Behavioral economics

Behavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.[1]

Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory.[2][3] The study of behavioral economics includes how market decisions are made and the mechanisms that drive public choice. The three prevalent themes in behavioral economics are:[4]

In 2002, psychologist Daniel Kahneman was awarded the Nobel Memorial Prize in Economic Sciences "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[5] In 2013, economist Robert J. Shiller received the Nobel Memorial Prize in Economic Sciences "for his empirical analysis of asset prices." (within the field of behavioral finance)[6] In 2017, economist Richard Thaler was awarded the Nobel Memorial Prize in Economic Sciences for "his contributions to behavioral economics and his pioneering work in establishing that people are predictably irrational in ways that defy economic theory."[7][8]

History

Adam Smith The Muir portrait
Adam Smith, author of The Wealth of Nations (1776) and The Theory of Moral Sentiments (1759).

During the classical period of economics, microeconomics was closely linked to psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of individual behavior, including concerns about fairness and justice.[9] Jeremy Bentham wrote extensively on the psychological underpinnings of utility. Then, during the development of neo-classical economics, economists sought to reshape the discipline as a natural science, deducing behavior from assumptions about the nature of economic agents. They developed the concept of homo economicus, whose behavior was fundamentally rational.

Neo-classical economists did incorporate psychological explanations: this was true of Francis Edgeworth, Vilfredo Pareto and Irving Fisher. Economic psychology emerged in the 20th century in the works of Gabriel Tarde,[10] George Katona,[11] and Laszlo Garai.[12] Expected utility and discounted utility models began to gain acceptance, generating testable hypotheses about decision-making given uncertainty and intertemporal consumption, respectively. Observed and repeatable anomalies eventually challenged those hypotheses, and further steps were taken by Maurice Allais, for example, in setting out the Allais paradox, a decision problem he first presented in 1953 that contradicts the expected utility hypothesis.

In the 1960s cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards,[13] Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. Mathematical psychology reflects a longstanding interest in preference transitivity and the measurement of utility.[14]

Bounded rationality

Herbert simon red complete
Herbert A. Simon, winner of the 1975 Turing award and the 1978 Nobel Prize in economics

Bounded rationality is the idea that when individuals make decisions, their rationality is limited by the tractability of the decision problem, their cognitive limitations and the time available. Decision-makers in this view act as satisficers, seeking a satisfactory solution rather than an optimal one. Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of decision-making. It complements "rationality as optimization", which views decision-making as a fully rational process of finding an optimal choice given the information available.[15] Simon used the analogy of a pair of scissors, where one blade represents human cognitive limitations and the other the "structures of the environment", illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment.[15]

Bounded rationality implicates the idea that humans take shortcuts that may lead to suboptimal decision-making. Behavioral economists engage in mapping the decision shortcuts that agents use in order to help increase the effectiveness of human decision-making. One treatment of this idea comes from Cass Sunstein and Richard Thaler's Nudge.[16][17] Sunstein and Thaler recommend that choice architectures are modified in light of human agents' bounded rationality. A widely cited proposal from Sunstein and Thaler urges that healthier food be placed at sight level in order to increase the likelihood that a person will opt for that choice instead of less healthy option. Some critics of Nudge have lodged attacks that modifying choice architectures will lead to people becoming worse decision-makers.[18][19]

Prospect theory

Daniel KAHNEMAN
Daniel Kahneman, winner of the 2002 Nobel Prize in economics

In 1979, Kahneman and Tversky published Prospect Theory: An Analysis of Decision Under Risk, that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory.[20] Prospect theory has two stages: an editing stage and an evaluation stage.

In the editing stage, risky situations are simplified using various heuristics. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include:

  • Reference dependence: When evaluating outcomes, the decision maker considers a "reference level". Outcomes are then compared to the reference point and classified as "gains" if greater than the reference point and "losses" if less than the reference point.
  • Loss aversion: Losses are avoided more than equivalent gains are sought. In their 1992 paper, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses hurt about 2.25 times more than equivalent gains reward.[21]
  • Non-linear probability weighting: Decision makers overweight small probabilities and underweight large probabilities—this gives rise to the inverse-S shaped "probability weighting function".
  • Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to the reference point increase in absolute value, the marginal effect on the decision maker's utility or satisfaction falls.

Prospect theory is able to explain everything that the two main existing decision theories—expected utility theory and rank dependent utility theory—can explain. Further, prospect theory has been used to explain phenomena that existing decision theories have great difficulty in explaining. These include backward bending labor supply curves, asymmetric price elasticities, tax evasion and co-movement of stock prices and consumption.

In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave a revised account of prospect theory that they called cumulative prospect theory.[21] The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in John Quiggin's rank-dependent utility theory.

