Behavioral Economics

Abstract

Behavioral economics uses evidence from psychology and other disciplines to create models of limits on rationality, willpower and self-interest, and explore their implications in economic aggregates. This paper reviews the basic themes of behavioral economics: sensitivity of revealed preferences to descriptions of goods and procedures; generalizations of models of choice over risk, ambiguity, and time; fairness and reciprocity; non-Bayesian judgment; and stochastic equilibrium and learning. A central issue is what happens in equilibrium when agents are imperfect but heterogeneous; sometimes firms “repair” limits through sorting, but profit-maximizing firms can also exploit limits of consumers. Frontiers of research include careful formal theorizing about psychology and studies with field data. Neuroeconomics extends the psychological data use to inform theorizing to include details of neural circuitry. It is likely to support rational choice theory in some cases, to buttress behavioral economics in some cases, and to suggest different constructs as well. THE THEMES AND PHILOSOPHY OF BEHAVIORAL ECONOMICS Behavioral economics applies models of systematic imperfections in human rationality, to the study and engineering of organizations, markets and policy. These imperfections include limits on rationality, willpower and self-interest (Rabin, 1998; Mullainathan and Thaler, 2000), and any other behavior resulting from an evolved brain with limited attention. The study of individual differences in rationality and learning is also important for understanding whether social interaction and economic aggregation minimize effects of rationality limits. In one sense, behavioral economics is the inevitable result of relaxing the assumption of perfect rationality.

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