Updated Jan 3, 2023 Behavioral economics is a method of economic analysis that applies basic psychological insights to people’s behavior to explain their actions and decision-making. It is a valuable addition to conventional economic theory because it adds a human element, which can help to explain certain inconsistencies and make economic models more applicable to the real world. Although this field of research is extremely extensive, we can summarize three key insights from behavioral economics that apply to most economic models: (1) People aren’t always rational, (2) People care about fairness, and (3) People are inconsistent over time. Despite the widespread economic assumption that people act like perfectly rational beings (i.e., Homo economicus), they aren’t always rational. That is, many economic models inherently assume that people always weigh all the costs and benefits of their actions and rationally choose the best possible option to maximize their profit or utility. However, in reality, people are far more complex than that. Although they are perfectly capable of making rational decisions, they can also be emotional, impulsive, short-sighted, or otherwise irrational at times. Some of the most common imperfections of human reasoning include overconfidence, distorted perception, and stubbornness. For a complete list, check out our post on the limits of Homo economicus. To give an example of irrational decision making, meet Joe, who is in the market for a new electric car. He is thinking about buying a brand new Edison Model E. To learn more about the vehicle, Joe reads 100 customer reviews online. Most of which are positive. In addition to that, he also talks to a friend, Jane, who recently bought the same model. Now, an entirely rational human being would realize that Jane’s review only increases the sample size by 1% (i.e., from 100 to 101) and should, therefore, not have a significant impact on the final decision. However, Joe values her opinion more than the online reviews because he trusts her, and her story is more vivid than all the online reviews. People’s decision making is partly determined by a sense of fairness, even if that makes them worse off. That means they shy away from accepting or making offers that they feel are not fair. Conventional economic theory suggests that people always maximize their profit. Thus, by that logic, they would accept every offer that makes them better off, regardless of how small the additional value is. Similarly, they would maximize their own wealth and offer only the least possible benefit to others when they are in a position of power. As it turns out, however, people often prefer to be worse off themselves than to accept unfairness. To illustrate this, let’s revisit Joe. Assume he has bought his new car and now uses it every day to go to work. That’s about a 20-minute drive. One day, one of his coworkers, Jake, approaches Joe and asks if they can carpool. Since Jake does not own a car himself, he offers to contribute USD 1.00/month as gas money. Not surprisingly, Joe does not think that’s a fair contribution and therefore rejects Jake’s proposal. Although absolutely understandable, this behavior is irrational if we look at it from a purely economic perspective. After all, Joe has to drive to work anyway, and he could have saved at least a bit of money if he’d accepted the proposal. People tend to underestimate the impact or significance of activities or events, the further into the future they are. That means, they often make plans for the future but then don’t follow through, because tasks to be done turn out to be more challenging than anticipated when the time has come. Economically speaking, in those situations, the need for instant gratification often outweighs potential future benefits. To give an example, assume that our friend Joe wants to live a healthier life. To do that, he decides to cut all the candy from his diet. He knows that if he sticks to this plan, it will benefit him in the long run. However, by the time he gets to the candy aisle in his local supermarket, he can’t resist the temptation and buys a whole bunch of candy. All of a sudden, he thinks to himself, he’ll still have enough time to live healthily in the future anyway. In other words, because the benefits of his actions lie so far in the future, but the gratification of eating candy is instant, Joe chooses sweets, even though he’ll regret it later. Behavioral economics is a method of economic analysis that applies basic psychological insights to people’s behavior to explain their actions and decision-making. We can summarize three key insights from behavioral economics that apply to most economic models: (1) People aren’t always rational. Unlike a Homo economicus, real people can be emotional, compulsive, or otherwise irrational. (2) People care about fairness. They’ll reject offers they consider unfair, even if that makes them worse off. And finally, (3) People are inconsistent over time. They tend to prefer instant gratification over possible future benefits.1. People aren’t always rational
2. People care about fairness
3. People are inconsistent over time
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