Behavioral Economics Comes of Age: A Review Essay on "Advances in Behavioral

Economics"
Author(s): Wolfgang Pesendorfer
Source: Journal of Economic Literature , Sep., 2006, Vol. 44, No. 3 (Sep., 2006), pp. 712-
721
Published by: American Economic Association

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Journal of Economic Literature
Vol. XLIV (September 2006), pp. 712-721

Behavioral Economics Comes of Age:

A Review Essay on Advances in
Behavioral Economics

WOLFGANG PESENDORFER*

Advances in Behavioral Economics contains influential second-generation contribu

tions to behavioral economics. Building on the seminal work by Kahnemann, Strotz
Thaler, Tversky, and others, these contributions have established behavioral econom
ics as an important field of study in economics. In this essay, I discuss aspects of t
research strategy and methodology of behavioral economics, as exemplified by th
contributions to Advances.

1. Introduction Expected Utility: Expected utility theory

assumes the independence axiom. The (sto-
The publication of Advances in Behav-
chastic version of the) independence axiom
ioral Economics (edited by Colin
says that the frequency with which a pool of
Camerer, George Loewenstein, and Matthew
subjects chooses lottery p over q does not
Rabin and published by the Russell Sage
change when both lotteries are mixed with
Foundation and Princeton University Press
in 2004) is a testament to the success of some common lottery r. Experiments by
behavioral economics. The book contains Allais, Kahneman, Tversky, and others
demonstrate systematic failures of the inde-
important second-generation contributions
to behavioral economics that build on the pendence axiom. Chapter 4 in the book dis-
cusses this experimental evidence and the
seminal work by Daniel Kahneman, Amos theories that address it.
Tversky, Richard H. Thaler, Robert H. Strotz,
and others. Kahneman and Tversky (1979) develop
prospect theory to address the failures of
Behavioral economics is organized around
expected utility theory. They argue that
experimental findings that suggest inadequa-
cies of standard economic theories. The most when analyzing choice under uncertainty it
is not enough to know the lotteries an agent
celebrated of those are (1) failures of expect-
is choosing over. Rather, we must know
ed utility theory; (2) the endowment effect;
more about the subject's situation at the
(3) hyperbolic discounting and (4) social
time he makes his choice. Prospect theory
preferences. Most of the articles collected in
distinguishes between gains and losses from
Advances deal with one of these four topics.
a situation-specific reference point. The
* I am grateful to Markus Brunnermeier, Drew agent evaluates gains and losses differently
Fudenberg, Faruk Gul, and Wei Xiong for helpful com- and exhibits first-order risk aversion locally
ments.
around the reference point.

712

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 Pesendorfer: Behavioral Economics Comes of Age: A Review 713