Psychological traits such as overconfidence, projection bias, and the effects of limited attention are now part of the theory. Other developments include a conference at the University of Chicago,[22] a special behavioral economics edition of the Quarterly Journal of Economics ("In Memory of Amos Tversky"), and Kahneman's 2002 Nobel Prize for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[23]

Intertemporal choice

David laibson 2007
David Laibson, professor of economics at Harvard University

Behavioral economics has been applied to intertemporal choice. Intertemporal choice is defined as making a decision and having the effects of such decision happening in a different time. Intertemporal choice behavior is largely inconsistent, as exemplified by George Ainslie's hyperbolic discounting—one of the prominently studied observations—and further developed by David Laibson, Ted O'Donoghue and Matthew Rabin. Hyperbolic discounting describes the tendency to discount outcomes in the near future more than outcomes in the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with basic models of rational choice, since the rate of discount between time t and t+1 will be low at time t-1 when t is the near future, but high at time t when t is the present and time t+1 is the near future.

This pattern can also be explained through models of sub-additive discounting that distinguish the delay and interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur.

Other areas of research

Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in preferences. Ernst Fehr, Armin Falk, and Rabin studied fairness, inequity aversion and reciprocal altruism, weakening the neoclassical assumption of perfect selfishness. This work is particularly applicable to wage setting. The work on "intrinsic motivation by Gneezy and Rustichini and "identity" by Akerlof and Kranton assumes that agents derive utility from adopting personal and social norms in addition to conditional expected utility. According to Aggarwal, in addition to behavioral deviations from rational equilibrium, markets are also likely to suffer from lagged responses, search costs, externalities of the commons, and other frictions making it difficult to disentangle behavioral effects in market behavior.[24]

"Conditional expected utility" is a form of reasoning where the individual has an illusion of control, and calculates the probabilities of external events and hence their utility as a function of their own action, even when they have no causal ability to affect those external events.[25][26]

Behavioral economics caught on among the general public with the success of books such as Dan Ariely's Predictably Irrational. Practitioners of the discipline have studied quasi-public policy topics such as broadband mapping.[27][28]

Applications for behavioral economics include the modeling of the consumer decision-making process for applications in artificial intelligence and machine learning. The Silicon Valley-based start-up Singularities is using the AGM postulates proposed by Alchourrón, Gärdenfors, and Makinson—the formalization of the concepts of beliefs and change for rational entities—in a symbolic logic to create a "machine learning and deduction engine that uses the latest data science and big data algorithms in order to generate the content and conditional rules (counterfactuals) that capture customer's behaviors and beliefs".[29]

Applications of behavioral economics also exist in other disciplines, for example in the area of supply chain management.[30]

Natural experiments

From a biological point of view, human behaviors are essentially the same during crises accompanied by stock market crashes and during bubble growth when share prices exceed historic highs. During those periods, most market participants see something new for themselves, and this inevitably induces a stress response in them with accompanying changes in their endocrine profiles and motivations. The result is quantitative and qualitative changes in behavior. This is one example where behavior affecting economics and finance can be observed and variably-contrasted using behavioral economics.

Behavioral economics' usefulness applies beyond environments similar to stock exchanges. Selfish-reasoning, 'adult behaviors', and similar, can be identified within criminal-concealment(s), and legal-deficiencies and neglect of different types can be observed and discovered. Awareness of indirect consequence (or lack of), at least in potential with different experimental models and methods, can be used as well—behavioral economics' potential uses are broad, but its reliability needs scrutiny. Underestimation of the role of novelty as a stressor is the primary shortcoming of current approaches for market research. It is necessary to account for the biologically determined diphasisms of human behavior in everyday low-stress conditions and in response to stressors.[31]

Criticism

Critics of behavioral economics typically stress the rationality of economic agents.[32] They contend that experimentally observed behavior has limited application to market situations, as learning opportunities and competition ensure at least a close approximation of rational behavior.

Others note that cognitive theories, such as prospect theory, are models of decision-making, not generalized economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment participants or survey respondents.

A notable concern is that despite a great deal of rhetoric, no consistent behavioral theory has yet been espoused. Behavioral economists have proposed no unified theory. Until that happens, behavioral economics is a collection of observations.

David Gal has argued that many of these issues stem from behavioral economics being too concerned with understanding how behavior deviates from standard economic models rather than with understanding why people behave the way they do. Understanding why behavior occurs is necessary for the creation of generalizable knowledge, the goal of science. He has referred to behavioral economics as a "triumph of marketing" and particularly cited the example of loss aversion.[33]

Traditional economists are skeptical of the experimental and survey-based techniques that behavioral economics uses extensively. Economists typically stress revealed preferences over stated preferences (from surveys) in the determination of economic value. Experiments and surveys are at risk of systemic biases, strategic behavior and lack of incentive compatibility.

