Behavioral economics

Behavioral economics and the related field, behavioral finance, study the effects of psychological,
social, cognitive, and emotional factors on the economic decisions of individuals and institutions and
the consequences for market prices, returns, and the resource allocation. The fields are primarily
concerned with the bounds of rationality ofeconomic agents. Behavioral models typically integrate
insights from psychology, neuroscience and microeconomic theory; in so doing, these behavioral
models cover a range of concepts, methods, and fields.
[1]

The study of behavioral economics includes how market decisions are made and the mechanisms
that drive public choice. The use of "Behavioral economics" in U.S. scholarly papers has increased in
the past few years as a recent study shows.
[2]

There are three prevalent themes in behavioral finances:
[3]

Heuristics: People often make decisions based on approximate rules of thumb and not strict
logic.
Framing: The collection of anecdotes and stereotypes that make up the mental emotional
filters individuals rely on to understand and respond to events.
Market inefficiencies: These include mis-pricings and non-rational decision making.

Issues
The central issue in behavioral finance is explaining why market participants make systematic
errors contrary to assumption of rational market participants. Such errors affect prices and returns,
creating market inefficiencies. It also investigates how other participants take advantage (arbitrage)
of such market inefficiencies.
Behavioral finance highlights inefficiencies such as under or over-reactions to information as causes
of market trends and in extreme cases of bubbles and crashes. Such reactions have been attributed
to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise
trading. Technical analysts consider behavioral finance, to be behavioral economics' "academic
cousin" and to be the theoretical basis for technical analysis.
[4]

Other key observations include the asymmetry between decisions to acquire, or keep resources,
known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued
possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell shares
or other equity, if doing so would result in a nominal loss.
[5]
It may also help explain why housing
prices rarely/slowly decline to market clearing levels during periods of low demand.
Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity
premium puzzle, something conventional finance models have been unable to do so
far.
[6]
Experimental finance applies the experimental method, e.g., creating an artificial market by
some kind of simulation software to study people's decision-making process and behavior in financial
markets.
Quantitative behavioral finance
Quantitative behavioral finance uses mathematical and statistical methodology to understand
behavioral biases. In marketing research, a study shows little evidence that escalating biases impact
marketing decisions.
[7]
Leading contributors include Gunduz Caginalp (Editor of the Journal of
Behavioral Finance from 20012004) and collaborators including 2002 Nobelist Vernon Smith, David
Porter, Don Balenovich,
[8]
Vladimira Ilieva and Ahmet Duran,
[9]
and Ray Sturm.
[10]

Financial models
Some financial models used in money management and asset valuation incorporate behavioral
finance parameters, for example:
Thaler's model of price reactions to information, with three phases, underreaction-
adjustment-overreaction, creating a price trend
One characteristic of overreaction is that average returns following announcements of good news is
lower than following bad news. In other words, overreaction occurs if the market reacts too strongly
or for too long to news, thus requiring adjustment in the opposite direction. As a result,
outperforming assets in one period are likely to underperform in the following period. This also
applies to customers' irrational purchasing habits.
[11]

The stock image coefficient
Criticisms
Critics such as Eugene Fama typically support the efficient-market hypothesis. They contend that
behavioral finance is more a collection of anomalies than a true branch offinance and that these
anomalies are either quickly priced out of the market or explained by appealing to market
microstructure arguments. However, individual cognitive biasesare distinct from social biases; the
former can be averaged out by the market, while the other can create positive feedback loops that
drive the market further and further from a "fair price" equilibrium. Similarly, for an anomaly to
violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this
is not the case for many anomalies.
[12]

A specific example of this criticism appears in some explanations of the equity premium puzzle. It is
argued that the cause is entry barriers (both practical and psychological) and that returns between
stocks and bonds should equalize as electronic resources open up the stock market to more
traders.
[13]
In reply, others contend that most personal investment funds are managed through
superannuation funds, minimizing the effect of these putative entry barriers. In addition,
professional investors and fund managers seem to hold more bonds than one would expect given
return differentials.
Behavioral game theory
Behavioral game theory analyzes interactive strategic decisions and behavior using
the methods of game theory,
[14]
experimental economics, and experimental psychology. Experiments
include testing deviations from typical simplifications of economic theory such as the independence
axiom
[15]
and neglect of altruism,
[16]
fairness,
[17]
and framing effects.
[18]
On the positive side, the
method has been applied to interactive learning
[19]
and social preferences.
[20][21]
As a research
program, the subject is a development of the last three decades.
[22]



