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What is Behavioral Economics?

Margo Upson
By
Updated Feb 15, 2024
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Behavioral economics is the study of the effects of psychology on economic decision making. In other words, how people’s emotions and thoughts can affect how they make decisions about money. One of the first supporters of this idea was Adam Smith. Behavioral economics was later disregarded when a more rational approach was taken in the 1800s. By the mid 1900’s, however, there was a clearer understanding of how much psychology plays into economics.

There are three main ideas in behavioral economics. The first is that people generally act on “rules of thumb” as opposed to rational thought. A rule of thumb is a principle that is mostly true in the majority of situations. An economical example of this is the phrase “you get what you pay for.” This phase is mostly true. However, sometimes cheaper products are just as good, if not better, than the brand with the highest price. It would be rational in this case to buy the cheaper, but just as good, product. Most people, however, would buy the more expensive product, thinking that it is superior.

The second idea is that people’s thoughts on a problem are affected by how the problem is presented. This is called framing. Framing can be seen when stores advertise sales. Product A costs $3.99 US dollars (USD), but it isn’t selling very well. So two stores have each devised a way to sell Product A as quickly as they can by advertising the product in their weekly fliers. The first store advertises it as 75% off the original. The second store advertises it as $3.00 USD off the original price. Both stores are now selling Product A for $ .99 USD. The first store will have more buyers than the second because 75% off sounds like a lot more than just $3.00 off, assuming that the consumer doesn't know the original price. How the discount was presented affected which store the consumers shopped at.

The third idea in behavioral economics is market inefficiencies, which explains outcomes when something other than the expected happens. This concept applies to the stock market. Market efficiency is the idea that prices reflect all the known information available about a stock. No investors know what is going to happen before all of the other investors. Market inefficiency is anything that happens to challenge that idea, in a non-rational way. An example of this is selling overvalued stocks, and using that money to buy undervalued stocks. If done correctly, investors can make a lot of money this way, even if it doesn’t seem rational.

Other ideas in behavioral economics are herding and group think. These state that people will follow whatever is popular at the time, thinking as a group of people instead of as individuals. For example, people who sell their stocks, and empty their bank accounts at the hint of a financial decline can start a panic. Others see it, and decide to do the same, which only continues to harm the economy. People may rationally understand that doing these things will make the economy worse, but because everyone else is doing it, they do it, too.

Behavioral economics can explain times of prosperity and times of economic hardship, as well as predict how people will respond to situations during each. People make financial decisions based on psychology all the time. When considering trends in economics, this emotional decision making should be taken into account to give the most authentic view.

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Margo Upson
By Margo Upson , Writer
With a vast academic background that has ranged from psychology and culinary arts to criminal justice and education, Margo Upson brings a wealth of knowledge and expertise to her role as a WiseGeek writer. Her wide-ranging interests and skill at diving into new topics make her articles informative, engaging, and valuable to readers seeking to expand their knowledge.

Discussion Comments

By comfyshoes — On Dec 05, 2010

I just want to say that Daniel Kahneman’s behavioral economics theory discusses the idea of nudge behavioral economics which means that people are flawed and need a little help in making the right economic decisions.

Obama is from this school of thought which is why there is so much governmental control in his administration.

This form of thinking is condensing because each individual should make their own choices and suffer the consequences good or bad for those choices.

The government has made plenty of mistakes. A perfect example of this theory is in the Cap and Trade bill. The government is going to force us to drive these tiny egg cars because they think it is a better use of our money than buying an SUV. I love SUV’s and will never drive anything else.

By suntan12 — On Dec 04, 2010

SauteePan- The same could be true when there are hurricane or blizzard warnings. People run to the stores to buy their emergency supplies rather than keeping a stash a home before an emergency.

Sometimes the phenomenon to spend has to do with what is perceived as popular. For example, during the Christmas holiday season there are a number of toys that become the “It toy” that everyone is looking for.

Some of these toys are sold out in minutes causing people to buy the toys on sites like EBay. People will go through all kind of lengths to get the toy and next year their child won’t even remember the name of the toy.

By SauteePan — On Dec 03, 2010

Behavioral economics can really be understood with the stock market. The stock market fluctuates according to how people react to news regarding their holdings.

If it is rumored that a company will file for bankruptcy then there will be a huge sell off that stock. It is like a herd mentality. The same could happen with a company that there is a lot of buzz about.

For example, when Apple goes out and releases information on a potential release of a new product, there stock price goes up because people flock to buy the stock. This is the best example of a behavioral economics definition.

Margo Upson

Margo Upson

Writer

With a vast academic background that has ranged from psychology and culinary arts to criminal justice and education,...
Learn more
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