Behavioral economics is a subfield of economics that analyses the economic behavior of individuals and its systematic deviations from the assumption of rational expectations. Against the premises of the classic economic model (homo oeconomicus), our decisions are frequently nor the result of careful cost-benefit analyses but rather occur under the influence of a multitude of social, psychological and cognitive factors. Behavioral economics uses experimental research to make sense of decisional processes and identify which factors affect them, in order to be able to make improved predictions.
What Is Behavioral Economics?
Although money is generally fungible, people tend to set up fictional mental accounts in which they categorise transactions by origin or use. These intentional self-restraints occasionally help counteract impulsive acts; however they may also lead in other cases to costly financial misallocations.
People’s decisions are strongly influenced by their environments. From an evolutionary perspective, environmental stimuli make up the starting point for formulating judgements. Nevertheless, irrelevant information can also be falsely perceived as relevant. For instance, it could be proven that utterly meaningless numbers such as the last three digits of one’s phone number influence fundamental economic decisions such as the valuation of one’s own house.
People are exceedingly optimistic with respect to their own lives and systematically underestimate their own risk of making a negative experience, as opposed to the risk of others. A smoker will accordingly assess their risk of getting cancer as a result of smoking as high, but will nevertheless also voice doubts that such a situation would ever happen to them personally.
The easier it is for people to retrieve information about an event from memory, the higher they will estimate its probability of occurrence. This happens predominantly in situations in which there is only limited or no access to information. This deduction process leads to systematic miscalculations of probabilities, such as when the risk of falling prey to a shark attack is overestimated due to reports in the media.
Time preferences refer to the tendency of assigning more weight to present experiences than to future ones. Discounting does not occur exponentially: events that lie on the immediate time horizon are discounted more than those in the distant future. Accordingly, most people will prefer to receive 100€ immediately rather than 110€ in a week – however, if they have to choose between 100€ in a year or 110€ in a year and a week, most people will choose the latter.
Individuals underestimate the impact of their emotional and physical state on their decisions, which makes predicting future preferences more difficult. One could for instance swear to renounce sweets after having eaten, but still reach for the chocolate whenever hunger strikes again, since it is difficult to realistically imagine hunger when one is full.