The Endowment Effect: In standard models that allow players' utility to depend
consumer theory, demand is a function on of
their own and their opponent's monetary
wealth and prices but does not depend on
payoffs. Closest to standard models is the
work
the composition of the endowment. Thaler, of Ernst Fehr and Klaus M. Schmidt
(chapter 9) in which the utility of a player
in his 1980 paper, coined the term "endow-
ment effect" to describe the experimental
depends on the monetary payoff of all play-
finding that subjects value a good moreers.
if There
it is additional evidence that players
not
is part of their endowment than if it is only care about the material outcomes of
not.
The endowment effect is addressedtheir by opponents but also about their oppo-
assuming that agents treat additions tonent's
theircharacter. As a result, players may care
about what other players reveal during the
endowments differently from subtractions.
Hence, the endowment point is treatedcourse
as a of the interaction about their charac-
reference point and agents are assumed
ter. John Geanakoplos, David Pearce, and
have a kink in their valuations around the
Ennio Stacchetti (1989) develop a frame-
endowment point. work that allows for such interdependence
Hyperbolic Discounting: Standard dy- and Matthew Rabin (chapter 10) applies that
namic decision theory assumes that framework.
intertemporal choices do not depend on the As these examples illustrate, the focus of
decision date. Whether the agent chooses research in behavioral economics is on indi-
consumption in the initial period or sequen- vidual choice and the motives underlying
tially has no effect on the choice if the budg- that choice. Starting with an experimental
et constraint is the same in both cases. finding that shows violations of standard eco-
Strotz (1955/56) develops a model of deci-
nomic assumptions, research in behavioral
economics
sion making that relaxes this assumption. As proceeds by introducing new
variables that are used to "parameterize"
David Laibson (1997) points out, this model
can be used to address experimental deviations
evi- from standard models. In many
cases, the new variable is used to describe a
dence of an "immediacy effect" in behavior:
subjects have a tendency to choose earlier,
"bias" in decision making, i.e., some form of
smaller rewards over later, larger rewards
irrationality or systematic mistake.
when the earlier reward offers immediate This essay contains three observations on
consumption but reverse this preferencethe direction and the focus of behavioral
when both rewards are delayed. economics. The next section previews the
Social Preferences: Standard incentivethree observations and sections 3-5 discuss
theory assumes that the choices of an agent in more detail. Section 6 concludes.
them
depend only on his own monetary payoff. 2. Three Observations
This assumption has been challenged by a
variety of experiments, perhaps most (1) Much of behavioral economics builds
famously the experiments on ultimatum bar-on experimental evidence in which a new
gaining. Introduced by Werner Guth, Rolf variable that is ignored in standard econom-
Schmittberger, and Bernd Scbwarze (1982), ic models is shown to "matter." While the
this experiment pairs subjects to play a sim-
new variable may be observable in experi-
ple bargaining game. The proposer makesmental
an settings, it is often unobservable
offer and the responder accepts or rejects. when
A the researcher must deal with eco-
nomic
rejection leaves both players with a zero pay- (field) data. A prominent example of
off. Responders routinely reject small offers
this is the reference point in prospect theo-
and therefore do not maximize their selfish ry. The reference point can be manipulated
monetary payoff. To address this evidence, in experimental settings but is essentially
behavioral economists have introduced unobservable outside the laboratory. This

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714 Journal of Economic Literature, Vol. XLIV (September 2006)

makes it difficult to adapt prospect theory to Successful innovations in economics find

economic contexts. new variables that "matter" and, in addition,
show how these variables can be identified
(2) Behavioral economics accommodates
observed violations of economic theory and by measured. In that case, the new theory
building the observed biases into the behav- delivers new testable predictions that
also
can be used to prove it wrong. Models of
ior of the individual. For example, if experi-
mental evidence suggests that subjects hyperbolic discounting (Strotz 1955; Laibson
underutilize their information, a behavioral1997) are examples of such innovations in
model might deal with this observation behavioral
by economics.
defining agent's actual posterior beliefs as an
3.1 Prospect Theory
average of the correct posterior and the
prior. But modeling devices that make sense
An expected utility maximizer has a utility
for an unbiased decisionmaker may not
function over consumption lotteries and
make sense for a biased one. For example,
chooses a portfolio to maximize his utility.
For prospect theory, the situation is more
why would individuals have priors and pos-
complicated. When an agent makes a deci-
teriors if they are destined to apply Bayes'
sion, he does not necessarily take into
law incorrectly? Similarly, why would indi-
account how this decision affects his con-
viduals maximize an objective function if the
objective function is the wrong one? sumption. He may view certain risky
(3) The focus on biases and mistakesprospects
in in isolation or combine them with
decision making naturally leads to an explo- other risky prospects and evaluate this sub-
ration of the psychological sources of these set of lotteries separately. Utility depends on
biases. In many instances, behavioral eco- a reference point that partitions outcomes
nomics turns into economic psychology. into gains and losses.
Observed behavior in experiments is taken The variables of prospect theory are
as a window into the mind of the decision- adapted to the setting of experiments where
maker and the theory explores how the per- the researcher can manipulate the reference
son thinks and feels in a particular situation. point. For example, the experimenter may
Such theories are difficult to connect to eco- frame a lottery L as (i) x with probability p
nomic data because their main insights are and y with probability 1- p; or, alternatively,
about psychological variables, that is, how as (ii) a payment of z and a subsequent lot-
the person thinks (i.e., deals with biases) and tery of x - z > 0 with probability p and the
feels. lottery y - z < 0 with probability 1 - p. The
difference in the two lotteries is interpreted
3. New Variables and Their Measurement
as a manipulation of the reference point.
Behavioral economics argues that econo- When prospect theory is applied to eco-
mists ignore important variables that affect nomic settings, it is often impossible to iden-
behavior. The new variables are typically tify the reference point. For example, in
shown to affect decisions in experimental many economic applications the researcher
settings. For economists, the difficulty is won't be able to determine whether (i) or (ii)
that these new variables may be unobserv- is the correct framing of an asset correspon-
able or even difficult to define in economic ding to lottery L. Behavioral economists deal
settings with economic data. From the per- with this ambiguity by treating the reference
spective of an economist, the unobservable point as a free variable chosen to match the
variable amounts to a free parameter in the observed behavior of an application.
utility function. Having too many such Depending on the application, the reference
parameters already, the economist finds it point may be the endowment, the value of
difficult to utilize the experimental finding. the endowment at a fixed date, the value at

