Behavioral Economics Phillip Huff

Behavioral Economics:

Re-Modeling Standard Economic Models For Human Irrationality

The standard perception of economics is that all consumers act completely rationally and try to maximize their

profits. However, this perception of economics fails to explain why things like the stock market don't operate with a high

level of efficiency; in fact, the standard model of economics would suggest that the stock market would be much more

efficient than it is. The field of behavioral economics was created in order to fill in the gaps and inconsistencies that were

left behind by standard economic theory. Behavioral economics is a theory that suggests that consumer decisions are prone

to be affected by irrelevant influences, making consumer decisions relatively irrational. To quote Collin Camerer, an

important behavioral economist, “Behavioral economics increases the explanatory power of economics by providing it with

more realistic psychological foundations.”[3] This theory attempts to adjust standard econometric models so that they

reflect consumer irrationality, which follows a predictable pattern, and to also help better understand the way the consumer

thinks and acts (and of course, buys). Behavioral economics is rife with many sub-theories and ideas which each try to

explain individual behaviors that are exhibited by consumers when presented a decision. These sub-theories have been able

to help explain illogical behaviors and phenomenon that are exhibited by consumers. Ironically, this field which threatens

to change many standard economic notions has existed in concept since the very birth of economics itself, but was initially

disregarded then due to it's basis in psychology, which was at the time much less scientific. The field of behavioral

economics, the fusion of psychology and economics, allows economic analysts to understand the decision-making of the

average consumer and previously abstruse economical phenomena.

The concept of behavioral economics has been always closely tied to economics ever since it's birth. In 1759,

Adam Smith, regarded by many as the father of modern economics, published a book in which he talked about principle

which is markedly similar to the behavioral economics principle of loss aversion. Jeremy Benthan wrote a great deal about

the concept of utility which plays a role in behavioral economics. Francis Edgeworth published included a model of social

utility in one of his publications which resembles the basis for the behavioral economics principle, inequity aversion. These

are only some of the many people who began publishing concepts and theories that resemble modern behavioral economics

concepts and theories. However, while the study of Psychology was still young, economic theory abandoned the

psychological basis for economics for a more scientific basis. Colin Camerer and George Loewenstein briefly chronicle the

birth of behavioral economics in their paper, “Behavioral Economics: Past, Present, and Future:”

[1/8]
Behavioral Economics Phillip Huff

“Many coincident developments led to the emergence of behavioral economics as represented in this book. One
development was the rapid acceptance by economists of the expected utility and discounted utility models as
normative and descriptive models of decision making under uncertainty and intertemporal choice, respectively...As
economists began to accept anomalies as counterexamples that could not be permanently ignored, developments in
psychology identified promising directions for new theory.”[3]
In essence, people began revealing anomalies in the models for the standard utility models and started proposing precise and

testable models that served as counterexamples. In 1979, the paper “Prospect Theory: An Analysis of Decision Under Risk”

was published in Econometrica and it showed many occurrences which conflicted with the current model of expected utility

at that time and used psychology to explain these conflicts. Later in 1986 at the University of Chicago, a conference led to

more developments regarding behavioral economics. The Quarterly Journal of Economics released an issue in 1997 that

was devoted entirely to behavioral economics. Some important pioneers of behavioral economics, according to Richard

Hattwick in the article “Behavioral Economics: An Overview,” include George Katona, Herbert Simon, Harvey Leibenstein,

Albert Hirschman and Amitai Etzioni. In the present day, the leading behavioral economist is Dan Ariely, a Duke

University (formerly MIT) professor of behavioral economics, and has published several works, including the well know

Predictably Irrational: The Hidden Forces That Shape Our Decisions. In this book, he described behavioral economics as

follows: “Behavioral economists, on the other hand, believe that people are susceptible to irrelevant influences from their

immediate environment (which we call context effects), irrelevant emotions, shortsightedness, and other forms of

irrationality.” [1](Ariely, 268) Notable behavioral economists who are a part of the Russell Sage Foundation (RSF) include

Daniel Kahneman, Amos Tversky, Richard Thaler, Colin Camerer, George Loewenstein, Matthew Rabin, and David

Laibson. According to the Russell Sage Foundation's website, their behavioral economics program “began in 1986 as a

joint activity with the Alfred P. Sloan Foundation with the aim of strengthening the accuracy and empirical reach of

economic theory by incorporating information from neighboring social science disciplines, especially psychology and

sociology.”[12] All of the notable RSF behavioral economics mentioned above are also in the RSF Behavioral Economics

Roundtable, which consists of well-known researchers in the field of behavioral economics.

