Behavioral Economics in Relation to Other Sciences & Economics
Module 2
2
Introduction – Economics
• Economic phenomena relate to any aspect of human
behavior that involves the allocation of scarce
resources; thus, economics is very wide-ranging in its
subject area.
• For example, all of the following can be described as
economic phenomena, although they may also of
course, involve other disciplines of study: searching for
a future spouse on the internet, watching a
documentary on television, making a charitable
donation, deciding to take a nap rather than mow the
lawn, teaching one’s child to play tennis, going to
church and so on.
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Introduction – Economics
• Economics, like any other social science, is concerned
with developing theories whose ultimate aim is to
help us better understand the world we live in.
• Economic theories attempt to describe and explain
relationships between economic phenomena.
• In order to do this, they need to proceed on the basis
of a number of assumptions or premises.
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Introduction – Economics
• Economic theories rely on explicit and implicit
assumptions to generate predictions. While some
assumptions are clearly stated, others remain
hidden—yet they are equally critical.
• Identifying implicit assumptions matters because If a
theory’s predictions fail to match real-world
observations, the problem may lie in its underlying
assumptions.
• To diagnose the issue, we must verify the logical
consistency between assumptions and predictions.
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What is Behavioral Economics?
• This is where behavioral economics is relevant. As
Camerer and Loewenstein succinctly put it:
– Behavioral economics increases the
explanatory power of economics by providing
it with more realistic psychological
foundations.
• Hence, behavioral economics is not seeking to
replace the standard framework of analysis. It
seeks to add to this framework.
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What is Behavioral Economics?
“It is important to emphasize that the behavioral
economics approach extends rational choice and
equilibrium models; it does not advocate abandoning
these models entirely.”- Ho, Lim and Camerer, 2006
• In order to understand these claims, and also to
understand various critiques of behavioral economics,
we must examine the major assumptions underlying
the standard model alluded to in the quotation above
and then consider various important and widespread
phenomena where this model has run into some
difficulty –often referred to as anomalies.
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Why Behavioral Economics?
• We will also see that unrealistic assumptions may still
yield useful empirical insights. It is difficult to conceive
of economic theories that are not built on some kind
of abstraction from the rich complexity of economic
phenomena.
• This means that there will always be a trade-off
between highly abstract but general behavioral
assumptions, such as they can be found in the
standard model, and empirically better grounded yet
often quite context-specific assumptions as we find
them in behavioral economics, an issue that was
recognized as far back as 1991.
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Why Behavioral Economics?
• It is in the nature of economic anomalies that
they violate standard theory.
• The next question is what to do about it. In many
cases, there is no obvious way to amend the
theory to fit the facts, either because too little is
known or because the changes would greatly
increase the complexity of the theory and
reduce its predictive yield.
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Standard Models and Economics
• The term ‘standard model’ has been used in the
discussion to indicate a contrast between behavioral
economics and what might be called ‘mainstream’
economics.
• However, this distinction has been losing its validity
over recent years, particularly since the financial crisis
in 2007.
• In order to understand this dynamic, it is really
necessary to consider ‘standard models’ in other areas
of science.
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Standard Models in Physics
• Perhaps the most fundamental, at least in a
reductionist sense, is the standard model of particle
physics, which seeks to describe and explain the
elementary particles and forces in the universe.
• This theory coalesced in the 1970s and has had great
success in predicting the existence of new particles,
notably the Higgs boson in 2012.
• However, it is acknowledged that the theory is
incomplete, since it does not give an account of
gravity, nor does it account for either dark matter or
dark energy, which cosmologists estimate constitute
about 96% of the mass-energy in the universe.
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Standard Models in Physics
• As a result, some might say this means that the
‘standard’ theory is highly incomplete.
• Cosmologists have developed the model further in the
1990s, referring to a lambda-CDM model, which does
take into account dark matter and dark energy, but
this is also incomplete and is more speculative.
• Both of the above models have certain aspects in
common with what has been called the standard
economic model, but there are some differences also.
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Standard Models in Physics & Economics
• Both have coalesced into a generally accepted
standard model much more recently, and for that
reason can be claimed to have fewer anomalies.
• As a consequence, scientists expect further
observations to result in minor modifications of the
models rather than a drastic overhaul.
