Behavioral economics is an interdisciplinary field on the border of economics and psychology.
It examines the impact of psychological, social, cognitive, and emotional factors on individuals' and institutions' economic decisions, as well as their consequences. In abbreviation, it explains how people manage money in real life, not in strictly planned and described economic models.
The main goal of behavioral economics is to highlight that humans are not rational. In this particular way, it denies many prevalent assumptions made by economists suggesting the existence of so-called 'homo oeconomicus.' This basic approach portrays people as consistently rational, narrowly self-interested creatures pursuing subjectively defined goals optimally. Due to the asymmetry of information, information distortion, basic cognitive errors, and the influence of emotions, it unluckily turns out that we are not utility-maximizing agents choosing only the carefully picked solutions.
Some people aptly compare behavioral economics to a double-edged sword – on the one hand, individuals' irrationality speaks in favor of greater interventionism. On the other hand, politicians are also human, which means that, just like us, they are also limited in their rationality. That speaks in favor of taking steps towards the free market with its powerful market mechanism driven by demand and supply. It effectively indicates ex-post which actions were rational (and profitable) and which ones were not (punishing particular market participants with losses).
Charles Munger – an American investor, businessman, and vice chairman of Berkshire Hathaway - famously wondered: "How could economics not be behavioral? If it isn't behavioral, what the hell is it?". It is no surprise that the assumption of perfect rationality is far from the truth; however, the power of behavioral economics in many cases is still underappreciated.
So, what exactly does behavioral economics honor us with?
Dan Ariely, an American professor, states that: "One of the big lessons from behavioral economics is that we make decisions as a function of the environment that we're in."
One of the underlying thinking traps, described by the famous Nobel laureate Daniel Kahneman is the planning fallacy. It bases on the tendency of formulating overly optimistic forecasts about the results of undertaken ventures.
Heuristics also serve as spectacular traps that anyone can fall into. But what exactly are they? Heuristics are practically proven (and not always consistent with theoretical knowledge/logical reasoning) dependencies between particular aspects of reality. They facilitate quick, schematic thinking. To give some examples of these simplified inference rules, we can mention the anchoring, which is a tendency to make decisions based on some information held as a reference point (not necessarily checked). Another instance, called availability heuristic, means basing our choices on the assessment of the situation's likelihood (e.g., frequent information about specific types of crime in the news may affect the excessive perception of the risk of their occurrence). We can also experience representational heuristic in which we make judgments based on the similarity to what we know.
Numerous cognitive errors are mainly associated with our presence in the markets, such as the capital market. Here, one of the best-known examples is called the attributive egotism. It involves attributing successes to our skills and failures to the external factors. Confirmation error can also be quite perilous, developing investors' tendency to focus on information confirming their views about a particular company or event.
The founding fathers of behavioral economics - Daniel Kahneman and Amos Tversky - have also described the Prospect Theory. They indicated that rather than calmly and objectively calculating the expected benefits, people are far more afraid of losing something than happy because of gaining something of the same value. People are also dependent on the endowment effect, which makes them overprice something they own.
It is essential to realize behavioral economics' main discoveries to be more aware of the possible irrational decisions that may not be in our best interest. It is also crucial in trying to be less susceptible to manipulation techniques prevalently used in marketing and media. Knowledge of behavioral economics can also help us in becoming better negotiators.
As you can see, digging into behavioral economics' wisdom can be very useful, so I would definitely recommend it! :)
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