Behavioral Economics

Behavioral Economics

Overview

Economics traditionally conceptualizes the world according to the assumption that the entire population is comprised of equally informed, educated, and equity maximizing individuals (Homo Economicus). It is argued that behavioral and psychological insights could improve the understanding of economic decisions by: 1. Identifying way in which behavior differs from the standard Homo Economicus model, and 2. showing how this behavior manifests itself in economic terms (Mullainathan and Thaler 2)

Behavioral Economics Theories

Prospect Theory

How people make choices under uncertainty. One needs to understand when indviduals faced with separate gambles treat them as separate gains and losses and when they treat them as one, pooling them to produce one gain or loss.

1. It is defined over change to wealth rather than levels of wealth to incorporate the concept of adaptation
2. The loss function is steeper than the gain function to incorporate the notion of "loss aversion"; the notion that people are more sensitive to descreases in their well being than to increases.
3. Both the gain and loss function display diminishing sensitvity (the gain function is concave, the loss function is convex) to reflect experimental findings.

Assymmetric Value Function

Rational efficient markets hypothesis

Finance Economics

1. Stock prices are "correct" in the sense that asset prices reflect the true or rational value of the security. (not tested because intrinsic values are not observable)
2. Upredictability- in an efficient market it is not possible to predict future stock price movements based on publicly available information

Behavioral Life-Cycle Theory

Savings Economics

1. People have the temptation to spend more of their income now than in the future.

Limits to arbitrage

1. The price of an asset may not equal its fundamental value – this represents a mispricing. However, this mispricing may persist for long periods of time because arbitraging it away may entail significant risks and costs

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Home Page | History of Behavioral Economics | Basic Concepts | Stock Markets | Gambling and Stocks | Gambler's fallacy and Law of Small Numbers |Hunting for Homo Sovieticus: Situational versus Attitudinal Factors | Criticism of Behavioral Economics | Behavioral Economics: Sources

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