which people decide quickly, often using simple rules of thumb rather than rigorously but robotically calculating the monetary benefits and costs of their decisions.

Behavioral economics also explores how quick thinking leads people into systematic mistakes but also explains how people can learn from their mistakes. In behavioral economic models, people look to others when making decisions and when seeking happiness.

Their decisions are affected by skills and personalities and also by moods and emotions. People aren’t necessarily good at planning systematically for future events and particularly when immediate pleasures tap into emotional and visceral influences.

This means that people will be susceptible to impulsive decision-making which may be detrimental to their long-term welfare, for example smoking and eating unhealthy food.

So overall, behavioral economics develops more traditional economic models to explore in more depth and detail the balancing acts that we go through every day when we choose and decide.

For the purposes of this book, behavioral economics will be defined broadly as the subject which attempts to enrich economic analyses of behavior grounded as it is in theories about preferences, incentives, decision-making and strategy with insights from psychology, sociology, cognitive neuroscience and evolutionary biology.

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