Economic reasoning in non-human animals
A handful of comparative psychologists have attempted to demonstrate economic reasoning in non-
human animals. Early attempts along these lines focus on the behavior of ratsand pigeons. These
studies draw on the tenets of comparative psychology, where the main goal is to discover analogs to
human behavior in experimentally-tractable non-human animals. They are also methodologically
similar to the work of Ferster and Skinner.
[23]
Methodological similarities aside, early researchers in
non-human economics deviate frombehaviorism in their terminology. Although such studies are set
up primarily in an operant conditioning chamber, using food rewards for pecking/bar-pressing
behavior, the researchers describe pecking and bar pressing not in terms
of reinforcement and stimulusresponse relationships, but instead in terms of
work, demand, budget, and labor. Recent studies have adopted a slightly different approach, taking a
more evolutionary perspective, comparing economic behavior of humans to a species of non-
human primate, the capuchin monkey.
[24]

The animal as a human analogy
Many early studies of non-human economic reasoning were performed on rats and pigeons in an
operant conditioning chamber. These studies looked at things like peck rate (in the case of the
pigeon) and bar-pressing rate (in the case of the rat) given certain conditions of reward. Early
researchers claim, for example, that response pattern (pecking/bar pressing rate) is an appropriate
analogy to human labor supply.
[25]
Researchers in this field advocate for the appropriateness of using
animal economic behavior to understand the elementary components of human economic
behavior.
[26]
In a paper by Battalio, Green, and Kagel (1981, p 621),
[25]
they write
Space considerations do not permit a detailed discussion of the reasons why economists
should take seriously the investigation of economic theories using nonhuman
subjects....[Studies of economic behavior in non-human animals] provide a laboratory
for identifying, testing, and better understanding general laws of economic behavior.
Use of this laboratory is predicated on the fact that behavior as well as structure vary
continuously across species, and that principles of economic behavior would be unique
among behavioral principles if they did not apply, with some variation, of course, to the
behavior of nonhumans.
Labor supply
The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons are
first deprived of food. Since the animals are hungry, food becomes highly desired. The pigeons are
placed in an operant conditioning chamber and through orienting and exploring the environment of
the chamber they discover that by pecking a small disk located on one side of the chamber, food is
delivered to them. In effect, pecking behavior becomes reinforced, as it is associated with food.
Before long, the pigeon pecks at the disk (or stimulus) regularly.
In this circumstance, the pigeon is said to "work" for the food by pecking. The food, then, is thought
of as the currency. The value of the currency can be adjusted in several ways, including the amount
of food delivered, the rate of food delivery and the type of food delivered (some foods are more
desirable than others).
Economic behavior similar to that observed in humans is discovered when the hungry pigeons stop
working/work less when the reward is reduced. Researchers argue that this is similar to labor
supply behavior in humans. That is like humans (who, even in need, will only work so much for a
given wage) the pigeons demonstrate decreases in pecking (work) when the reward (value) is
reduced.
[25]

Demand
In human economics, a typical demand curve has negative slope. This means that as the price of a
certain good increases, the amount that consumers are willing to purchase decreases. Researchers
studying the demand curves of non-human animals, such as rats, also find downward slopes.
Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons.
Specifically, say we have experimental subjects, rats, in an operant chamber and we require them to
press a lever to receive a reward. The reward can be either food (reward pellets), water, or a
commodity drink such as cherry cola. Unlike previous pigeon studies, where the work analog was
pecking and the monetary analog was reward, in the studies on demand in rats, the monetary analog
is bar pressing. Under these circumstances, the researchers claim that changing the number of bar
presses required to obtain a commodity item is analogous to changing the price of a commodity item
in human economics.
[27]

In effect, results of demand studies in non-human animals are that, as the bar-pressing requirement
(cost) increases, the animal presses the bar the required number of times less often (payment).
Monkey trading behavior
Recent work on economic behavior in non-human animals has focused on capuchin monkeys. Here
the researchers seem less inclined toward the behaviorist tradition of the laboratory animal-human
behavior analog. Instead, they attempt to adopt a more evolutionary perspective, positing that
economic reasoning might be basic, unlearned, and serve some adaptive function.
One recent study
[24]
involves the introduction of a currency system into a colony of captive capuchin
monkeys. The currency is in the form of coins and is redeemable for food and other purchasable
items when exchanged with a researcher. Under these conditions, the researchers studied three
features of monkey trading: demand, loss aversion, andrisk aversion.
In this study, monkeys are presented with an amount of money and are shown a certain amount of
food or other goods. The monkeys must take the money and hand it to the experimenter in exchange
for goods. In one condition of the experiment, after the monkey has paid for the goods, it has the
option to take a sure amount of food now, or wait until the experimenter alters the amount of food
presented. In this circumstance, the experimenter can either increase or decrease the amount of
food given. Thus, this experimental setup allows the researchers to look at the gambling behavior of
the animals. The experimenters can therefore ask the following questions: will the monkey take the
sure amount of food? Will the monkey gamble by waiting until the experimenter changes the
amount of food present? Does the decision of the animal depend on the circumstances? Results
indicate that the monkeys are risk-averse: they prefer to take the initial amount of food than wait for
the experimenter to change the amount presented.
The experimenters introduce several other manipulations, including changing the allocated budget,
changing the cost of certain items, changing the items themselves. Specifically, the researchers found
an increase in item purchase and consumption when that item decreases in value, a result consistent
with those found in human economics.
[24]