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 Pesendorfer: Behavioral Economics Comes of Age: A Review 715

which the agent previously bought an asset, value of asset when it was purchased and
or the expected earnings at the end of a does not adjust over time. Moreover, it is
working day. Colin F. Camerer (chapter 5) assumed that assets are treated in isolation so
illustrates how prospect theory is applied to that the agent cannot use a different asset
a variety of economic settings. with superior return to recover losses.
Shlomo Benartzi and Thaler (1997) sug- Camerer, Linda Babcock, George Loew-
gest an explanation of the equity premium enstein, and Thaler (chapter 19) suggest that
based on prospect theory. Investors' utility New York cab drivers use a daily income tar-
depends on the annual return of their port- get as a reference point and stop working
folio. In particular, investors are loss averse after the target is achieved. Income targeting
and compute gains and losses with respect to is an extreme form of loss aversion with the
the value of their portfolio at the beginning target income level as a reference point. As
of the planning horizon (approximately one Henry S. Farber (2005) points out, this
year). In this model, the reference point is implies that cab drivers quit early on days
the value of the asset in the portfolio at the where it is easy to make money and quit late
beginning of the year (the beginning of the on days when it is hard to make money.
"planning horizon"). If investors are suffi- Farber reexamines the evidence presented
ciently risk averse around the reference by Camerer et al. and finds that there is no
point, this formulation will imply a large evidence of a target-income behavior among
equity premium. To match the observed New York cab drivers. Farber concludes that
equity premium, it is essential that gains and the primary determinant of stopping work is
losses are computed over relatively short hours worked and that cumulative income is
periods (annually rather than over five or ten at most weakly related to stopping work.
years) and that the reference point adjusts Farber (2004) estimates a more general util-
over time. If the reference point stays con- ity function that allows intertemporal substi-
stant (for example at the price the asset was tution but also includes loss aversion around
purchased), then over time the effect of loss a reference point. For that model, he finds
aversion fades. evidence that a reference level may effect
Studies on stock trading (Terrance Odean the labor supply decision on a given day. But,
1998) and housing transactions (David even for a given driver, the estimated refer-
Genesove and Christopher Meyer 2001) find ence level varies substantially from day to
that agents are less likely to sell assets thatday. Farber concludes that "This [variation]
have incurred losses than assets that have seriously limits the predictive power of the
incurred gains. Prospect theory explains thisreference point, and undermines the useful-
behavior by assuming that investors treat ness of the construct of the reference income
each asset as a separate decision and use the level as a determinant of labor supply"
purchase price as a reference point. Investors (Farber 2004, p. 4).
are assumed to tolerate more risk when they In all these applications, we cannot
try to recover a loss than when they try toobserve variations in the reference point in
increase their gains. As a result, investors the same way that experimenters can fix
may hold on to assets that have made lossesand manipulate the reference point.
even if those assets yield a lower expected Therefore, the reference point becomes a
return than some other asset in their portfo- parameter that is calibrated to match the
lio.1 In this case, the reference point is theobserved data. But unlike risk aversion or
the discount factor, the reference point
1 Nicholas Barberis and Wei Xiong (2006) show that
need not be consistent across applications
this argument is flawed. A formal model corresponding to
the intuitive description by Camerer (chapter 5) may notor even consistent across periods for the
be consistent with the evidence in Odean. same application. Essentially, it captures a

