what is behavioral economics 
behavioral economics is the study of psychology as it relates to the economic decision making processes of individuals and institutions behavioral economics is often related with normative economics it draws on psychology and economics to explore why people sometimes make irrational decisions and why and how behavior diverges from the predictions of economic models investopedia mira norianunderstanding behavioral economicsin an ideal world people would always make optimal decisions that provide them with the greatest benefit and satisfaction in economics rational choice theory states that when humans are presented with various options under the conditions of scarcity they would choose the option that maximizes their individual satisfaction this theory assumes that people given their preferences and constraints are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them the final decision made will be the best choice for the individual the rational person has self control and is unmoved by emotions and external factors and hence knows what is best for himself alas behavioral economics explains that humans are not rational and are incapable of making good decisions because humans are emotional and easily distracted beings they make decisions that are not in their self interest for example according to the rational choice theory if charles wants to lose weight and is equipped with information about the number of calories available in each edible product he will opt only for food products with minimal calories behavioral economics states that even if charles wants to lose weight and sets his mind on eating healthy food going forward his end behavior will be subject to cognitive bias emotions and social influences if a commercial on tv advertises a brand of ice cream at an attractive price and quotes that all human beings need 2 000 calories a day to function effectively after all the mouth watering ice cream image price and seemingly valid statistics may lead charles to fall into the sweet temptation and fall off of the weight loss bandwagon showing his lack of self control behavioral economics and behavioral finance are often driven by many of the same factors though behavior finance is often more related to financial markets history of behavioral economicsnotable individuals in the study of behavioral economics include nobel laureates gary becker motives consumer mistakes 1992 herbert simon bounded rationality 1978 daniel kahneman illusion of validity anchoring bias 2002 george akerlof procrastination 2001 and richard h thaler nudging 2017 in the 18th century adam smith noted that people are often overconfident with their own abilities noting the chance of gain is by every man more or less over valued and the chance of loss is by most men under valued and by scarce any man who is in tolerable health and spirits valued more than it is worth 1 in this sense smith believed individuals are not rational with their own limitations more recently behavioral economics took shape as early as the 1960 s when several economists identified key biases when recalling information this idea called availability heuristic was explained by amos tversky and daniel kahneman and it leads individuals to irrationally interpret data 2 for example shark attacks tend to happen less than people think but headlines may make people feel otherwise tversky and kahneman are also credited with developing prospect theory how people are potentially more adverse to losses as opposed to receiving an equal win in 2017 richard thaler received the sveriges riksbank price in economics science for his work in identifying factors that guide individuals economic decision making thaler s work included limited rationality social preferences lack of self control and individual decision making factors that influence behaviorthere are often five factors that are cited when analyzing how individual behavior is influenced bounded rationality is the idea that individuals make decisions based on the knowledge they have unfortunately this information is often limited whether by the individual s lack of expertise of lack of available information in regards to finance and investing the same public information is available to everyone though investors may not know true circumstances of what is happening with a company internally people can be easily manipulated and this is often on display in the way promoters craft incentives or deals to make consumers buy certain products consider how a cracker display may be presented right next to the cheese aisle within a supermarket this type of design is meant to steer a consumer into making a decision based on a choreographed demonstration often between complementary goods whether people realize it or not everybody makes decisions that are influenced by cognitive bias consider the choice of choosing between two companies to invest in behavioral economics holds the theory that the color of the logo the name of the ceo or the city in which each company is headquartered in may stir up an unknown bias that yields us to choose the other company in a similar light behavioral economics is often associated with discrimination people perceive things events or other people through their own lenses potentially discriminating towards others because they simply favor a different alternative this does not necessarily mean the alternative is a better option though many consumer decisions are influenced by what other people are doing whether it is the fear of missing out or whether others want to be part of a larger collective herd mentality is the belief that individual decisions are swayed based on what other people do not necessarily on what is the best outcome after all it is much easier rooting for your favorite team even if they haven t won a championship in a while as long as other fans share your pain the media plays a critical part in behavioral economics consider how a single headline can grab your attention and make you want to either pursue or avoid a product principals of behavioral economicsthe field of economics is vast although behavioral economics is just a subset of the field it itself has a number of guiding principles that dictate the themes within behavioral economics some of the primary principles and themes are listed below framing is the principle of how something is presented to an individual this behavioral economics concept presents a cognitive bias in that an outcome may be determined based on the structure of how something has been presented consider how someone may feel about the two following statements about babe ruth both of which are describing the same thing heuristics is a complicated field but it simply means that humans tend to make decisions using mental shortcuts as opposed to using long rational optimal reasoning most often people latch onto something as true even if it may no longer be the case in this situation it s easier for the consumer to continue what they ve been doing as opposed to realizing a more beneficial situation exists behavioral economics is rooted in the notion that people do not like losses in fact people are loss averse to the point that an economic outcome of one financial value that is negative outweighs the emotional toll of the same financial value but positive for example some people feel there is much stronger negative emotions associated with losing a 20 bill compared to finding a 20 bill on the ground for lack of a better phrase the market can take advantage of behavior economics for this reason market inefficiencies play a crucial part in behavior economics consider how overpriced stocks may still lure in investors due to drops in p e ratios though the trading multiple may still be abnormally high investors may think something in the market is more reasonable simply because it is lower for example a stock worth 20 may be trading at 50 should the price to 40 investors may feel this is a great opportunity consumers and investors may change their spending and trading tendencies based on circumstances though this is fair often times it is illogical and shapes many aspects of behavioral economics for example after receiving one s annual bonus an investor may choose to invest in riskier stocks this mental accounting exercise led an investor to make a decision based on their circumstances not their long term strategy the sunk cost fallacy is the emotional attachment to costs that have been incurred in the past consumers and investors tend to have a harder time letting go of failed investments or committed capital consider a failed stock that was purchased at 100 share that is now worth 15 share an investor may not feel compelled to buy in at 15 share because they think the company is not worth that however they are unwilling to sell their shares bought at 100 share due to an emotional attachment to that committed capital 