Taken together, the results of this study indicate that capuchin monkeys are not only risk-averse, but
are also sensitive to constructs such as price, budget, and payoff expectation. According to the
researchers, the animals are not trained to behave in this way; these behaviors arise naturally in the
trading environment. As a result, these researchers argue that basic economic behavior and
reasoning might be unlearned, innate, and subject to natural selection.
Evolutionary psychology
See also: Evolutionary economics
An evolutionary psychology perspective is that many of the seeming limitations in rational choice can
be explained as being rational in the context of maximizing biological fitness in the ancestral
environment but not necessarily in the current one. Thus, when living at subsistence level where a
reduction of resources may have meant death it may have been rational to place a greater value on
losses than on gains. It may also explain differences between groups such as males being less risk-
averse than females since males have more variable reproductive success than females. While
unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially
increase their reproductive success much more than females from successful risk-seeking.
[28]

History
During the classical period, microeconomics was closely linked to psychology. For example, Adam
Smith wrote The Theory of Moral Sentiments, which proposed psychological explanations of
individual behavior, including concerns about fairness and justice,
[29]
and Jeremy Bentham wrote
extensively on the psychological underpinnings of utility. However, during the development of neo-
classical economics economists sought to reshape the discipline as a natural science, deducing
economic behavior from assumptions about the nature of economic agents. They developed the
concept of homo economicus, whose psychology was fundamentally rational. This led to unintended
and unforeseen errors.
However, many important neo-classical economists employed more sophisticated psychological
explanations, including Francis Edgeworth, Vilfredo Pareto, and Irving Fisher. Economic psychology
emerged in the 20th century in the works of Gabriel Tarde,
[30]
George Katona,
[31]
and Laszlo
Garai.
[32]
Expected utility and discounted utility models began to gain acceptance, generating
testable hypotheses about decision making given uncertainty and intertemporal
consumption respectively. Observed and repeatable anomalies eventually challenged those
hypotheses, and further steps were taken by the Nobel prizewinner Maurice Allais, for example in
setting out the Allais paradox, a decision problem he first presented in 1953 which contradicts the
expected utility hypothesis.

Daniel Kahneman, winner of 2002 Nobel prize in economics.

In the 1960s cognitive psychology began to shed more light on the brain as an information processing
device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards,
[33]
Amos
Tversky, and Daniel Kahneman began to compare their cognitive models of decision-making under
risk and uncertainty to economic models of rational behavior. In mathematical psychology, there is a
longstanding interest in the transitivity of preference and what kind of measurement scale utility
constitutes (Luce, 2000).
[34]

Prospect theory
In 1979, Kahneman and Tversky wrote Prospect theory: An Analysis of Decision Under Risk, an
important paper that used cognitive psychology to explain various divergences of economic decision
making from neo-classical theory.
[35]
Prospect theory has two stages, an editing stage and an
evaluation stage.
In the editing stage, risky situations are simplified using various heuristics of choice. In the evaluation
phase, risky alternatives are evaluated using various psychological principles that include the
following:
(1) Reference dependence: When evaluating outcomes, the decision maker has in mind a
"reference level". Outcomes are then compared to the reference point and classified as
"gains" if greater than the reference point and "losses" if less than the reference point.
(2) Loss aversion: Losses bite more than equivalent gains. In their 1979 paper in
Econometrica, Kahneman and Tversky found the median coefficient of loss aversion to be
about 2.25, i.e., losses bite about 2.25 time more than equivalent gains.
(3) Non-linear probability weighting: Evidence indicates that decision makers overweight
small probabilities and underweight large probabilities this gives rise to the inverse-S
shaped "probability weighting function".
(4) Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to
the reference point increase in absolute value, the marginal effect on the decision maker's
utility or satisfaction falls.
Prospect theory is able to explain everything that the two main existing decision theories expected
utility theory and rank dependent utility can explain. However, the converse is false. Prospect
theory has been used to explain a range of phenomena that existing decision theories have great
difficulty in explaining. These include backward bending labour supply curves, asymmetric price
elasticities, tax evasion, co-movement of stock prices and consumption etc.
In 1992, in the Journal of Risk and Uncertainty, Kahneman and Tversky gave their revised account of
prospect theory that they called cumulative prospect theory. The new theory eliminated the editing
phase in prospect theory and focused just on the evaluation phase. Its main feature was that it
allowed for non-linear probability weighting in a cumulative manner, which was originally suggested
in John Quiggin's rank dependent utility theory.
Psychological traits such as overconfidence, projection bias, and the effects of limited attention are
now part of the theory. Other developments include a conference at theUniversity of Chicago,
[36]
a
special behavioral economics edition of the Quarterly Journal of Economics ('In Memory of Amos
Tversky') and Kahneman's 2002 Nobel for having "integrated insights from psychological research
into economic science, especially concerning human judgment and decision-making under
uncertainty".
[37]