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716 Journal of Economic Literature, Vol. XLIV (September 2006)

(subjective and unobservable) state of the the usefulness of dynamically inconsistent

decisionmaker. preferences for (macro)economic analysis.
Applications of prospect theory are similar The behavior of Strotzian decisionmakers
to models of habit formation. In habit mod- depends not only on their budget (wealth)
els, a new parameter (typically a function of but also on the availability of "commitment."
past consumption) is added to the utility In economic applications, commitment can
function and calibrated to match observed be achieved by holding illiquid assets or
data. This research seeks the "right" utility through regulation. Standard consumers
function for a particular application. In its have no demand for commitment and hence
most general form, the utility of a decision- will (weakly) prefer liquid assets while
maker depends on his choice x and on a sub- Strotzian consumers may strictly prefer illiq-
jective state s that, in turn, is a function of all uid assets. The liquidity of an asset is often
other observable variables. The goal is toobservable for economists.
find the best specification of u(x, s). Strotzian models add new variables to the
Applications of prospect theory and habit analysis but also add new testable predic-
formation are particular examples of that tions. For example, we would expect agents
program. to pay for commitment. Laibson, Andrea
The unobservability of the subjective state Repetto, and Jeremy Tobacman (2005) esti-
makes it more difficult to falsify the theory. mate the parameters of Strotzian consumers
It is hard to imagine that one could formu- and find that they would greatly benefit from
late a "puzzle" analogous to the equity commitment: "Specifically, according to a
premium puzzle for prospect theory. comparison of value functions, at age 20,
Ultimately, the theory allows too many sophisticated quasi-hyperbolics would be
degrees of freedom. (Of course, defenders willing to pay 2,000 USD to get rid of their
of prospect theory might say that there can't credit cards immediately and never have
be a puzzle because prospect theory is access to them in the future. This begs the
right!) question of why only a tiny fraction of con-
sumers cut up their credit cards" (Laibson,
3.2 Discounting
Repetto, and Tobacman 2005, p. 22). The
In their survey of evidence on time pref- Strotzian model can generate this type of
erence, Shane Frederick, Loewenstein, and "puzzle" because the basic ingredients are
Ted O'Donoghue (chapter 6) discuss evi- observable in many economic contexts.
dence that subjects resolve the same In addition to evidence in favor of the

intertemporal trade-off differently depend- Strotzian model, Frederick, Loewenstein,

ing on when the decision is made. Consider
a choice between x at time t and y > x at time
t' > t. For appropriate choices of the param-
eters, subjects choose (x, t) if the decision is
made in period t and (y, t') if the decision is
made in period t - 1 or earlier.
Strotz, in his seminal 1955 article, propos-
es a solution concept (consistent planning)
similar to modern subgame perfect equilib-
rium to solve dynamically inconsistent deci-
sion problems. As Strotz points out, the
consequence of consistent planning is a
preference for commitment. Laibson (1997)
initiated research that seeks to demonstrate
and O'Donoghue emphasize that other
aspects of decision problems that economists
routinely ignore "matter." They present evi-
dence that "gains are discounted more than
losses; small amounts are discounted more
than large amounts; greater discounting is
shown to avoid delay of a good than to expe-
dite its receipt" (p. 175-76). In typical eco-
nomic applications the data do not allow a
distinction between reduced gains and
increased losses, or between decreasing
delay and expediting receipt. Even at modest
levels of aggregation, it is impossible to dis-
tinguish between several small and a single