Responses

Matthew Rabin[34] dismisses these criticisms, countering that consistent results typically are obtained in multiple situations and geographies and can produce good theoretical insight. Behavioral economists, however, responded to these criticisms by focusing on field studies rather than lab experiments. Some economists see a fundamental schism between experimental economics and behavioral economics, but prominent behavioral and experimental economists tend to share techniques and approaches in answering common questions. For example, behavioral economists are investigating neuroeconomics, which is entirely experimental and has not been verified in the field.

The epistemological, ontological, and methodological components of behavioral economics are increasingly debated, in particular by historians of economics and economic methodologists.[35]

According to some researchers,[31] when studying the mechanisms that form the basis of decision-making, especially financial decision-making, it is necessary to recognize that most decisions are made under stress[36] because, "Stress is the nonspecific body response to any demands presented to it."[37]

Applied issues

Nudge theory

Richard Thaler Chatham
Richard Thaler, winner of the 2017 Nobel Prize in economics

Nudge is a concept in behavioral science, political theory and economics which proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals. Nudging contrasts with other ways to achieve compliance, such as education, legislation or enforcement. The concept has influenced British and American politicians. Several nudge units exist around the world at the national level (UK, Germany, Japan and others) as well as at the international level (OECD, World Bank, UN).

The first formulation of the term and associated principles was developed in cybernetics by James Wilk before 1995 and described by Brunel University academic D. J. Stewart as "the art of the nudge" (sometimes referred to as micronudges[38]). It also drew on methodological influences from clinical psychotherapy tracing back to Gregory Bateson, including contributions from Milton Erickson, Watzlawick, Weakland and Fisch, and Bill O'Hanlon.[39] In this variant, the nudge is a microtargetted design geared towards a specific group of people, irrespective of the scale of intended intervention.

In 2008, Richard Thaler and Cass Sunstein's book Nudge: Improving Decisions About Health, Wealth, and Happiness brought nudge theory to prominence. It also gained a following among US and UK politicians, in the private sector and in public health.[40] The authors refer to influencing behaviour without coercion as libertarian paternalism and the influencers as choice architects.[41] Thaler and Sunstein defined their concept as:

A nudge, as we will use the term, is any aspect of the choice architecture that alters people's behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.

In this form, drawing on behavioral economics, the nudge is more generally applied to influence behaviour.

One of the most frequently cited examples of a nudge is the etching of the image of a housefly into the men's room urinals at Amsterdam's Schiphol Airport, which is intended to "improve the aim".[16]

Nudging techniques aim to use judgmental heuristics to our advantage. In other words, a nudge alters the environment so that when heuristic, or System 1, decision-making is used, the resulting choice will be the most positive or desired outcome.[42] An example of such a nudge is switching the placement of junk food in a store, so that fruit and other healthy options are located next to the cash register, while junk food is relocated to another part of the store.[43]

In 2008, the United States appointed Sunstein, who helped develop the theory, as administrator of the Office of Information and Regulatory Affairs.[41][44][45]

Notable applications of nudge theory include the formation of the British Behavioural Insights Team in 2010. It is often called the "Nudge Unit", at the British Cabinet Office, headed by David Halpern.[46]

Both Prime Minister David Cameron and President Barack Obama sought to employ nudge theory to advance domestic policy goals during their terms.[47]

In Australia, the government of New South Wales established a Behavioural Insights community of practice.[48]

Nudge theory has also been applied to business management and corporate culture, such as in relation to health, safety and environment (HSE) and human resources. Regarding its application to HSE, one of the primary goals of nudge is to achieve a "zero accident culture".[49]

Leading Silicon Valley companies are forerunners in applying nudge theory in a corporate setting. These companies are using nudges in various forms to increase the productivity and happiness of employees. Recently, further companies are gaining interest in using what is called "nudge management" to improve the productivity of their white-collar workers.[50]

Behavioral insights and nudges are currently used in many countries around the world.[51]

Criticisms

Nudging has also been criticised. Tammy Boyce, from public health foundation The King's Fund, has said: "We need to move away from short-term, politically motivated initiatives such as the 'nudging people' idea, which is not based on any good evidence and doesn't help people make long-term behaviour changes."[52]

Cass Sunstein has responded to critiques at length in his The Ethics of Influence[53] making the case in favor of nudging against charges that nudges diminish autonomy,[54] threaten dignity, violate liberties, or reduce welfare. Ethicists have debated this rigorously.[55] These charges have been made by various participants in the debate from Bovens[56] to Goodwin.[57] Wilkinson for example charges nudges for being manipulative, while others such as Yeung question their scientific credibility.[58]

Some, such as Hausman & Welch[59] have inquired whether nudging should be permissible on grounds of (distributive) justice; Lepenies & Malecka [60] have questioned whether nudges are compatible with the rule of law. Similarly, legal scholars have discussed the role of nudges and the law.[61][62]

Behavioral economists such as Bob Sugden have pointed out that the underlying normative benchmark of nudging is still homo economicus, despite the proponents' claim to the contrary.[63]

It has been remarked that nudging is also a euphemism for psychological manipulation as practiced in social engineering.[64][65]

There exists an anticipation and, simultaneously, implicit criticism of the nudge theory in works of Hungarian social psychologists who emphasize the active participation in the nudge of its target (Ferenc Merei),[66] Laszlo Garai[12]).