Intertemporal choice
Behavioral economics has also been applied to intertemporal choice. Intertemporal choice behavior
is largely inconsistent, as exemplified by George Ainslie's hyperbolic discounting (1975) which is one
of the prominently studied observations, further developed by David Laibson, Ted O'Donoghue, and
Matthew Rabin. Hyperbolic discounting describes the tendency to discount outcomes in near future
more than for outcomes in the far future. This pattern of discounting is dynamically inconsistent (or
time-inconsistent), and therefore inconsistent with basic models of rational choice, since the rate of
discount between time t and t+1 will be low at time t-1, when t is the near future, but high at
time twhen t is the present and time t+1 the near future.
The pattern can actually be explained through models of subadditive discounting which distinguishes
the delay and interval of discounting: people are less patient (per-time-unit) over shorter intervals
regardless of when they occur. Much of the recent work on intertemporal choice indicates that
discounting is a constructed preference.

Discounting is influenced greatly by expectations, framing,
focus, thought listings, mood, sign, glucose levels, and the scales used to describe what is discounted.
Some prominent researchers

question whether discounting, the major parameter of intertemporal
choice, actually describes what people do when they make choices with future consequences.
Considering the variability of discount rates, this may be the case.
Other areas of research
Other branches of behavioral economics enrich the model of the utility function without implying
inconsistency in preferences. Ernst Fehr, Armin Falk, and Matthew Rabin studied "fairness", "inequity
aversion", and "reciprocal altruism", weakening the neoclassical assumption of "perfect selfishness."
This work is particularly applicable to wage setting. Work on "intrinsic motivation" by Gneezy and
Rustichini and on "identity" by Akerlof and Kranton assumes agents derive utility from adopting
personal and social norms in addition to conditional expected utility. According to Aggarwal (2014),
in addition to behavioral deviations from rational equilibrium, markets are also likely to suffer from
lagged responses, search costs, externalities of the commons,and other frictions making it difficult to
disentangle behavioral effects in market behavior.<ref
[38]
>
"Conditional expected utility" is a form of reasoning where the individual has an illusion of control,
and calculates the probabilities of external events and hence utility as a function of their own action,
even when they have no causal ability to affect those external events.
[39][40]

Behavioral economics caught on among the general public, with the success of books like Dan
Ariely's Predictably Irrational. Practitioners of the discipline have studied quasi-public policy topics
such as broadband mapping.
[41][42]

Criticisms
Critics of behavioral economics typically stress the rationality of economic agents.
[43]
They contend
that experimentally observed behavior has limited application to market situations, as learning
opportunities and competition ensure at least a close approximation of rational behavior.
Others note that cognitive theories, such as prospect theory, are models of decision making, not
generalized economic behavior, and are only applicable to the sort of once-off decision problems
presented to experiment participants or survey respondents.
Traditional economists are also skeptical of the experimental and survey-based techniques which
behavioral economics uses extensively. Economists typically stress revealed preferences over stated
preferences (from surveys) in the determination of economic value. Experiments and surveys are at
risk of systemic biases, strategic behavior and lack of incentive compatibility.
Rabin (1998)
[44]
dismisses these criticisms, claiming that consistent results are typically obtained in
multiple situations and geographies and can produce good theoretical insight. Behavioral economists
have also responded to these criticisms by focusing on field studies rather than lab experiments.
Some economists see a fundamental schism betweenexperimental economics and behavioral
economics, but prominent behavioral and experimental economists tend to share techniques and
approaches in answering common questions. For example, behavioral economists are actively
investigating neuroeconomics, which is entirely experimental and cannot yet be verified in the field.
Other proponents of behavioral economics note that neoclassical models often fail to predict
outcomes in real world contexts. Behavioral insights can influence neoclassical models. Behavioral
economists note that these revised models not only reach the same correct predictions as the
traditional models, but also correctly predict some outcomes where the traditional models failed.