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 Pesendorfer: Behavioral Economics Comes of Age: A Review 717

large purchase. As a consequence, it is diffi- Rather, the calibration has to be done sepa-
cult to use economic data to calibrate utility rately for every context. As a result, the exper-
functions that depend on those variables. imental evidence offers little quantitative
guidance for economists.
3.3 Calibrating from Experiments
Since novel behavioral variables such as 4. Humans as Stubborn Operators of
Broken Machines
the reference point can be manipulated in
experiments, it seems tempting to use exper- Behavioral economics grew out of a cri-
imental data to estimate the parameters tique
of of standard economic assumptions.
This tradition sometimes leads to a view of
utility functions and then apply these esti-
behavioral economics as a collection of
mates to economic applications. The experi-
mental evidence on discounting offers"biases,"
a that is, violations of standard
good illustration of the difficulty of this assumptions in economics.
approach. Behavioral models often take as a starting
The impatience displayed by subjects in point a standard economic model and re-
experimental settings is striking. Thaler interpret the model as a description how the
(1981) finds annual discount rates over 300 person thinks and feels. Next, an (often
percent for time-delays of a month. A recent compelling) case is made that many of the
experiment by Benhabib, Bisin, and assumptions are unrealistic because humans
Schotter (2005) finds annual discount rates cannot perform the difficult mental tasks
of 472 percent. These findings are striking embodied in the formalism. The mistake or
because there are market prices for these bias is typically modeled by assuming that
intertemporal trade-offs. Real interest rates some aspect of the optimization procedure
are typically in the low single digits-orders in the decision model is done incorrectly.
of magnitude off the experimental findings. Typically, behavioral economists take great
Moreover, economic agents tend to hold care in motivating the particular mistake and
assets that offer those low rates of return.2 provide detailed evidence that humans
A second striking feature of the experi- indeed have trouble performing the task
ments is the large cross-study differences in required by the model. Finally, the psycho-
estimated discount rates. Frederick, logical and sometimes also the economic
Loewenstein, and O'Donoghue write "theconsequences of the model with the bias are
spectacular cross-study differences in dis- explored. However, rarely do these theories
count rates also reflect the diversity of con-ask whether--once the mistake is taken for
siderations that are relevant in intertemporal granted-the original model makes sense.
choices and that legitimately affect different In other words, why would humans go to the
types of intertemporal choices differently"trouble of maximizing objective fiunctions,
(p. 211). The argument by Frederick, formulating complicated beliefs only to get
Loewenstein, and O'Donoghue implies that things systematically wrong?
experimental evidence cannot be used to cal- For example, consider the O'Donoghue-
ibrate utility functions that then are applied Rabin model of naive, dynamically inconsis-
in (very different) economic contexts. tent decisionmakers. These decisionmakers
maximize a standard utility function but
have incorrect beliefs about their own future
2 Of course, there is substantial diversity in savings
behavior. As Laibson et al. (2005) point out, many U.S. behavior. The assumption that humans have
households hold credit card debt at high interest rates wrong, even systematically biased, beliefs
which suggests a great deal of impatience. On the other
hand, savings behavior in Germany has puzzled
seems plausible and strikes a cord with most
researchers (see Axel Boersch-Supan et al. 2001) because readers. At the same time, it seems highly
it suggests a great deal of patience. implausible that individuals would go to the