Behavioral finance

Robert J. Shiller 2017
Robert J. Shiller, winner of the 2013 Nobel Prize in economics

The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants.[1] Such errors affect prices and returns, creating market inefficiencies. The study of behavioral finance also investigates how other participants take advantage (arbitrage) of such errors and market inefficiencies.

Behavioral finance highlights inefficiencies, such as under- or over-reactions to information, as causes of market trends and, in extreme cases, of bubbles and crashes. Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider behavioral finance to be behavioral economics' "academic cousin" and the theoretical basis for technical analysis.[67]

Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell shares or other equity if doing so would result in a nominal loss. It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of low demand.

Benartzi and Thaler, applying a version of prospect theory, claim to have solved the equity premium puzzle, something conventional finance models so far have been unable to do.[68] Experimental finance applies the experimental method, e.g., creating an artificial market through some kind of simulation software to study people's decision-making process and behavior in financial markets.

Quantitative behavioral finance

Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. In marketing research, a study shows little evidence that escalating biases impact marketing decisions.[69] Leading contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 2001–04), and collaborators include 2002 Nobel Laureate Vernon Smith, David Porter, Don Balenovich,[70] Vladimira Ilieva and Ahmet Duran,[71] and Ray Sturm.[72]

Financial models

Some financial models used in money management and asset valuation incorporate behavioral finance parameters. Examples:

  • Thaler's model of price reactions to information, with three phases (underreaction, adjustment, and overreaction), creating a price trend.
One characteristic of overreaction is that average returns following announcements of good news is lower than following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to news, thus requiring an adjustment in the opposite direction. As a result, outperforming assets in one period is likely to underperform in the following period. This also applies to customers' irrational purchasing habits.[73]

Criticisms

Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that behavioral finance is more a collection of anomalies than a true branch of finance and that these anomalies are either quickly priced out of the market or explained by appealing to market microstructure arguments. However, individual cognitive biases are distinct from social biases; the former can be averaged out by the market, while the other can create positive feedback loops that drive the market further and further from a "fair price" equilibrium. Similarly, for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case for many anomalies.[74]

A specific example of this criticism appears in some explanations of the equity premium puzzle. It is argued that the cause is entry barriers (both practical and psychological) and that returns between stocks and bonds should equalize as electronic resources open up the stock market to more traders.[75] In response, others contend that most personal investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials.

Behavioral game theory

Behavioral game theory, invented by Colin Camerer, analyzes interactive strategic decisions and behavior using the methods of game theory,[76] experimental economics, and experimental psychology. Experiments include testing deviations from typical simplifications of economic theory such as the independence axiom[77] and neglect of altruism,[78] fairness,[79] and framing effects.[80] On the positive side, the method has been applied to interactive learning[81] and social preferences.[82][83][84] As a research program, the subject is a development of the last three decades.[85][86][87][88][89][90][91]

Economic reasoning in animals

A handful of comparative psychologists have attempted to demonstrate quasi-economic reasoning in non-human animals. Early attempts along these lines focus on the behavior of rats and pigeons. These studies draw on the tenets of comparative psychology, where the main goal is to discover analogs to human behavior in experimentally-tractable non-human animals. They are also methodologically similar to the work of Ferster and Skinner.[92] Methodological similarities aside, early researchers in non-human economics deviate from behaviorism in their terminology. Although such studies are set up primarily in an operant conditioning chamber using food rewards for pecking/bar-pressing behavior, the researchers describe pecking and bar-pressing not in terms of reinforcement and stimulus-response relationships but instead in terms of work, demand, budget, and labor. Recent studies have adopted a slightly different approach, taking a more evolutionary perspective, comparing economic behavior of humans to a species of non-human primate, the capuchin monkey.[93]

Animal studies

Many early studies of non-human economic reasoning were performed on rats and pigeons in an operant conditioning chamber. These studies looked at things like peck rate (in the case of the pigeon) and bar-pressing rate (in the case of the rat) given certain conditions of reward. Early researchers claim, for example, that response pattern (pecking/bar-pressing rate) is an appropriate analogy to human labor supply.[94] Researchers in this field advocate for the appropriateness of using animal economic behavior to understand the elementary components of human economic behavior.[95] In a paper by Battalio, Green, and Kagel,[94] they write,

Space considerations do not permit a detailed discussion of the reasons why economists should take seriously the investigation of economic theories using nonhuman subjects....[Studies of economic behavior in non-human animals] provide a laboratory for identifying, testing, and better understanding general laws of economic behavior. Use of this laboratory is predicated on the fact that behavior, as well as structure, vary continuously across species, and that principles of economic behavior would be unique among behavioral principles if they did not apply, with some variation, of course, to the behavior of nonhumans.

