The Behavioral Economics Framework

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

Behavioral economics is primarily 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 public 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.

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.” 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). 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.”

The field of behavioral economics blends ideas from psychology and economics, and it can provide valuable insight that individuals are not behaving in their own best interests.

Behavioral economics provides a framework to understand when and how people make errors. Systematic errors or biases recur predictably in particular circumstances. Lessons from behavioral economics can be used to create environments that nudge people toward wiser decisions and healthier lives.

Behavioral economics emerged against the backdrop of the traditional economic approach known as rational choice model. The rational person is assumed to correctly weigh costs and benefits and calculate the best choices for himself. The rational person is expected to know his preferences (both present and future), and never flip-flop between two contradictory desires. He has perfect self-control and can restrain impulses that may prevent him from achieving his long-term goals.

Traditional economics uses 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, and let them choose the one they like best (with minimum government intervention). 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. 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, such as taking drugs or overeating.

They are profoundly influenced by context, and often have little idea of what they will prefer next year or even tomorrow. As Daniel Kahneman (2011, p5) 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 beings. We choose a goal and then frequently act against it because self-control prevents us from implementing our goals.

Behavioral economics traces these decision errors to the design of the human mind. Neuroscientists argue that the mind consists of many different parts (mental processes), each operating by its own logic (Kurzban, 2011). Brocas and Carrillo (2013) note that the brain is best represented by an organization of systems that interact with each other. A key insight is that the brain is a democracy (Tononi, 2012). That is, there is no dominant decision-maker. Although the behavioral goal of an individual can be stated as maximizing happiness, reaching that goal requires contributions from several brain regions.

Behavioral economics attempts to integrate psychologists’ understanding of human behavior into economic analysis. In this respect, behavioral economics parallels cognitive psychology, which attempts to guide individuals toward more healthy behaviors by correcting cognitive and emotional barriers to the pursuit of genuine self-interest (Lowenstein, and Haisley, 2008).

Finally, behavioral economics suggests ways how policymakers might restructure environments to facilitate better choices (Sunstein, 2014). The focus on errors suggests ways that policymakers might restructure environments to facilitate better choices. For example, simply rearranging items that are currently offered within the school encourages children to buy more nutritious items (e.g., placing the fruit at eye level, making choices less convenient by moving soda machines into distant areas, or requiring students to pay cash for desserts and soft drinks).

In sum, the basic message of behavioral economics is that humans are hard-wired to make judgment errors and they need a nudge to make decisions that are in their own best interest. The understanding of where people go wrong can help people go right. This approach complements and enhances the rational choice model.