How Behavioral Economics Changed Economic Research

Abstract

Over the past thirty years, economic research has undergone a real revolution. Drawing on the results of numerous laboratory and field experiments, behavioral economists have extended the classical model so that it better explains and predicts human decisions. Interdisciplinary, behavioral economics combines discoveries from other social sciences and traditional approaches to economic research. Where classical economic theory assumes rationalism and personal advantage, behavioral economics admits that humans are social beings with a multitude of motives who, while trying to make the right choices, can also be wrong.

For a long time, behavioral economic research has long been influenced by the homo oeconomicus model, a key concept in classical economic theory. Homo economicus is a rational decision maker who pursues his sole economic interests.

There is no doubt that the traditional model has serious advantages. First, it is based on a few simple assumptions and can therefore be applied on a large scale. This universality is an advantage of economics over other social sciences such as psychology or sociology, where theories are often contextual and difficult to generalize. Then, the theory of rational self-interest makes it possible to formulate surprisingly precise forecasts… in certain contexts! The experiments of Vernon Smith, a pioneer of experimental economic research, demonstrated, as early as the 1950s and 1960s, that classical theory could successfully predict the trade balances of competitive markets.

The foundations of behavioral economics were laid when economists took a closer look at strategic interactions outside of classical market structures. In the 1960s and 1970s, game theory – a mathematical concept for the analysis of strategic decisions – thus gained in importance. In the early 1980s, creative economists began to experimentally test prognoses of social interaction established according to game theory. These tests quickly showed that, to explain human behavior in strategic situations, traditional theories of rationalism and personal advantage were not enough.

Motivated by this disconnect between observed behavior and the prognoses of standard theory, behavioral economists have attempted since the late 1980s – and despite a strong initial reluctance from their peers – to adapt economic theory so that it can better explain and predict actual human behavior. Their work often drew on existing findings from related disciplines such as psychology, biology, sociology or neurology.

For most behavioral economists, the goal has never been to reject the traditional model entirely. Thus, personal advantage is still seen as an important driver of human behavior and the majority of behavioral economists also believe that people try to make their choices as rationally as possible. Unlike the proponents of classical theory, they understood that besides personal advantage, other motives were also relevant, and the path of rationality could also be synonymous with failure.

Loss aversion, an economic factor

Over the past thirty years, behavioral economics has documented a wide variety of human behaviors that the classical model is unable to explain. Our degree of satisfaction, for example, depends less on how much we have of a thing and more on the extent of the change it has undergone. Someone who suddenly becomes rich is – for a time – more satisfied than before, whereas people who have always lived-in wealth and used to living on a big foot are, on average, not much happier than other.

We seem to constantly compare our achievements to so-called benchmarks. While a pleasant surprise like an unexpected bonus makes us happy, a bad surprise like the collapse of stock prices affects our well-being. It is interesting to note that in these comparisons, we always place more importance on the losses than on the gains. In other words, most people are much more affected by a loss of 1000 dollars than they are overcome by the gain of the same sum. This is called loss aversion. Psychologists Daniel Kahneman and Amos Tversky were the first to document it in the late 1970s. Since then, it has been repeatedly confirmed in numerous laboratory and field experiments.

The fact that humans generally think in terms of comparisons and that our well-being is more affected by losses has important implications for economic choices. For example, loss aversion pushes people to avoid risk, even if it comes at high costs. Insurance for rental cars or electronics is a good example. Because people want to avoid losses at all costs, they are willing to pay a huge price for this kind of insurance, even though the objective risk of high damage is relatively low. Added to this is the tendency to significantly overestimate the low probabilities.

Another implication of loss aversion is that it increases susceptibility to certain sales techniques. Promotional offers work because, in the perception of consumers, not getting the product in question is a loss. They are even willing to pay a high price for a substitute product when the original supply is no longer available. This principle also explains why car salesmen often start by presenting their customers with a fully equipped model. After that, the customer will feel every missing option as a loss.

Unfair pay cuts

Another major finding from behavioral economics is that when making strategic decisions, individuals often deviate from maximizing personal benefit. Very early on, the experiences of behavioral researchers like Werner Güth, Richard Thaler or Ernst Fehr convincingly demonstrated that many people are willing to reward the fair actions of others or punish injustices – even if they incur significant costs. Equity does not have the same value for everyone, however: while some are willing to take a lot in order to achieve a fair outcome, many others seek personal benefit instead. Equity also decreases when you think you are out of sight or know how to hide your egoism.

The integration of social reasons in economic theory makes it possible to explain empirical phenomena which are not in line with the classical model. An example: in times of recession, employers are more inclined to lay off their employees than to cut wages. Why? Pay cuts are often seen as unfair. There is therefore a risk that workers will punish the employer by reducing their benefits. Reasons for fairness can also explain why people are determined to uphold social norms and fight crime. The civil courage that some people show in the face of litter in parks or nuisance in public space is a good example. Conversely, strangers who will never meet again are often ready to help each other. Just think of anonymous donations or people helping accident victims.

Social reasons can also have an influence on the formulation of contracts or the style of conduct of managers. In studies with Ernst Fehr and Oliver Hart, we demonstrate that, in contradiction to classical theory, it makes sense to formulate contracts very rigidly, as this can prevent conflicts in economic relations. In a recent work with John Antonakis, Giovanna d’Adda and Roberto Weber, we analyzed the effect of motivational speeches by business leaders. It turns out that the motivational boost given to employees by a charismatic speech is comparable to the effect of financial incentives.

Living in the present

Intertemporal decisions are also important in behavioral economics: many choices made on a daily basis have a direct effect on the near future, but also consequences in the more distant future. This applies to all types of investments (financial investments, training, security) as well as to many choices in terms of consumption (drugs, healthy food). Classical theory asserts that rational actors carefully assess the immediate and future consequences, and then make the optimal decision. However, research findings by David Laibson and Matthew Rabin suggest that most people underestimate the long-term impact in favor of the immediate effect.

The tendency to give more importance to the present than to the future explains many problematic economic behaviors such as insufficient retirement provision in countries like the United States or the increase in overweight, addictions and over-indebtedness. By identifying the causes of these phenomena, behavioral economists have paved the way for targeted methods such as soft incentives (“nudges”) or choice by default (see box ).

We can therefore conclude that by taking into account the work of related disciplines, behavioral economics has broadened and adapted the economic model, so that it can better explain and predict the approach followed in many decision-making processes. A realistic view of humans is necessary, because in order to be able to provide relevant analyzes and propose interventions with a chance of success, economists must understand the cause of economic developments on a behavioral level.

Bibliography

  • Ariely Dan, It’s (really?) Me who decides: The hidden reasons for our choices , 2008, Flammarion.
  • Fehr Ernst, Hart Olivier and Zehnder Christian, “Contracts as Reference Points – Experimental Evidence”, American Economic Review , 101 (2), 2011, pp. 493–525.
  • Kahneman Daniel, System 1 / System 2: The two speeds of thought , 2012, Flammarion.
  • Levitt Steven and Dubner Stephen, Freakonomics , 2007, Folio.
  • Thaler Richard and Sunstein Cass, Nudge: The Soft Method to Inspire the Right Decision , 2012, EVOL DEV’T PERS.
  • Zehnder Christian, Herz Holger and Bonardi Jean-Philippe, “A Productive Clash of Cultures: Injecting Economics into Leadership Research”, Leadership Quarterly , 28 (1), 2017, pp. 65–85.

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