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 regret. |
People can and often do make decisions they end up regretting. |
| 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 income. |
| 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 environment. |
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 environment. |
| People are pretty much all the same. | People are different, with different tastes and preferences. |
| 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:
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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.
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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.
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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.
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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.