About Behavioral Economics
Behavioral economics explores the foundations of decisionmaking by seeking to integrate insights from psychology and other social sciences into standard economic theory. A favored approach of researchers in the field is the use of controlled experiments and observation to study economic behavior under various conditions.
What is “behavioral economics”?
To some extent, all economic research is about “behavior.” Until recently, however, economists have relied on some key simplifying assumptions about how humans behave to make their research problems more tractable. These assumptions include the following:
- Individuals have no self-control problems.
- Individuals have strong information-processing and problem-solving abilities.
- Individuals maximize their self-interest defined by stable “utility functions.”
Most of the time, these simplifying assumptions are innocuous. At other times, however, the assumptions may confuse our understanding and misinform policymakers. Here are some examples:
Self-Control: Many people report that they lack the “will power” to save for the future. At the start the year, it is easy to plan to put aside a certain amount each month, but when it comes time to put money in the bank, many people are tempted to spend the money instead. The traditional economic model cannot explain this lack of self-control because it implies that plans should always be carried out unless some new information about the future arrives.
Information-Processing: The modern economy offers us a blizzard of information. Keeping up with changing prices for goods and services and forecasting our future demand for goods and services are daunting tasks. Just as difficult is figuring the proper price of assets like houses, stocks, and financial instruments. The standard model states that asset prices are determined by expected benefit flows to their owners, but these flows can only be forecasted imperfectly. Many economists believe that the stock-market “bubble” of the late 1990s was an example of this phenomenon. Because people could not accurately forecast the fundamental value of new stocks, they based their judgments on the stocks’ recent price behavior.
Self-Interest: The “homo economicus” of the standard economic model is assumed to act as if he were maximizing a stable “utility function,” which defines his preferences for goods and leisure. His actions on behalf of others are usually motivated by some psychic or monetary return in the future, not out of “altruism” or a genuine concern for others. Yet people do not always behave selfishly – they tip waitresses and cabdrivers they will never see again, they help less fortunate people who will never be able to repay them, and they give money to charities that will never help them personally. Additionally, human utility functions do not appear stable over time. We change our demand for particular goods or types of leisure as we grow older in ways that are not related to prices – the standard driving force of the traditional model.
How does behavioral economics approach these issues?
Although behavioral economics questions the standard models of behavior, it strives to maintain the high degree of analytical rigor that economists demand. It is not enough to say that agents are “not fully rational” or “altruistic” and leave it at that. Behavioral economics tries to answer how the traditional assumptions of perfectly rational consumers and investors with unlimited information-processing power fail, and why these failures matter for economics and monetary policy. Sometimes, the approach is to change the function that agents are assumed to maximize, in order to allow their behavior to more closely approximate psychological regularities. Other times, researchers try to make precise statements about how the human brain processes information or makes decisions that may be in conflict with traditional assumptions.
How can behavioral economics influence macroeconomic policy?
Behavioral economics is potentially valuable in a number of areas. When the Fed lowers interest rates, for example, the additional liquidity interjected into the economy will stimulate the economy more if price-setters do not simply mark up their prices in response. Understanding how agents set prices is currently an active area of macroeconomic research. Behavioral economics explores the information problems and decision biases of individual agents, including price-setters, and can therefore be helpful in understanding the effects of Fed policy. Additionally, about two-thirds of the economy is accounted for by private consumption. Behavioral research has been very active in determining how people actually make consumption decisions, which is potentially useful in charting how the economy will behave in the future.
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