Over the many decades that behavioral economics has been in existence, it has developed many theories and

principles on the predictability of a consumer's irrational behavior. Some well known principles include hyperbolic

discounting, also known as temporal discounting, inequity aversion, loss aversion, and prospect theory. There are many

other principles, but to describe them all would be an unnecessary bombardment of mere details, rather than large concepts.

Hyperbolic discounting is documented tendency for people to value earlier rewards over later rewards, even if the later

reward is greater than the earlier one. However, as both rewards are pushed later (the same amount later for each reward),

[2/8]
Behavioral Economics Phillip Huff

the consumer progressively values the larger reward more (regardless of whether it is sooner or not) until it becomes the

preferred choice. Colin Camerer describes an example of hyperbolic discounting in the following in an article in the

Proceedings of the National Academy of Sciences of the United States of America: “For example, people tend to prefer

getting $100 now over getting $110 in a week, but they also prefer $110 in 11 weeks to $100 in 10 weeks, even though both

choices involve waiting an extra week to get $10 more.”[2] Another behavioral economics principle, inequity aversion is a

well-known preference that most consumers have for fairness. In standard economics, the consumer will try to maximize

their profits since the consumer is expected to have a rational mindset. However it has been shown that people will forgo

maximizing their profits if they feel like either they (the consumer) or other people in the deal are not getting a fair deal.

Colin Camerer also presents an example of inequity aversion in the article reference above using “ultimatum games” as a

scenario:

“For example, in 'ultimatum games,' one player offers a portion of $10 to another player and keeps the rest for
herself. The responding player can either accept the offer or reject it and leave them both with nothing. Wealth-
maximizing players will accept anything; thus, the first player should offer very little. Surprisingly to economists,
in many studies in several countries, some with very high stakes, players routinely offer about $4 of $10, and low
offers of less than $2 are rejected half of the time.”[2]
This example shows the error in the expected utility theory of neoclassical economics that so many papers and theories were

pointing out. Neoclassical expected utility would assume that players would accepts anything that they could, but the

opposite was true, the players would only accept offers that give each-other relatively equal deals. Camerer's example is

one of inequity aversion because people would only offer around $4 and that means the receiver would get $4, and the giver

would keep $6, making them relatively equal. If the giver offered $2, that would leave the giver with $8, which is not close

to equal, and the receiver would deny the offer. Similar in concept to inequality aversion, loss aversion is the tendency to

be more impacted by a loss of value than by a gain of value of the same magnitude. Loss aversion proposed as a cause of

the phenomenon called the endowment effect by Kahneman, Knetsch, and Thaler. This proposal was made in the journal

article titled “Experimental Test of the endowment effect and the Coarse Theorem” in the Journal of Political Economy

(1990):

“Thaler (1980) labeled the increased value of a good to an individual when the good becomes part of the
individual's endowment the 'endowment effect.' This effect is a manifestation of 'loss aversion,' the generalization
that losses are weighted substantially more than objectively commensurate gains in the evaluation of prospects and
trades. An implication of this asymmetry is that if a good is evaluated as a loss when it is given up and as a gain
when it is acquired, loss aversion will, on average, induce a higher dollar value for owners than for potential
buyers, reducing the set of mutually acceptable trades.”[9]
Essentially, the seller sees selling their possession as a loss, and since based on the principle of loss aversion, the seller will

want to sell it for more. The endowment effect will be addressed in greater detail later. A well-known behavioral economic

[3/8]
Behavioral Economics Phillip Huff

theory, prospect theory, was presented as a replacement for expected utility theory and was developed by Kahneman and

Tversky. Prospect theory describes how consumers make decisions which involve risk where they know the rewards and

the probabilities for each reward. In the paper referenced much earlier “Prospect Theory: An Analysis of Decision under

Risk,” Kahneman and Tversky go into some detail regarding how prospect theory view's consumer decision-making:

“Prospect theory distinguishes two phases in the choice process: an early phase of editing and a subsequent phase
of evaluation. The editing phase consists of a preliminary analysis of the offered prospects, which often yields a
simpler representation of these prospects. In the second phase, the edited prospects are evaluated and the prospect
of highest value is chosen.”[8]
Prospect theory can be seen as a theory on the human appraisal of risk and reward and the decisions that a person makes

regarding that appraisal. Prospect theory plays an important role in the stock market, where investors constantly evaluate

the risk and reward, often irrationally, of certain stocks and trade according. A deeper analysis of human appraisal in

prospect theory could reveal the causes of stock market inefficiencies and allow investors to change their strategies to

capitalize on human behavior, making the market more efficient.