Labor supply

The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons are first deprived of food. Since the animals become hungry, food becomes highly desired. The pigeons are then placed in an operant conditioning chamber and through orienting and exploring the environment of the chamber they discover that by pecking a small disk located on one side of the chamber, food is delivered to them. In effect, pecking behavior becomes reinforced, as it is associated with food. Before long, the pigeon pecks at the disk (or stimulus) regularly.

In this circumstance, the pigeon is said to "work" for the food by pecking. The food, then, is thought of as the currency. The value of the currency can be adjusted in several ways, including the amount of food delivered, the rate of food delivery and the type of food delivered (some foods are more desirable than others).

Economic behavior similar to that observed in humans is discovered when the hungry pigeons stop working/work less when the reward is reduced. Researchers argue that this is similar to labor supply behavior in humans. That is, like humans (who, even in need, will only work so much for a given wage), the pigeons demonstrate decreases in pecking (work) when the reward (value) is reduced.[94]

Demand

In human economics, a typical demand curve has negative slope. This means that as the price of a certain good increase, the amount that consumers are willing and able to purchase decreases. Researchers studying the demand curves of non-human animals, such as rats, also find downward slopes.

Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons. Specifically, in an operant conditioning chamber containing rats as experimental subjects, we require them to press a bar, instead of pecking a small disk, to receive a reward. The reward can be food (reward pellets), water, or a commodity drink such as cherry cola. Unlike in previous pigeon studies, where the work analog was pecking and the monetary analog was a reward, the work analog in this experiment is bar-pressing. Under these circumstances, the researchers claim that changing the number of bar presses required to obtain a commodity item is analogous to changing the price of a commodity item in human economics.[96]

In effect, results of demand studies in non-human animals show that, as the bar-pressing requirement (cost) increase, the number of times an animal presses the bar equal to or greater than the bar-pressing requirement (payment) decreases.

Evolutionary psychology

An evolutionary psychology perspective states that many of the perceived limitations in rational choice can be explained as being rational in the context of maximizing biological fitness in the ancestral environment, but not necessarily in the current one. Thus, when living at subsistence level where a reduction of resources may result in death, it may have been rational to place a greater value on preventing losses than on obtaining gains. It may also explain behavioral differences between groups, such as males being less risk-averse than females since males have more variable reproductive success than females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially increase their reproductive success from successful risk-seeking much more than females can.[97]

Artificial intelligence

Much of the decisions are more and more made either by human beings with the assistance of artificial intelligent machines or wholly made by these machines. Tshilidzi Marwala and Evan Hurwitz in their book,[98] studied the utility of behavioral economics in such situations and concluded that these intelligent machines reduce the impact of bounded rational decision making. In particular, they observed that these intelligent machines reduce the degree of information asymmetry in the market, improve decision making and thus making markets more rational.

The use of AI machines in the market in applications such as online trading and decision making has changed major economic theories.[98] Other theories where AI has had impact include in rational choice, rational expectations, game theory, Lewis turning point, portfolio optimization and counterfactual thinking.

Related fields

Experimental economics

Experimental economics is the application of experimental methods, including statistical, econometric, and computational,[99] to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in order to mimic real-world incentives. Experiments are used to help understand how and why markets and other exchange systems function as they do. Experimental economics have also expanded to understand institutions and the law (experimental law and economics).[100]

A fundamental aspect of the subject is design of experiments. Experiments may be conducted in the field or in laboratory settings, whether of individual or group behavior.[101]

Variants of the subject outside such formal confines include natural and quasi-natural experiments.[102]

Neuroeconomics

Neuroeconomics is an interdisciplinary field that seeks to explain human decision making, the ability to process multiple alternatives and to follow a course of action. It studies how economic behavior can shape our understanding of the brain, and how neuroscientific discoveries can constrain and guide models of economics.[103]