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718 Journal of Economic Literature, Vol. XLIV (September 2006)

trouble of solving a dynamic optimization case-based decision theory (chapter 25) is an

problem when solving this problem has no example of such a departure. In that paper,
clear benefit. In a standard model, maximiz- Itzhak Gilboa and David Schmeidler devel-
ing a utility function is simply a concise rep- op an alternative to the standard expected
resentation of how the agent behaves. But utility framework. Their model replaces
once the model is interpreted as a mental probabilities (subjective or objective) with a
process, we must imagine that the decision- less demanding similarity function that is
maker actually performs the optimization. used to weigh the relevance of past experi-
Since the decisionmaker is systematically ences (cases) for every action. The paper
wrong about future behavior there is no offers an intriguing alternative to the famil-
obvious benefit from maximizing the objec- iar probabilistic models of decision making.
tive function as opposed to taking some 5. Behavioral Economics or Economic
other (perhaps arbitrary) action. The
Psychology?
metaphor of an operator of a broken
machine comes to mind. Think of a car Traditional choice theoretic models and
behavioral theories differ in their focus when
owner who operates a car with a defective
steering and yet behaves as if the steering
analyzing "behavioral" phenomena. To illus-
were in perfect working condition. He
trate the traditional perspective, consider
spends great effort learning how to drive on
the work of Larry G. Epstein and Stanley E.
a perfectly working car only to crash his
Zin (1989). In that paper, the authors pro-
defective vehicle at every opportunity. vide a synthesis of non-expected utility theo-
Bayes' rule is an implication of the stan-
ry and the Kreps-Porteus model of dynamic
dard model of decision making together
choice. Their purpose is to find a user-
friendly formulation that can be taken to
with the existence of subjective probabilities
and the separation of payoffs and beliefs. macroeconomic data. The theoretical work
There are numerous experiments to of Epstein and Zin formulates assumptions
describe how individuals process informa- on individual behavior that allow deviations
from expected utility and yet maintain the
tion incorrectly, that is, in ways inconsistent
with Bayes' rule. One way in which behav- essential structure used in macroeconomics
ioral models deal with violations of Bayesianand finance.
updating is to assume that individuals apply The work by Epstein and Zin is motivated
Bayes' rule incorrectly or apply it to the by psychological and experimental evidence
wrong underlying stochastic process. The that demonstrates violations of expected
problem with this type of model is that utility
by theory. Yet, it would not be considered
introducing the bias the model has lost the a paper in behavioral economics. While
reason why individuals should hold proba- Epstein and Zin deal with the Allais paradox,
bilistic beliefs to begin with. Why go to theanxiety and other psychological phenomena,
trouble of forming numerical representa- their focus is on the economic implications
tions of likelihoods when those representa- of these effects.
tions are used incorrectly? While it is veryTheoretical work in behavioral economics
plausible that agents make mistakes in infor-
often focuses on the psychology of the situa-
tion using the economic behavior as a win-
mation processing, it seems even more plau-
sible that the remainder of the standard dow into the mind of the decisionmaker. For
model is also wrong given that information isexample, in chapter 3, Richard Thaler dis-
processed incorrectly. cusses his theory of mental accounting.
Dealing with deviations from the standard Mental accounting is a description of the
model often requires more radical depar- thought processes of an economic decision-
tures from standard theory. The chapter on maker. It catalogues how decisionmakers

