Behavioral Economics and Behavioral Finance are closely related fields making up a separate branch of economic and financial analysis using social, cognitive and emotional factors to understand the economic decisions of consumers, borrowers and investors, and their effects on market prices, returns and the allocation of resources.
The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral Finance has become the theoretical basis for technical analysis.
Behavioral analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest.
During the classical period, economics had a close link with psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, an important text describing psychological principles of individual behavior; and Jeremy Bentham wrote extensively on the psychological underpinnings of utility. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a natural science, with explanations of economic behavior deduced from assumptions about the nature of economic agents. The concept of homo economicus was developed, and the psychology of this entity was fundamentally rational. However, this introduced serious errors.
Psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes.
Although psychology had nearly disappeared from economic discussions, during the 20th century there appeared an economic psychology in works of the French Gabriel Tarde the American George Katona and the Hungarian Laszlo Garai Expected utility and discounted utility models began to gain wide acceptance, generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively. Soon a number of observed and repeatable anomalies challenged those hypotheses.
Furthermore, during the 1960s cognitive psychology had begun 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, 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).
An important paper in the development of the behavioral economics and finance fields was written by Kahneman and Tversky in 1979. This paper, ‘Prospect theory: An Analysis of Decision Under Risk’, used cognitive psychological techniques to explain a number of documented divergences of economic decision making from neo-classical theory (Kahneman, 2003). However, ‘Theory of Crime’ written by Nobel Laureate Gary Becker in 1967 was a seminal work that factored in psychological elements into economic decision making; Becker, however, insisted on maintaining strict consistency of preferences. In tracing the history of behavioral economics, reference should be made to the theory of Bounded Rationality by Nobel Laureate Herbert Simon who explained how people irrationally tend to be satisfied, instead of maximizing utility, as generally assumed. Other prominent forerunners of modern behavioral economics include Maurice Allais, whose “Allais Paradox” represented a crucial early challenge to expected utility.
Over time many other psychological effects have been incorporated into behavioral economics, such as overconfidence, projection bias, and the effects of limited attention. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago, a special 1997 edition of the Quarterly Journal of Economics (’In Memory of Amos Tversky’) devoted to the topic of behavioral economics and the award of the Nobel prize to Daniel Kahneman in 2002 “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty”.
Prospect theory is an example of generalized expected utility theory. Although not commonly included in discussions of the field of behavioral economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory.
Behavioral economics has also been applied to problems of intertemporal choice. The most prominent idea is that of hyperbolic discounting, proposed by George Ainslie (1975) and developed by David Laibson, Ted O’Donoghue, and Matthew Rabin, in which a high rate of discount is used between the present and the near future, and a lower rate between the near future and the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with some 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. As part of the discussion of hypberbolic discounting, has been animal and human work on Melioration theory and Matching Law of Richard Herrnstein. They suggest that behavior is not based on expected utility rather it is based on previous reinforcement experience, verbal framing, direct-acting and verbally-governed contingencies. Thus, financial and utilitarian choice making becomes a deterministic process amendable to empirical modelling, investigation, understanding and influence.
Other branches of behavioral economics represent less of a challenge to neoclassical utility theory, enriching the model of the utility function without implying inconsistency in preferences. A great deal of work on “fairness” and “reciprocal altruism” by scholars such as Ernst Fehr, Armin Falk, and Matthew Rabin has weakened the neoclassical assumption of “perfect selfishness.” This work is particularly applicable to wage setting in labor markets. Work on “intrinsic motivation” by Gneezy and Rustichini and on “identity” by Akerlof and Kranton allow agents to derive utility from meeting personal and social norms in addition to consumption.
Note that behavioral economics (enriching economic models by applying psychology) is distinct from experimental economics (using experimental methods to study economic questions). Not all economics experiments are psychological. While many experimental economics studies (such as the ultimatum game and the public goods game) probe psychological aspects of decision making, other experiments explore institutional features or serve as “beta testing” for new market mechanisms. And not all behavioral economics uses experiments; behavioral economists rely heavily on theory and on observational studies “in the field.”