It combines research methods from neuroscience, experimental and behavioral economics, and cognitive and social psychology.[104] As research into decision-making behavior becomes increasingly computational, it has also incorporated new approaches from theoretical biology, computer science, and mathematics. Neuroeconomics studies decision making by using a combination of tools from these fields so as to avoid the shortcomings that arise from a single-perspective approach. In mainstream economics, expected utility (EU) and the concept of rational agents are still being used. Many economic behaviors are not fully explained by these models, such as heuristics and framing.[105]

Behavioral economics emerged to account for these anomalies by integrating social, cognitive, and emotional factors in understanding economic decisions. Neuroeconomics adds another layer by using neuroscientific methods in understanding the interplay between economic behavior and neural mechanisms. By using tools from various fields, some scholars claim that neuroeconomics offers a more integrative way of understanding decision making.[103]

Notable people

Economics

Finance

Psychology

See also

Citations

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References

External links

Allais paradox

The Allais paradox is a choice problem designed by Maurice Allais (1953) to show an inconsistency of actual observed choices with the predictions of expected utility theory.

Behavior informatics

Behavior informatics (BI) is the informatics of behaviors so as to obtain behavior intelligence and behavior insights.Different from applied behavior analysis from the psychological perspective, BI builds computational theories, systems and tools to qualitatively and quantitatively model, represent, analyze, and manage behaviors of individuals, groups and/or organizations [1].

BI is built on classic study of behavioral science, including behavior modeling, applied behavior analysis, behavior analysis, behavioral economics, and organizational behavior. Typical BI tasks consist of individual and group behavior formation, representation, computational modeling, analysis, learning, simulation, and understanding of behavior impact, utility, non-occurring behaviors etc. for behavior intervention and management.

Bounded rationality

Bounded rationality is the idea that rationality is limited when individuals make decisions: by the tractability of the decision problem, the cognitive limitations of the mind, and the time available to make the decision. Decision-makers, in this view, act as satisficers, seeking a satisfactory solution rather than an optimal one.

Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of decision-making, as used in economics, political science and related disciplines. It complements "rationality as optimization", which views decision-making as a fully rational process of finding an optimal choice given the information available. Simon used the analogy of a pair of scissors, where one blade represents "cognitive limitations" of actual humans and the other the "structures of the environment", illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment. Many economics models assume that people are on average rational, and can in large enough quantities be approximated to act according to their preferences. The concept of bounded rationality revises this assumption to account for the fact that perfectly rational decisions are often not feasible in practice because of the intractability of natural decision problems and the finite computational resources available for making them.

Some models of human behavior in the social sciences assume that humans can be reasonably approximated or described as "rational" entities, as in rational choice theory or Downs Political Agency Models.

Dan Ariely

Dan Ariely (Hebrew: דן אריאלי‎; born April 29, 1967) is an Israeli James B. Duke Professor of Psychology and Behavioral Economics at Duke University and is the founder of The Center for Advanced Hindsight and co-founder of Kayma BEworks, Timeful, Genie and Shapa. Ariely is also associated with Qapital and Lemonade in the capacity of Chief Behavioral Economist and Chief Behavioral Officer, respectively. Ariely's TED talks have been viewed over 10 million times. He is the author of Dollars and Sense, Predictably Irrational, The Upside of Irrationality, and The Honest Truth about Dishonesty. All three books became New York Times best sellers. He also wrote two semi-books: Irrationally Yours – an illustrated collection of his immensely popular The Wall Street Journal advice column, “Ask Ariely” – and Payoff, a short TED book. Ariely was involved in the movie (Dis)Honesty: The Truth About Lies as both a producer and a participant.

Daniel Kahneman

Daniel Kahneman (; Hebrew: דניאל כהנמן‎; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarded the 2002 Nobel Memorial Prize in Economic Sciences (shared with Vernon L. Smith). His empirical findings challenge the assumption of human rationality prevailing in modern economic theory.

With Amos Tversky and others, Kahneman established a cognitive basis for common human errors that arise from heuristics and biases (Kahneman & Tversky, 1973; Kahneman, Slovic & Tversky, 1982; Tversky & Kahneman, 1974), and developed prospect theory (Kahneman & Tversky, 1979).

In 2011, he was named by Foreign Policy magazine to its list of top global thinkers. In the same year, his book Thinking, Fast and Slow, which summarizes much of his research, was published and became a best seller.He is professor emeritus of psychology and public affairs at Princeton University's Woodrow Wilson School. Kahneman is a founding partner of TGG Group, a business and philanthropy consulting company. He was married to cognitive psychologist and Royal Society Fellow Anne Treisman, who died on February 9, 2018.In 2015, The Economist listed him as the seventh most influential economist in the world.

Ernst Fehr

Ernst Fehr (born June 21, 1956 in Hard, Austria) is an Austrian-Swiss behavioral economist and neuroeconomist and a Professor of Microeconomics and Experimental Economic Research, as well as the vice chairman of the Department of Economics at the University of Zürich, Switzerland. His research covers the areas of the evolution of human cooperation and sociality, in particular fairness, reciprocity and bounded rationality.

