Behavioral economics draws upon the fields of economics and psychology to study how people make choices. Behavioral economists believe that the choices individuals make may be neither statistically predictable, nor always rational. This article explores concepts of behavioral economics; cites relevant findings; and summarizes some of the contemporary research in the field. The article concludes with a glossary of relevant terms.
Keywords: Behavioral Economics; Economics; Decision Making; Illusion of Validity; Intuitive Prediction; Judgment under Uncertainty; Prospect Theory
Behavioral economics draws upon the fields of both economics and psychology to study how people make choices (Lambert, 2006, p. 50). According to Merriam-Webster's Collegiate Dictionary:
Economics is a social science that describes and analyzes the production, distribution, and consumption of goods and services (2000, p. 365) [while] psychology is the study of mind and behavior (2000, p. 940).
Because behavioral economics is concerned with how individuals make their choices rather than how statistical data or calculated notions predict what their choices should be, behavioral economic concepts are differentiated from two well-known economic theories. These theories are: The Bayesian theory, which relies upon statistics to draw conclusions about the future occurrence of a given parameter of a statistical distribution by calculating from prior data on its frequency of occurrence ("Bayesian theory," 2007) and the rational choice theory which assumes that an individual, using reason, will choose the option that yields maximum advantage or gain and minimizes disadvantage or loss ("Rational choice theory," 2009). In fact, behavioral economists believe that the choices individuals make may be neither statistically predictable, nor always rational. Rather, decisions are heavily influenced by other factors; it is these patterns of irrational choice that form the basis of study for behavioral economists (Fillion, 2008).
Psychology Melds with Economics
In 1982, Daniel Kahneman and Amos Tversky met psychologist Eric Wanner, who wanted to integrate the fields of psychology and economics. Under his presidency of the Russell Sage Foundation, Wanner awarded a grant to economist Richard Thaler to spend the 1984-85 academic year with Kahneman and explore the integration. During that year, psychologists Kahneman and Tversky, and economists Thaler and Jack Knetsch, conducted a series of research experiments that studied the nature and rules of fairness for a variety of transactions (Kahneman, 2002). In 1986, Richard Thaler, Daniel Kahneman, and Jack Knetsch published "Fairness as a Constraint on Profit Seeking: Entitlements in the Market," in the American Economic Review. The article described their analysis of a telephone survey which was conducted during the 1984-85 academic year. Among the findings, the survey respondents indicated that they thought it was fair for firms to raise prices or lower wages when profits are suffering but that it was unfair for firms to raise prices or lower wages for the purpose of exploiting market demand, such as when quantities of an item are temporarily limited, or when unemployment is high (Kahneman, Knetsch, & Thaler, 1986, p. 728). This research on the nature and perception of fairness among individuals provided psychological insight into economic factors in the marketplace: The public applies fairness concepts to their transactions with merchants, landlords, and employers. If the rules of fairness (what individuals have deemed acceptable or unacceptable according to their fairness reference points) are violated, the public will retaliate (Kahneman, 2002). For example, the retaliation may take the form of withholding business from a merchant who is considered unfair, or by paying more to transact with a merchant because he is deemed to be fair.
In 2002, Daniel Kahneman won half of the Sveriges Riksbank Prize in Economic Sciences — the Nobel Prize for Economic Sciences — "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty" ("The Sveriges Riksbank Prize," 2002). (The "other half" of the Prize was won by Vernon L. Smith, an experimental economist.) This prize brought the field of behavioral economics to the forefront as a legitimate and important area of study.
Based upon the preliminary research and analysis mentioned above, as well as subsequent research and study, five prominent concepts within the field of behavioral economics have been identified:
- Judgment under Uncertainty
- Illusion of Validity
- Intuitive Prediction
- Prospect Theory
Judgment under Uncertainty
Judgment under uncertainty refers to an individual's process for assessing probabilities and predicting values (Tversky & Kahneman, 1974, p. 1124) when choosing an option. As Sleeth-Keppler noted, judgment under uncertainty is not a rigid process and individuals will often rely upon heuristic strategies to aid their judgment (2007, p. 768).
Heuristics is a method for problem solving or decision making that arrives at solutions through exploratory means such as experimentation, trial and error, or evaluation ("Heuristics," 2007).
In 1974, Daniel Kahneman and his long-time collaborator Amos Tversky published an influential paper in Science, "Judgment under Uncertainty: Heuristics and Biases." The paper defined three heuristic methods which encompass multiple biases that individuals rely upon to assess the probability of an uncertain event or the value of an uncertain quantity (Tversky & Kahneman, 1974).
These three heuristics include:
- Judgment by Representativeness
- Judgment by Availability
- Judgment by Adjustment and Anchoring
Judgment by Representativeness
Judgment by representativeness is a determination of the probability that object A belongs to class B, or that event A originates from process B, or that the probability that process B will generate event A (Tversky & Kahneman, 1974, p. 1124).
For example, in the "object A belongs to class B" scenario, an individual is provided with a personality description of a man and then asked to guess the man's occupation from a list of possibilities. The individual, relying upon judgment by representation, will guess the man's occupation to be the one that fits his personality most stereotypically (Tversky & Kahneman, 1974, p. 1124). This practice is referred to as stereotyping. Bodenhausen (1990, p. 319) argues that while stereotyping is convenient and common, it is a less likely strategy when individuals are motivated by personal involvement or are at their peak energy levels.
Judgment by Availability
Judgment by availability is an assessment of the frequency of a class or the probability of an event by the ease with which instances or occurrences can be recalled (Tversky & Kahneman, 1974, p. 1127).
For example, a person may suppose that a new pizza restaurant will fail because three other pizza restaurants in the same neighborhood failed.
Judgment by Adjustment
In judgment by adjustment & anchoring, adjustment involves estimating using a base number that is then altered to garner the final value. Anchoring refers to the phenomenon that different starting points will yield different estimates that are biased toward the initial values (Tversky & Kahneman, 1974, p. 1128). When using adjustment and anchoring to estimate an unknown quantity, an individual uses information he already knows (the anchor) and then makes adjustments from that point to arrive at an acceptable answer (the adjustment) (Epley & Gilovich, 2006, p. 311).
For example, groups of research subjects were asked to estimate the percentage of African countries in the United Nations by adjusting their numbers up or down from a number obtained by spinning a wheel of fortune (the anchor or starting point). Despite the relevance, or lack thereof, the arbitrary anchor numbers represented, subject answers varied according to them (the adjustment) (Tversky & Kahneman, 1974, p. 1128).
Illusion of Validity
Illusion of validity refers to a "complete lack of connection between the statistical information and the compelling experience of insight" (Kahneman, 2002).
Intuitive prediction refers to a "willingness to make extreme predictions about future performance on the basis of a small sample of behavior" (Kahneman, 2002).
The terms "illusion of validity" and "intuitive prediction" were created by Daniel Kahneman when he first began developing his behavioral viewpoints of individual choice as a psychologist in the Israeli army. After comparing the results of an exercise designed to identify which soldiers showed the best potential to be officers, to the actual success of the same soldiers in officer training, Kahneman deduced that the correlation was minimal. The term he created for this disconnect between statistical information and the experience of insight is the "illusion of validity" (Kahneman, 2002). Kahneman also noted that there was an "intuitive prediction" factor to this method of identifying officers: It resulted in making extreme predictions about future...
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