Intro to Behavioral Economics: Key Theories, Goals, and Applications

Dec 30, 2023 By Susan Kelly

Psychology and economics are used in behavioral economics to study how individuals and organizations make economic choices. This area studies why people stray from classic economic models' logical predictions. Always making decisions that maximize advantages and enjoyment is ideal. Traditional economics relies on rational choice theory, which states that people choose the option that best meets their requirements when they have limited resources, given they can weigh the pros and drawbacks. Rational choice theory assumes individuals can make good judgments by knowing their preferences and restrictions. It implies that a logical, emotion-free person may determine what's best for them. Behavioral economics claims that irrationality prevents people from making optimum judgments.

Emotional and easily influenced persons sometimes behave against their self-interest. For instance, traditional theory would suggest that someone like Charles, who aims to lose weight and is informed about calorie content, would consistently choose low-calorie foods. However, behavioral economics suggests that Charles's decisions are more complex. Influenced by cognitive biases, emotions, and social factors, Charles might be tempted by a well-priced, appealing ice cream advertised on TV despite his weight loss goals. With its enticing visuals and persuasive messaging, the advertisement could easily derail Charles from his dietary plans, illustrating the challenges of maintaining self-control in the face of compelling external stimuli.

History of Behavioral Economics

Nobel Prize winners Gary Becker, Herbert Simon, Daniel Kahneman, George Akerlof, and Richard H. Thaler have shaped behavioral economics. Becker studied consumer errors and motives, Simon studied bounded rationality, Kahneman studied anchoring and the illusion of validity, Akerlof studied procrastination, and Thaler studied nudging and limited rationality. Adam Smith was among the first to notice people's overconfidence in the 18th century. He found that people often overestimate favorable results and underestimate drawbacks. This early discovery suggested non-rational decision-making.

Amos Tversky and Daniel Kahneman advanced the discipline in the 1960s. They developed the availability heuristic, illustrating how people's judgments are impacted by what's most immediate. Due to media attention, rare yet spectacular incidents like shark attacks may seem more regular. Tversky and Kahneman helped establish prospect theory, which explains how humans value losses and profits. The 2017 Nobel Prize in Economics for Richard Thaler elevated behavioral economics. His research showed how self-control, social preferences, and limited rationality affect economic decision-making.

Key Influences on Behavior

Behavioral economics emphasizes many decision-making factors:

  • Bounded Rationality: People judge based on available facts, frequently constrained by knowledge or information. Financial choices, when investors may not have all essential information, highlight this constraint.
  • Choice Architecture: The way choices are presented can significantly influence decisions. Stores typically display crackers alongside cheese to promote complimentary purchases.
  • Cognitive bias: Subconscious biases influence decision-making. For instance, a company's logo color, CEO name, and location might influence investment decisions.
  • Discrimination: Behavioral economics studies how biases affect choices. This can manifest in favoring one option over another based on subjective preferences rather than objective merit.
  • Herd Mentality: Decisions are often influenced by observing the actions of others. This can range from following trends due to a fear of missing out to supporting a sports team because of shared community sentiment, even if the team is not performing well.

Principles of Behavioral Economics

Behavioral economics, a major subfield of economics, follows various ideas and themes. Let’s discuss some of the major principles of behavioral economics:


This principle revolves around the presentation or context in which information is given. How a scenario or data is framed can significantly influence decisions and perceptions. For example, describing Babe Ruth's batting average (.342) paints a different picture than stating he failed to hit two-thirds of his at-bats, despite both statements referring to the same performance.


This aspect refers to people's mental shortcuts to make decisions quickly rather than through detailed, rational analysis. Often, these shortcuts are based on outdated or incomplete information, leading to persistent but potentially flawed behaviors.

Loss Aversion

The premise that losses hurt more than profits is fundamental to behavioral economics. Losing $20 is usually more upsetting than finding $20. This principle illustrates the disproportionate weight losses hold in decision-making.

Market Inefficiencies

Behavioral economics recognizes that cognitive biases may cause market inefficiencies. Even if a company is overpriced, its lower price may entice investors since it seems cheaper. This perception can create opportunities or pitfalls for investors.

Mental Accounting

This principle highlights how individuals categorize and treat money differently based on its source or intended use. An example is an investor who might take more risks with a recent bonus than their regular income, even though all funds have equal value. This tendency can lead to decisions that deviate from one's long-term financial strategy.

Sunk-Cost Fallacy

This fallacy happens when individuals engage in a losing venture since they've already committed resources, regardless of present or future costs and rewards. An investor may hesitate to sell a $100 investment for $15 owing to emotional connection and unwillingness to accept the loss.

Applications of Behavioral Economics

Behavioral economics has several applications:

  • Financial Markets: Behavioural finance studies why investors make illogical or impulsive judgments. This field exploits opponents' illogical behavior like poker. In financial markets, recognizing investor irrationality might improve trading methods.
  • Game Theory: Behavioural game theory uses behavioral economics to explain irrational behavior. It predicts strategic behavior and shows how cognitive biases affect results.
  • Pricing Strategies: Companies employ behavioral economics to increase sales. The high initial price of a product, followed by a price decrease, makes buyers feel like they're receiving a fantastic bargain. This strategy was used to price the iPhone in 2007.
  • Product Packaging and Distribution: Behavioral economics affects product packaging and distribution. For instance, a soap manufacturer might market the same product in different packaging to appeal to various consumer groups. One package could target general users, while another is labeled for those with sensitive skin, influencing purchase decisions based on perceived specificity.

Examples of Behavioral Economics in Action

Retail Promotions

Payless Shoes offers "buy one, get one" promotions. Customers typically buy more shoes because of a bargain, even if they don't need them.

Limited-Time Offers

Amazon’s Lightning Deals are an example of creating a sense of scarcity and urgency. Consumers, driven by the fear of missing out, may purchase items they don't need, influenced by the time-limited nature of the deal.

Seasonal Products

The seasonal availability of certain Starbucks drinks creates a sense of scarcity, prompting consumers to buy now or miss out. This tactic leverages the desire to seize limited opportunities.

Advertising and Framing

Television commercials and advertising, such as Tesla's website for its Model Y, often employ framing. They highlight a product's strengths and positive aspects, influencing consumer perception and decision-making.

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