He is also well known for his important contributions to the new field of neuroeconomics, as well as to behavioral economics, behavioral finance and experimental economics. According to IDEAS/REPEC, he is the second-most influential German-speaking economist, and is ranked at 86th globally.In 2010 Ernst Fehr founded, together with his brother, Gerhard Fehr, FehrAdvice & Partners, the first globally operating consultancy firm completely dedicated to behavioral economics.

In 2016, Fehr was ranked as the most influential economist in Germany, Austria, and Switzerland.

Gambler's conceit

Gambler’s conceit is the fallacy described by behavioral economist David J. Ewing, where a gambler believes they will be able to stop a risky behavior while still engaging in it. This belief frequently operates during games of chance, such as casino games. The gambler believes they will be a net winner at the game, and thus able to avoid going broke by exerting the self-control necessary to stop playing while still ahead in winnings. This is often expressed as “I’ll quit when I’m ahead.”Quitting while ahead is unlikely, though, since a gambler who is winning has little incentive to quit, and is instead encouraged to continue to gamble by their winning. Once in the throes of a winning streak, the individual may even become convinced that it is their skill, rather than chance, causing their winnings, or good luck is on their side, and thus it seems especially senseless to stop.The gambler's conceit frequently works in conjunction with the gambler's fallacy: the mistaken idea that a losing streak in a game of chance, such as roulette, has to come to an end because the frequency of one event has an effect on a following independent event.

Therefore, players think that it is necessary to continue playing while winning and necessary to continue playing while losing.

Relatedly, gambler's ruin shows that a player with finite resources continuously playing will inevitably go broke against a player with infinite resources in a fair or negative-expectation game. However, this is also true in a positive-expectation game if the player with finite resources continually plays and increases his stakes when winning, but does not reduce them when losing.

As casinos have a house advantage in games of chance, a casino is more likely over time to take a player's money than a player is to win money from the casino, and thus it is to the casino's advantage to keep a winning player playing. Casinos thus frequently encourage winning players to continue playing. An example can be seen in the Martin Scorsese movie Casino in which Robert De Niro's character ensures that a high-stakes gambler continues to gamble to ensure that the money returns to the casino. On a smaller scale, casinos offer players free alcoholic drinks to encourage them to keep gambling.

Homo economicus

The term homo economicus, or economic man, is a caricature of economic theory framed as a "mythical species" or word play on homo sapiens, and used in pedagogy. It stands for a portrayal of humans as agents who are consistently rational and narrowly self-interested, and who usually pursue their subjectively-defined ends optimally.

Generally, homo economicus attempts to maximize utility as a consumer and profit as a producer. As a theory on human conduct, it contrasts to the concepts of behavioral economics, which examines cognitive biases and other irrationalities, and another mythical species, homo reciprocans, a model which emphasizes human cooperation). In game theory, homo economicus is often modelled through the assumption of perfect rationality.

The notion of "homo economicus" is often used by non-economists to critique an economic approach. There are distinct concepts involved: the preferences that individuals have among outcomes; and the processes that individuals use to make decisions. The question of whether individuals are in fact able to make the best choices, given their preferences, leads to the economic definition of rationality, or the so-called "rational economic man". This concept of rationality does not restrict what sort of preferences are admissible.

Journal of Behavioral and Experimental Economics

The Journal of Behavioral and Experimental Economics is a bimonthly peer-reviewed academic journal covering behavioral and experimental economics. It was established in 1972 as the Journal of Behavioral Economics, and was renamed the Journal of Socio-Economics in 1991. It obtained its current name in 2014. The editor-in-chief is Ofer Azar (Ben-Gurion University of the Negev). According to the Journal Citation Reports, the journal has a 2017 impact factor of 0.966.

Market anomaly

A market anomaly (or market inefficiency) in a financial market is a price and/or rate of return distortion that seems to contradict the efficient-market hypothesis.The market anomaly usually relates to:

Structural factors, such as unfair competition, lack of market transparency, regulatory actions, etc.

Behavioral biases by economic agents (see behavioral economics)

Calendar effects, such as the January effect.There are anomalies in relation to the economic fundamentals of the equity, technical trading rules, and economic calendar events.

Anomalies could be fundamental, technical, or calendar related. Fundamental anomalies include value effect, small-cap effect (low P/E stocks and small cap companies do better than index on an average) and the low-volatility anomaly. Calendar anomalies involve patterns in stock returns from year to year or month to month, while technical anomalies include momentum effect.

Matthew Rabin

Matthew Joel Rabin (born December 27, 1963) is the Pershing Square Professor of Behavioral Economics in the Harvard Economics Department and Harvard Business School. Rabin's research focuses primarily on incorporating psychologically more realistic assumptions into empirically applicable formal economic theory. His topics of interest include errors in statistical reasoning and the evolution of beliefs, effects of choice context on exhibited preferences, reference-dependent preferences, and errors people make in inference in market and learning settings.

Neuroeconomics

Neuroeconomics is an interdisciplinary field that seeks to explain human decision making, the ability to process multiple alternatives and to follow a course of action. It studies how economic behavior can shape our understanding of the brain, and how neuroscientific discoveries can constrain and guide models of economics.It combines research from neuroscience, experimental and behavioral economics, and cognitive and social psychology. As research into decision-making behavior becomes increasingly computational, it has also incorporated new approaches from theoretical biology, computer science, and mathematics. Neuroeconomics studies decision making by using a combination of tools from these fields so as to avoid the shortcomings that arise from a single-perspective approach. In mainstream economics, expected utility (EU) and the concept of rational agents are still being used. Many economic behaviors are not fully explained by these models, such as heuristics and framing.Behavioral economics emerged to account for these anomalies by integrating social, cognitive, and emotional factors in understanding economic decisions. Neuroeconomics adds another layer by using neuroscientific methods in understanding the interplay between economic behavior and neural mechanisms. By using tools from various fields, some scholars claim that neuroeconomics offers a more integrative way of understanding decision making.

Neuromanagement

Neuromanagement uses cognitive neuroscience, among other life science fields, and technology to analyze economic and managerial issues. It focuses on exploring human brain activities and mental processes when people are faced with typical problems of economics and management. This research provides insight into human decision-making and other general social behavior. The main research areas include decision neuroscience, neuroeconomics, neuromarketing, neuro-industrial engineering, and neuro-information systems. Neuromanagement was first proposed in 2006 by Professor Qingguo Ma, the director of Neuromanagement Laboratory of Zhejiang University.

Nudge theory

Nudge is a concept in behavioral science, political theory and behavioral economics which proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision making of groups or individuals. Nudging contrasts with other ways to achieve compliance, such as education, legislation or enforcement. The concept has influenced British and American politicians. Several nudge units exist around the world at the national level (UK, Germany, Japan and others) as well as at the international level (e.g. World Bank, UN, and the European Commission.

Prospect theory

Prospect theory is a theory in cognitive psychology that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are uncertain. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using some heuristics. The model is descriptive: it tries to model real-life choices, rather than optimal decisions, as normative models do.

The theory was created in 1979 and developed in 1992 by Daniel Kahneman and Amos Tversky as a psychologically more accurate description of decision making, compared to the expected utility theory. In the original formulation, the term prospect referred to a lottery. The paper "Prospect Theory: An Analysis of Decision under Risk" (1979) has been called a "seminal paper in behavioral economics".

Relative income hypothesis

Developed by James Duesenberry, the relative income hypothesis states that an individual’s attitude to consumption and saving is dictated more by his income in relation to others than by abstract standard of living; the percentage of income consumed by an individual depends on his percentile position within the income distribution.

Secondly, it hypothesizes that the present consumption is not influenced merely by present levels of absolute and relative income, but also by levels of consumption attained in a previous period. It is difficult for a family to reduce a level of consumption once attained. The aggregate ratio of consumption to income is assumed to depend on the level of present income relative to past peak income.

Richard Thaler

Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was president of the American Economic Association.He is a theorist in behavioral economics, and collaborated with Daniel Kahneman, Amos Tversky and others in further defining that field. In 2018, he was elected a member in the National Academy of Sciences.

In 2017, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to behavioral economics. In its Nobel prize announcement, the Royal Swedish Academy of Sciences said that his "contributions have built a bridge between the economic and psychological analyses of individual Decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioral economics."

Russell Sage Foundation

The Russell Sage Foundation is an American philanthropic foundation that primarily funds research relating to income inequality. Located in New York City, it is a research center and grant-making organization for studies by scholars at academic and research institutions. The foundation also publishes, under its own imprint, the books that result from the work of its grantees and visiting scholars. The foundation focuses on labor markets, immigration and ethnicity, and social inequality in the United States, as well as behavioral economics.

Social preferences

Social preferences are a type of preference studied in behavioral and experimental economics and social psychology, including interpersonal altruism, fairness, reciprocity, and inequity aversion.

The term "social preferences" incorporates obstreperous (esp. the Fehr-Schmidt inequity aversion model) and non-obstreperous (e.g., vulnerability-based) theories.

Much of the recent evidence used to test society ideas and models has come from economics experiments.

However, social preferences also matter outside the laboratory.

Pre-modern
Early modern
Modern
20th- and 21st-century
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