The behavioral economics principles and theories described above, among others, are useful in understanding

important market and behavioral phenomenon. Some examples of such phenomenon are the endowment effect, mentioned

earlier, herd behavior, time inconsistency, and the money illusion. The endowment effect, which was presented as a product

of loss aversion by Kahneman, Knetsch, and Thaler, is a phenomenon and is described by the observation that people give

items that they own (in their endowment) a higher value than those they do not own. Kahneman, Knetsch, and Thaler

performed an experiment where they the gave mugs to half of a group of economics students and told them that they now

owned those mugs and could sell them, and the other half had the option of buying those mugs. The experiment had the

following result:

“The allocation of a particular mug to each seller evidently induced a sense of endowment that the choosers did not
share: the median value of the mug to the sellers was more than double the value indicated by the choosers even
though their choices were objectively same.”[9]
The experiment found that sense of endowment alone increases the value of an object to the owner. This effect of

endowment also explains the reduction in trading that occurred during the experiment versus when the prices were induced;

the owners valued their mug more than the buyers and inherently the owners would be more likely to put a price on the item

that the buyer would not be willing to take, causing undertrading. An important market phenomenon, herd behavior, which

is when groups of people act together without any sort of planning or coordination. Herd behavior has a wide range of

implications, but the most important implication for behavioral economics is the effect that it has on the stock market. This

behavior is responsible for stock market bubbles and collapses and different types of markets like bear or bull, for example.

[4/8]
Behavioral Economics Phillip Huff

In the article “Herd Behavior and Investment” by David Scharfstein and Jeremy Stein in The American Economic Review,

they state that “investment is also driven by group psychology, which weakens the link between information and market

outcomes.”[13] Herd behavioral essentially undermines rational decision-making, and as a corollary, the neoclassical

model of economics as well. This behavior is important for behavioral economics because it is an anomaly which

behavioral economics needs to better understand so that the standard model can be changed to reflect this lapse of

rationality. It is also an important behavioral overall because of the overarching implications it has. Another important

phenomenon, time inconsistency, is the change of a consumer's preferences over time and how it effects their decision-

making. This phenomenon is well-explained by the behavioral economic principle of hyperbolic discounting. According to

George Loewenstein and Stephen Hoch, “a time-inconsistent choice is one that would not have been made if it had been

contemplated from a removed, dispassionate perspective; it represents a transient alteration in tastes, not a permanent

reevaluation of an alternative due to reciept of new information.” [7] Hyperbolic discounting serves as an factor in time

inconsistency when you look at the concept of temporal proximity. Loewenstein and Hoch “suggests that temporal

proximity not only increases desirability, but also increases impatience.”[7] In hyperbolic discounting, when you change

the temporal proximity of the reward, you can also change the decision. Since temporal proximity is also a factor in time

inconsistency, one can conclude that hyperbolic discounting plays a role in time inconsistencies, or vice versa. The money

illusion is another phenomenon in which money is thought in terms of something besides its purchasing power. The

implication is that people will view a change in income as more drastic than a change in inflation, assuming they produce an

equal change in purchasing power. Money illusion plays an important role in the economy according to Camerer,

Loewenstein, and Rabin.

“Moreover, the paper proposes a psychological account of money illusion based on the presence of multiple
representations. By illustrating the interaction between money illusion and other decision factors such as loss
aversion, risk attitude, and fairness concerns, the paper underlines the potential importance of money illusion in the
economy.”[4](Camerer, 484)
Money illusion is an important phenomenon because it can greatly impact the decisions we make and can effect our

appraisal for principles such as loss aversion. For example, if one thinks that he/she is losing money in a stock, based on the

numerical value of the money, when he/she actually has not yet lost any money based on it's purchasing power due to

deflation, then he/she may hold on to the faltering stock even though he/she could get out and break even.

However, all of these behavioral economics theories and principles are not without criticisms and debate. Mikhail

Myagkov and Charles Plott criticized prospect theory, suggesting that the theory doesn't apply to experienced market

[5/8]
Behavioral Economics Phillip Huff

systems like the stock market for example. To quote the abstract of their paper “Exchange Economies and Loss Exposure:

Experiments Exploring Prospect Theory and Competitive Equilibria in Market Environments:” “Contrary to prospect

theory, risk seeking seems to diminish with experience; preferences in the market setting are not labile; and risk-seeking

preferences are not simply a result of framing effects.”[10] Myagkov and Plott also were criticizing time consistencies /

hyperbolic discounting by stating that preferences in the market setting were not likely to change. Most of the criticisms

that behavioral economics receives is regarding the applicability of behavioral economy theory to a market setting. Many,

including Myagkov and Plott argue that a market setting is much different in the way that consumer's make decisions and

appraise situations, so much different that it makes many behavioral economics principles not applicable. However, many

of the arguments that are made criticizing behavioral economics generally can be disproved with specific, testable

experiments and results. Later, evidence will be cited with contradicts the points made by Myagkov and Platt.

These theories and principles are not just useless concepts which only purpose is to widen human knowledge; the

field of behavioral economics has many implications in macroeconomics. According to Camerer and Loewenstein, “Many

concepts in macroeconomics probably have a behavioral underpinning that could be elucidated by research in psychology.

For example, it is common to assume that prices and wages are rigid (in nominal terms), which has important implications

for macroeconomic behavior.”[3] Behaviors that are described in macroeconomics can be described using behavioral

economics principles and theories. In the example they presented, the “important implications” could be due to the effects

of money illusion; if people think of money in terms of it's face value, then they may not respond to inflation and deflation,

which would affect spending habits and reactions to changes in cost of living or income. A popular version of a theory in

macroeconomics, labor economics, suggests that unemployment is the result of wages being paid above the level which

would balance supply (job positions) and demand (people who want a job) which causes a surplus of workers with not

enough jobs. A behavioral economics approach to why the wages are higher than the equilibrium point suggests that

inequality aversion plays a role in higher wages. Since the worker is being paid more by the employer, the worker

inherently works harder in order to balance out the higher wages, thus avoiding inequality and can still maintain

equilibrium. Camerer and Loewenstein describe an experiment by Fehr and Gachter in the paper referenced above:

“In their experiments there is an excess supply of workers. Firms offer wages; workers who take the jobs then
choose a level of effort, which is costly to the workers and valuable to the firms. To make the experiments
interesting, firms and workers can enforce wages, but not effort levels. Since workers and firms are matched
anonymously for just one period, and do not learn each other's identities, there is no way for either side to build
reputations or for firms to punish workers who chose low effort. Self-interested workers should shirk, and firms
should anticipate that and pay a low wage. In fact, firms deliberately pay high wages as gifts, and workers choose

[6/8]
Behavioral Economics Phillip Huff

higher effort levels when they take higher-wage jobs.”[3]

Evidently behavioral economics does have important implications in macroeconomics and the market, as Myagkov and

Plott argued otherwise. Inequality aversion, a theory that contrasts certain neoclassical economics notions, interestingly

applies to situations that seem quite different than the “ultimatum game” that was used an example.

A similar branch of theory, behavioral finance, explores the idea that investors have limited rationality and is quite

similar to behavioral economics in concept. An important phenomenon in the area of behavioral finance, the equity

premium puzzle, is the observation that average returns to stocks are greatly higher than returns to bonds. To quote Camerer

and Loewenstein: “To account for this pattern, Benartzi and Thaler assume a combination of decision isolation— investors

evaluate returns using a 1-year horizon— and aversion to losses. These two ingredients create much more perceived risk to

holding stocks than would be predicted by expected utility.”[3] In order to account for this observation, people dealing with

stocks would have a higher perceived risk than would be predicted with the standard model for utility, which means that

there is a problem with the current theories regarding market operation. Although the cause of this phenomenon and others

have not yet been fully understood, behavioral economics attempts to discover the cause of these phenomenon. Another

phenomenon, according to Camerer and Loewenstein, is the sheer number of volume in the stock market.

“The so-called 'Groucho Marx' theorem states that people should not want to trade with people who would want to
trade with them, but the volume of stock market transactions is staggering. For example, Odean notes that the
annual turnover rate of shares on the New York Stock Exchange is greater than 75 percent, and the daily trading
volume of foreign-exchange transactions in all currencies is equal to about one-quarter of the total world trade and
investment flow.”[3]
This phenomenon is also another one which behavioral finance is attempted to discover more about: what drives the

exorbitant and irrational amount of volume on the stock market? Behavioral finance attempts to do to notions about the

market system what behavioral economics has done to notions about neoclassical economic models.

The similar fields of behavioral economics and behavioral finances both serve to help change the models and

theories of neoclassical economics so that they better reflect the irrational behaviors that consumers make and shows that

cause of many economical phenomena. Behavioral economics theories and principles like hyperbolic discounting, loss

aversion, inequality aversion, and prospect theory serve as useful tools in understanding economical phenomena like the

endowment effect, herd behavior, time inconsistency, and the money illusion. These theories and principles also serve

useful in understand abstruse finance phenomena like market volume and the equity premium puzzle. To quote a passage

from Dan Ariely's, the leading behavioral economist, book Predictably Irrational:

“We are really far less rational than standard economic theory assumes. Moreover, these irrational behaviors of
ours are neither random nor senseless. They are systematic, and since we repeat them again and again, predictable.

[7/8]
Behavioral Economics Phillip Huff

So, wouldn't it make sense to modify standard economics, to move it away from naïve psychology? This is exactly
what the emerging field of behavioral economics, and this book as a small part of that enterprise, is trying to
accomplish.”[1](Ariely,xx)
Behavioral economics serves as an important field and with it, we can change the way we think about economics for the

better.

Works Cited
[1]Ariely, Dan. Predictably Irrational: The Hidden Forces That Shape Our Decisions. New York: HarperCollins, 2008.
Print.
[2]Camerer, Colin. "Behavioral Economics: Reunifyng Psychology and Economics." Proceedings of the National Academy
of Sciences of the United States of America 96.19 (1999): 10575-0577. Jstor. Web. 11 May 2010.
<http://www.jstor.org/stable/48792>.
I chose the article because it contained information regarding some key principles regarding behavioral economics which
would be useful to reference and explain in my paper.
[3]Camerer, Colin F., and George Loewenstein. Behavioral Economics: Past, Present, Future. Iowa State University, 25
Oct. 2002. Web. 27 May 2010. <http://econ2.econ.iastate.edu/tesfatsi/CamererIntroChapter.AdvancesBE.pdf>.
[4]Camerer, Colin, George Loewenstein, and Matthew Rabin. Advances in Behavioral Economics. New York: Russell Sage
Foundation, 2004. Print.
[5]Hattwick, Richard E. "Behavior Economics: An Overview." Journal of Business and Psychology 4.2 (1989): 141-
54. Jstor. Web. 11 May 2010. <http://www.jstor.org/stable/25092223>.
I chose to include this article despite it's age because it touched on some important, unchanging ideas regarding behavioral
economics like the lack of purely rational thought when making decisions.
[6Heukelom, Floris. Who Are the Behavioral Economists and What Do They Say? Discussion Paper. Tinbergen Institute.
Web. 27 May 2010. <http://www.tinbergen.nl/discussionpapers/07020.pdf>.
[7]Hoch, Stephen J., and George F. Loewenstein. "Time-Inconsistent Preferences and Consumer Self-Control." The Journal
of Consumer Research 17.4 (1991): 492-507. Jstor. Web. 27 May 2010. <http://www.jstor.org/stable/2626842>.
[8]Kahneman, Daniel, and Amos Tversky. "Prospect Theory: An Analysis of Decision Making Under
Risk." Econometrica 47.2 (1979): 263-92. Jstor. Web. 27 May 2010. <http://www.jstor.org/stable/1914185>.
[9]Kahneman, Daniel, Jack L. Knetsh, and Richard H. Thaler. "Experimental Tests of the Endowment Effect and the Coarse
Theorem." The Journal of Political Economy 98.6 (1990): 1325-348. Jstor. Web. 27 May 2010.
<http://www.jstor.org/stable/2937761>.
[10]Myagkov, Mikhail, and Charles R. Plott. "Exchange Economies and Loss Exposure: Experiments Exploring Prospect
Theory and Competitive Equilibria in Market Environments." The American Economic Review 87.5 (1997): 801-28. Jstor.
Web. 27 May 2010. <http://www.jstor.org/stable/2951326>.
[11]Pesendorfer, Wolfgang. "Behavioral Economics Comes of Age: A Review Essay on Advances in Behavioral
Economics." Journal of Economic Business 44.3 (2006): 712-21. Jstor. Web. 11 May 2010.
<http://www.jstor.org/stable/30032350>.
I chose to include this resource because it is recent, goes into detail regarding behavioral economics principles, and touches
on organizing ideas involving behavioral economics.
[12]"Russell Sage Foundation." Russell Sage Foundation: Home. Web. 27 May 2010.
<http://www.russellsage.org/programs/other/behavioral/>.
[13]Scharfstein, David S., and Jeremy C. Stein. "Herd Behavior and Investment." The American Economic Review 80.3
(1990): 465-79. Jstor. Web. 27 May 2010. <http://www.jstor.org/stable/2006678>.

[8/8]