Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. 

The definition

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

Primarily, this discipline is concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory. The study of behavioral economics includes how market decisions are made and the mechanisms that drive our choice.

The three prevalent themes in behavioral economics are:

  • Heuristics: Humans make 95% of their decisions using mental shortcuts or rules of thumb.
  • Framing: The collection of anecdotes and stereotypes that make up the mental filters individuals rely on to understand and respond to events.
  • Market inefficiencies: These include mis-pricing and non-rational decision making.

Traditional economic VS behavioral economics

Behavioral economics emerged against the backdrop of the traditional economic approach known as rational choice model.

To some extent, the rational person is assumed to correctly weigh costs and benefits and calculate the best choices for himself. As well as, he is expected to know his preferences (both present and future). Moreovern he is expected to never flip-flops between two contradictory desires. In other words, he has perfect self-control and can restrain impulses that may prevent him from achieving his long-term goals.

Traditional economics use these assumptions to predict real human behavior. The standard policy advice that stems from this way of thinking is to give people as many choices as possible. Similarly, let them choose the one they like best (with minimum government action). Because they know their preferences better than government officials do, individuals are in the best position to know what is best for them.

In contrast, behavioral economics shows that actual human beings do not act that way. Indeed, people have limited cognitive abilities and a great deal of trouble exercising self-control. People often make choices that bear a mixed relationship to their own preference (happiness). They tend to choose the option that has the greatest immediate appeal at the cost of long-term happiness. The context profoundly influenced them, and they often have little idea of what they will like next year or even tomorrow.

As Daniel Kahneman put this, “it seems that traditional economics and behavioral economics are describing two different species.”

The latter shows that we are exceptionally inconsistent and fallible human being. We choose a goal and then frequently act against it, because self-control problem fails us to implement our goals.