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Behavioral economics and the related field, behavioral finance, study the effects of
social, cognitive, and emotional factors on the economic decisions of individuals and
institutions and the consequences for market prices, returns, and the resource allocation. [1]
The fields are primarily concerned with the bounds of rationality of economic agents.
Behavioural models typically integrate insights from psychology with microeconomic
theory; in so doing, these behavioural models cover a range of concepts, methods, and
fields.[2]
The study of behavioural economics includes how market decisions are made and the
mechanisms that drive public choice.
There are three prevalent themes in behavioural 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.
Economics
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Contents
[hide]

1 Issues in behavioral economics
o
1.1 Behavioral finance

o
1.2 Financial models







1.2.1 Criticisms
o
1.3 Behavioral game theory
o
1.4 Economic reasoning in non-human animals
o

1.1.1 Quantitative behavioral finance

1.4.1 The animal as a human analog

1.4.2 Labor supply

1.4.3 Demand

1.4.4 Monkey trading behavior
1.5 Evolutionary psychology
2 History
o
2.1 Prospect theory
o
2.2 Intertemporal choice
o
2.3 Other areas of research
3 Criticisms
4 Notable behavioral economics theorists
o
4.1 Economics
o
4.2 Finance
5 See also
6 References
7 Notes
8 External links
Issues in behavioral economics[edit]
Behavioral finance[edit]
The central issue in behavioral finance is explaining why market participants make
systematic errors contrary to assumption of rational market participants. [4] 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, behavioral
economics' academic cousin, to be the theoretical basis for technical analysis.[5]
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.[6] 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.[7]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[edit]
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.[8] Leading contributors include Gunduz Caginalp (Editor of
the Journal of Behavioral Finance from 2001–2004) and collaborators including 2002
Nobelist Vernon Smith, David Porter, Don Balenovich,[9] Vladimira Ilieva and Ahmet
Duran,[10] and Ray Sturm.[11]
Financial models[edit]
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.[12]

The stock image coefficient
Criticisms[edit]
Critics such as Eugene Fama typically support the efficientmarket hypothesis. They contend that behavioral finance is
more a collection of anomalies than a true branch
of finance and that these anomalies are either quickly priced
out of the market or explained by appealing to market
microstructure arguments. However, individual cognitive
biases are 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.[13]
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.[14] 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[edit]
Behavioral game theory analyzes
interactive strategic decisions and behavior using
the methods of game theory,[15] experimental economics,
and experimental psychology. Experiments include testing
deviations from typical simplifications of economic theory
such as the independence axiom[16] and neglect
of altruism,[17] fairness,[18] and framing effects.[19] On
the positive side, the method has been applied to interactive
learning[20] and social preferences.[21][22] As a research
program, the subject is a development of the last three
decades.[23]
Economic reasoning in non-human animals[edit]
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 rats and pigeons. These studies draw on the tenets
of behavioral psychology, where the main goal is to discover
analogs to human behavior in experimentally-tractable nonhuman animals. They are also methodologically similar to the
work of Ferster and Skinner.[24] Methodological similarities
aside, early researchers in non-human economics deviate
from behaviorism 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 stimulus–response relationships, but
instead in terms of work, demand, budget, and labor. Recent
studies have adopted a slightly different approach, taking a
moreevolutionary perspective, comparing economic behavior
of humans to a species of non-human primate, the capuchin
monkey.[25]
The animal as a human analog[edit]
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 analog to human labor
supply.[26] Researchers in this field advocate for the
appropriateness of using animal economic behavior to
understand the elementary components of human economic
behavior.[27] In a paper by Battalio, Green, and Kagel (1981, p
621),[26] 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[edit]
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.[26]
Demand[edit]
In human economics, a typical demand curve is negative. This
means that as the price of a certain good increases, the amount
that consumers are willing to purchase decreases. Researchers
studying demand curves in non-human animals such as rats
observe that demand curves have negative slopes, consistent
with the slope of human demand curves.
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.[28]
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[edit]
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 [25] 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,
and risk 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.[25]
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[edit]
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.[29]
History[edit]
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,[30] 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,[31] George Katona,[32] and Laszlo
Garai.[33] 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,[34] 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).[35]
Prospect theory[edit]
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.[36] 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 the University of Chicago,[37] 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".[38]
Intertemporal choice[edit]
See also: Time inconsistency
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 t when 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.[citation
needed]
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[who?] 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[edit]
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.
"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 quasipublic policy topics such as broadband mapping.[41][42]
Criticisms[edit]
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.[citation needed]
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.[citation needed]
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 between experimental
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.[citation needed]
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.[verification needed]
Notable behavioral economics theorists[edit]
Economics[edit]

Dan Ariely[45]

B. Douglas Bernheim [46]

Colin Camerer

Ernst Fehr

Daniel Kahneman

Simon Gaechter

Armin Falk

George Loewenstein

Urs Fischbacher

Drazen Prelec

Matthew Rabin

Herbert A. Simon

Paul Slovic

Vernon L. Smith

Larry Summers

Richard Thaler

Amos Tversky

John Quiggin

Margaret McConnell
Finance[edit]

Malcolm Baker

Nicholas Barberis

Gunduz Caginalp

David Hirshleifer

Andrew Lo

Michael Mauboussin

Terrance Odean

Richard L. Peterson

Charles Plott

Hersh Shefrin

Robert Shiller

Andrei Shleifer

Richard Thaler

Robert Vishny
See also[edit]

Book:
Finance

Adaptive market hypothesis

Behavioralism

Behavioral finance

Behavioral operations research

Cognitive bias

Cognitive psychology

Confirmation bias

Cultural economics

Culture change

Economic sociology

Emotional bias

Experimental economics

Experimental finance

Fuzzy-trace theory

Habit (psychology)

Hindsight bias

Homo economicus

Important publications in behavioral finance

Journal of Behavioral Finance

List of cognitive biases

Methodological individualism

Neuroeconomics

Observational techniques

Praxeology

Rationality

Repugnancy costs

Socioeconomics

Socionomics
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Daniel, K.; Hirshleifer, D.; Subrahmanyam, A. (1998).
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
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External links[edit]

Overview of Behavioral Finance

Geary Behavioural Economics Blog, of
the Geary Institute at University College
Dublin

Society for the Advancement of
Behavioural Economics

Behavioral Economics: Past, Present,
Future – Colin F. Camerer and George
Loewenstein

A History of Behavioural Finance /
Economics in Published Research: 1944–
1988

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