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 Pesendorfer: Behavioral Economics Comes of Age: A Review 719

perceive and experience outcomes in vari- the decisions of dynamically inconsistent

ous situations and how these decisions are
evaluated.
Thaler (chapter 3, p. 83) notes that sunk
costs play a role in decision making and he
gives the example of season tickets to a the-
ater. In an experiment, season ticket holders
were randomly given a discount on their sea-
son ticket purchase. It turns out that the dis-
agents. Their purpose is to capture "the
human tendency to grab rewards and to
avoid immediate costs in a way that our
'long-run selves' do not appreciate" (p. 223).
The time-inconsistent agents are described
by a sequence of "selves" and the decision
problem under consideration serves to illus-
trate how the conflict between the selves is

played out. O'Donoghue and Rabin ask how

count affects the subsequent probability of
attendance-a fact that is in conflict with
decisionmakers are harmed by their time-
standard economic models. However, over
inconsistency. They compare naive and
time the difference in attendance diminish- sophisticated agents with normal time-
es and in the second half of the season the consistent agents and ask when the time-
difference in behavior between individuals inconsistent agents consume too early or
who paid the full price and those who got acomplete a task too late-where the norm is
discount disappears. defined as the time-consistent decisions.
In Thaler's model, the initial purchase ofComparing naive and sophisticated decision-
the season ticket opens an account in themakers they ask whether naivete or sophisti-
mind of the decisionmaker with a negative cation helps or hurts the agent's well-being.
balance. Every time the individual fails to In this work, as in Thaler's analysis of men-
attend the theater, he experiences a mental tal accounting, economic behavior is the
loss proportional to the price of the seasonstarting point for psychological explorations.
ticket. The agent wishes to offset this lossThe main contribution is to provide an
with a corresponding gain from attending analysis of mental processes and their bene-
the theater and hence is more inclined to gofit or harm for an agent's well-being. While
to the theater if the price of the ticket is the model reproduces the motivating eco-
high. The fact that over time the effect of the nomic evidence and suggests related behav-
sunk cost wears off is interpreted as a depre- iors in similar contexts, the development of
ciation of the mental account that records an applicable economic model is not the
the initial purchase of the ticket. In the sec-
focus of the analysis. Instead, the psychology
ond half of the season, the decisionmakerof the particular situation takes center stage.
apparently closes his mental account for the This is in contrast to Epstein and Zin (1989)
season ticket. We know this because the where the psychological evidence may moti-
sunk cost no longer plays a role. vate the attempt to generalize the prefer-
Note the reversal in the roles of econom- ences. However, the particular formulas are
ics and psychology. The economic evidence not meant as describing a mental process,
is used to flesh out the details of a particular nor is the psychology of decision making the
mental process that is operational for this focus of the analysis.
particular case. If the effect of sunk costs did Standard economic models relate behav-
not wear off after half a season we would ior in different situations. For example, the
conclude that the mental account does not Epstein-Zin axioms describe how the deci-
depreciate over the course of a year.sionmaker behaves in simple situations and
Conversely, if there is no effect of the sunk the formula derived in the representation
cost we would conclude that the account is theorem (applied to an economic decision
"closed" very quickly. problem) describes how decisions are made
In their paper "Doing It Now or Later" in more complicated economic problems.
(chapter 7), O'Donoghue and Rabin analyze The theory does not ask what psychological

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720 Journal of Economic Literature, Vol. XLIV (September 2006)

motives are behind the assumed behavior. objective function or process probabilities
By contrast, economic psychology ex- incorrectly.
plores the psychological mechanisms behind Behavioral economics emphasizes the
economic behavior. An implication of this context-dependence of decision making. A
shift in focus is that the interesting observa- corollary of this observation is that it is diffi-
cult to extrapolate from experimental set-
tions of behavioral theories are often psycho-
logical, that is, about the mental processes tings to field data or, more generally,
behind behavior. The objective of a broadly economic settings. Moreover, not all vari-
applicable economic framework becomes ables that are shown to matter in some
less important, is left for future work or is experiment are useful or relevant in eco-
viewed as a psychologically unrealistic goal. nomic applications. The question whether a
6. Conclusions particular variable is useful or even observ-
able for economics rarely comes up in
Behavioral economics has reached the sta- behavioral models, yet the success or failure
tus of an established discipline. The central of modeling innovations often depends on its
issues and theories discussed in Advances answer.

are familiar to most current PhD students in

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