The study of this “new” branch of economics is, by its very nature, interdisciplinary in character, and requires the collaboration of psychologists, sociologists, marketing researchers, decision-behaving theorists, financial economists, macro economists and accounting researchers, among others.
Indeed, for some time now psychology, cognitivism and economics have opened and interlaced their respective doors and paths to analyze the economic behavior of agents and better understand their decisions and the impact on markets, prices, benefits and the allocation of resources.
However, the relationship between economics and psychology is not new. Adam Smith wrote an important text describing the psychological principles of individual behavior, “Theory of Moral Sentiments” (1759).
Jeremy Bentham wrote extensively on the basics of utility. His main work was the “Introduction to the principles of morality and legislation” (1789). Its foundations were:
- The goal of ethics must be the common good. Philosophy and humanity must concentrate on offering solutions to the question of how to obtain happiness
- The maximum good for the maximum number of people
- Pleasure can be measured (felicific calculus) (see ower post about happiness)
- The limit is in the impositions against the freedom of others
Economists began to distance themselves from psychology during the development of neoclassical economics as they sought to redefine discipline as a natural science, with explanations of economic behavior inferred 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, psychological explanations continued to appear in the analysis of many important figures in the development of neoclassical economics, such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes.
Nobel of Economy 2017
On October 9, 2017, the Royal Swedish Academy of Sciences awarded Richard H. Thaler the Nobel Prize in Economics for his studies on behavioral economics. In the citation of his award, the Academy said that his research had used psychologically realistic assumptions in the analysis of economic decision making, exploring the consequences of limited rationality, social preferences and lack of self-control.
We talk about Thaler and his ideas about “the little push” (Nudge Theory) in a past post about the forms of influence. A nudge is any aspect of the decision-making architecture that modifies the behavior of people in a predictable way, but without prohibiting any option and without significantly changing the economic incentives. For an intervention to be considered a nudge, it must be possible (to create it and) to avoid it easily and cheaply. The nudges are not orders, since their introduction should not prevent people from being free to choose, but they are going to try to guide their decisions so that they improve their lives, that is, they benefit from them in their own judgment. It is based on the science of behavior: that positive reinforcement and indirect suggestion are more effective than prohibition and punishment when modifying behaviors.
Richard H. Thaler is also known for his collaboration with Daniel Kahneman (see our posts on decision making and intuition). Thaler’s contributions to economic science are extensive and are superbly collected in his recent book “Misbehaving: The Making of Behavioral Economics”.
The economy of behavior revolves around the idea that people, when making decisions, make errors of judgment that usually follow certain patterns or biases. So much so that some investors use checklists or decision diagrams that include checking for the existence of these emotional tendencies or cognitive biases in their investment decision making.
The “Prospect theory” identifies some of these cognitive biases:
- Loss aversion: Lack of objectivity on the loss-earnings balance.
- Endowment effect: a thing perceived as our worth more to us than its real price.
- Heuristics of Representativeness or Probability Negligence: overestimate unlikely events and underestimate very probable events.
- Confirmation heuristics: tendencies to confirm what we already thought
Thaler’s first contributions focused on listing and identifying several of these cognitive biases. In addition to the endowment effect, it talks about mental accounting, lack of self-control and the framing effect:
- The mental accounting tries to explain the habit that we have of pigeon-holing our income in different accounts (the account of the current expenses, the account of the education of our children), when the money is perfectly fungible.
- The lack of self-control, by which people prefer to bear additional expenses to having to suffer the decision not to spend or consume in a certain way or occasion.
- The framing effect. The form of presentation of the information, the available resources and the state of mind substantially modify the perception of the same information and can lead to different conclusions.
Behavioral finance is a new field of research that takes into account the cognitive and emotional factors that influence the decision-making processes of individuals, groups and organizations.
The classical paradigm of financial theory assumes that investors are rational, well informed and make rational decisions in efficient markets. However, there is ample evidence to suggest that this paradigm is not adequate to describe the observable behavior of individuals in financial markets (Elton, Gruber, and Busse, 2004, Stewart, 2006).
The key observations documented in the behavioral finance literature include the lack of symmetry between decisions to acquire or maintain resources, colloquially called the “bird in the bush paradox“, and the strong aversion to loss or repentance attached to any decision where some Emotionally valuable resources (eg a house) can be totally lost. Aversion to losses seems to manifest itself in the behavior of investors as a lack of inclination to sell shares or other securities if doing so can force the seller to make a nominal loss (Genesove & Mayer, 2001). It can also help explain why housing market prices do not adjust down to the level of market equilibrium during periods of low demand.
Applying a version of the prospective theory, Benartzi and Thaler (1995) claimed to have solved the paradox of the overpricing of stocks, something that conventional financial models had been unable to do.
Criticism of behavioral finances
Critics of behavioral finance, such as Eugene Fama, typically support the Efficient-market Hypothesis. They argue that behavioral finances are more a collection of anomalies than an authentic branch of finance and that these anomalies will normally be valued outside the market or explained with market microstructure arguments. However, a distinction must be made between individual trends and social trends; the first ones can be averaged by the market, while the others can create feedback loops that lead the market further and further from equilibrium.
In parallel to behavioral economics other models of great interest are developed that in this post we only aim and that perhaps will be the object of our attention shortly: Happiness Economics; Narrative Economics and the Economy of Ideas (Idea Economy). You can review other fields of today’s economy in our post on heterodox economics.
If you want to know more …
Thaler, R.H. (2016) Behavioral Economics: Past, Present, and Future. May 27, 2016.
Shiller, R.J. (2017) Narrative Economics. Cowles Foundation Discussion Paper No. 2069. January 2017.
Weiers, G. (2013) Innovation through cooperation: The emergence of an Idea Economy. Springer.
Elton, E.J. et al. (2004) Are Investors Rational? Choices among Index Funds. The Journal of Finance, 59(1):261-288.
Stewart, P. (2006) Behavioral Finance-Not To Be Ignored. Trusts & Estates, 145(6):46-50.
Kahneman, D and Tversky, A (1974). Judgment under uncertainty: Heuristics and Biases, Science New Series, 185 (4157):1124-1131.
Kahneman, D and Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2):263-292.
Thaler, R. H. (1999) The End of Behavioral Finance. Financial Analysts Journal, 56(6):12-17.
Fama, E. F. (1998) Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics, 49: 283-306.
CaixaBank (2017) Dossier: En Busca de la felicidad. Informe mensual no. 414. Julio-Agosto 2017.
Other web pages of interest in the subject: