Behavioral Economics & Finance Research Paper Starter

Behavioral Economics & Finance

(Research Starters)

A burgeoning field within the economics discipline concerns itself with consumer psychology. As such, the field of behavioral economics and finance employs a broad array of tools and methods to create a substantial composite of the consumer. Such an illustration is critical as it aids economists, financial professionals and policymakers to implement effective approaches and responses to problems within a system. This paper takes an in-depth look at the growing field of behavioral economics and finance and its significance for the overall study of economics.

Keywords: Framing; Heuristics; Prospect Theory; Representativeness; Utility

Behavioral Economics

Overview

The esteemed political economist and writer Peter Drucker once said "A business exists because the consumer is willing to pay you his money. You run a business to satisfy the consumer. That isn't marketing. That goes way beyond marketing" ("Building brands," 2009).

The most significant "x-factor" in an economic system is the behavior of the consumer. How he or she acts or reacts in a given situation is arguably the key to determining a business's best course of action. It is for this reason that economics looks to understand consumer behavior as part of its pursuits.

For generations, the approach to understanding consumer behavior in economics has been somewhat limited, due scientific dependence upon modeling and "real time" assessments. Such a conservative approach has led to a lack of information regarding consumer mindsets and also on how consumer behavior impacts the economic system in question.

A burgeoning field within the economics discipline concerns itself with consumer psychology. As such, the field of behavioral economics and finance employs a broad array of tools and methods to create a substantial composite of the consumer. Such an illustration is critical as it aids economists, financial professionals and policymakers to implement effective approaches and responses to problems within a system. This paper takes an in-depth look at the growing field of behavioral economics and finance and its significance for the overall study of economics.

The Development of a New Sub-Discipline

Behavioral economics and behavioral finance are terms that apply to a field of study that involves the application of social and human cognitive and emotional patterns for the purposes of understanding economic decisions and how they impact market prices, returns and resource allocation ("What is behavioral economics?", 2005). Behavioral economics is combines the disciplines of psychology and sociology within an economic framework.

Because it entails the application of varying degrees of other scientific fields, a great deal of debate continues regarding the origins of behavioral economics. In the view of many observers, iconic economist Adam Smith was perhaps the first to see "psychology as part of decision-making," according to business professor Nava Ashraf, adding, "He saw a conflict between the passions and an impartial spectator" (Lambert, 2006). Regardless of the founder of this increasingly relevant field, the fact that many applications of behavioral economics in recent history have coincided with major changes in economic conditions is undeniable.

In the mid-19th century, for example, the introduction of the concept of social insurance (like Social Security) in Chancellor Otto von Bismarck's Germany represented a major change in economic systems. Such programs were implemented in large part to counter the growing socialist and communist movements in Europe. They also heralded a new order of government-managed financial assistance programs which transformed bureaucratic institutions and administrative budgets. At the same time that Bismarck introduced these programs, Germany saw an increase in the number of university departments and research institutions that were dedicated to studying the social aspects of economics. It was believed that the idea of social insurance programs originated not in economic policymaking circles but by non-academic social activists. Therefore, the study of the forces that created such programs would require methodologies and disciplinary applications from outside of the economic sphere, such as sociology, political science and psychology (Shiller, 2005).

Prospect Theory

The application of psychology and other non-economic disciplines to the study of economics has continued to develop for more than a century. One of the most prominent manifestations of this field of study came in 1979, when psychologists Daniel Kahneman and Amos Tversky introduced the "Prospect Theory." With this theory, Kahneman and Tversky offered a critique on the inability of mainstream economic analysis to accurately account for consumer decision-making behavior. Specifically, they noted that people tend to underweigh outcomes that are based on probability (as opposed to certain outcomes) in risk situations. In this capacity, value was assigned to gains and losses, rather than the conventional approach, which assigned value in terms of final assets ("Prospect theory," 2008). Their theory represented a milestone in the burgeoning field of behavioral economics and finance.

The evolution of behavioral economics and finance has indeed progressed alongside the ever-changing economic landscape; it is to the fundamental elements of this growing field of economics that this paper will next turns attention.

Heuristics

At the center of behavioral economics is the notion that neoclassical economics falls short of fully explaining consumer behavior. Neoclassical economics has long dominated microeconomics, focusing on supply and demand frameworks (such as pricing, output, profits and income distribution). However, it also relies heavily on assumptions that the actors involved in a given study are going to act in a rational manner in order to create the maximum utility (value derived from choice). Such themes are evident in utility theory, which is often used to explain decision-making in situations with risk and explicitly outlined probabilities ("Utility theory," 2009).

Behavioral economics does not necessarily dismiss utility theory — rather, it compliments it with an additional perspective. By adding the psychological concept of heuristics (a method used to rapidly come to a conclusion based on the probability of an optimal solution), behavioral economists believe a more comprehensive picture of the consumer's decision-making may be presented. In essence, heuristics involves so-called "rules of thumb" rather than in-depth, case-by-case analysis.

Heuristic decision-making processes entail biased judgments. In other words, past experiences or conditions that are either familiar or imaginable to the individual are seen as influences on the decision being made. In fact, people often overestimate the likelihood that past events and experiences will occur again (or have occurred prior to the decision), which will in turn create more biases in the decision-making process. In financial investments, such judgments may be critical to how the individual proceeds with his or her money.

Heuristic decision-making also often involves "representativeness." This term applies to judgments by individuals of conditional probabilities that are based on how the data or sample represents the existing hypothesis or classification (Camerer & Lowenstein, 2002). For example, an individual who is operating from the hypothesis that a student fits the profile to attend a certain class might glean a set of generalities about that class and affix them to the student's profile.

Like other forms of heuristics, representativeness does not necessarily provide wholly accurate information about a concept — however, what is important for the purposes of this paper is the fact that such a thought-process creates a short-cut methodology for individuals to make decisions...

(The entire section is 3516 words.)