• However, caution is needed here, since physicists had
the same attitude at the end of the nineteenth
century, believing classical physics was more or less
complete, and then came the revolutions of quantum
mechanics and general relativity which dramatically
altered the previous ‘standard model’.
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Standard Models in Biology
• Perhaps the ‘standard model’ closest to economics is
in evolutionary biology, with the neo-Darwinian
synthesis.
• As in economics, the main foundation was laid in the
nineteenth century, but fundamental modifications to
the model were made in the twentieth century to
take into account discoveries in genetics, and then
molecular biology.
• It wasn’t until the discovery of DNA in 1953 that this
model moved closer to being regarded as complete.
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Standard Models in Biology
• Nevertheless, alternative models, most recently
emerging from the so-called Evo-Devo literature
in evolutionary biology, for example, out of
attempts to better account for the
morphogenetic development of organisms,
proceed from different assumptions and the
underlying debates are far from resolved.
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Standard Models and Economics
• Where does this all leave us as far as any standard model
in economics is concerned?
• As we will see, the standard model in economics has its
intellectual origins in the neoclassical tradition of
economic thought and is, therefore, more appropriately
referred to as the neoclassical model (NM).
• By the end of the 1970s, it was clear that there were
numerous fundamental anomalies in this model, and
these accounted for the emergence of behavioral
economics.
16
Economics to Behavioral Economics
• For some decades there was an uneasy tension in the
economics discipline, with behavioral economics being
regarded as an unruly offshoot from the mainstream,
consisting of a number of often conflicting and ad hoc
hypotheses, with no coherent body of theory.
• This situation has gradually changed since the
millennium, with more behavioral aspects becoming
incorporated into the mainstream of the discipline.
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Economics to Behavioral Economics
• This may ultimately lead to the death of behavioral
economics, in terms of its current status as a
collection of separate approaches. Alternatively, if its
main precepts all become absorbed into a revised
standard model that is commonly accepted then the
distinction will cease to be meaningful.
• For this reason, we regard it now preferable to
benchmark behavioral economics against a static
‘neoclassical model’ rather than against a dynamic,
constantly changing ‘standard model’.
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Economics to Behavioral Economics
• In many ways, debates in economics on the strengths
and weaknesses of a standard model are debates on
useful and less useful ways of arriving at economic
concepts and theories through abstraction from
concrete phenomena.
• Methodological considerations are thus at the heart of
many debates in behavioral economics, the best
starting point for understanding these debates is to
look at some of the methodological foundations of
economic rationality and how it has been captured
with the NM.
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Economic Rationality
• The standard model of rationality in the neoclassical
tradition of economics is essentially a decision-making
model, which claims to be both descriptive and
normative.
• This means that the model is supposed to both
accurately describe how people behave, and to
prescribe how they should behave to achieve a certain
given objective.
• Unfortunately, the term normative is used in two
different senses by economists, causing confusion.
20
Positive Statements
• Sometimes it is used in the sense of being opposite to
positive. Positive statements relate to descriptions
involving factual information.
• Such statements can be judged to be correct or
incorrect, often with a margin of error, based on
empirical observation.
• Normative statements in this context relate to value
judgments, which are necessarily subjective, and
cannot be judged to be correct or incorrect
empirically.
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Positive Statements
• An example is Statement 1:
– Statement 1: It is not fair that Firm A pays its
workers such a low wage.
• Such statements often include the words ‘ought’
or ‘should’; for example, we might modify the
above statement by saying:
– Statement 2: Firm A ought to pay its workers
a higher wage.
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Non-Normative Statements
• However, care must be exercised here, because
statements including these words are not always
normative in the sense of involving a value judgment.
An example is:
– Statement 3: Firm A ought to pay its workers a
higher wage if it wants to maximize profit.
• Statement 3 does not involve a value judgment and
can be evaluated empirically. Of course, one can
question the social value of profit, but that is a
separate issue.
23
Normative Statements
• Confusion can arise because the last type of
statement is also often referred to as normative.
• In this context, the term normative is interpreted
as a statement that refers to behavior as it should
be if it were to accomplish goals in an optimal
way, in contrast to a descriptive statement that
describes behavior as it actually is.
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Prescriptive vs Descriptive Statements
• It is perhaps preferable to label it as prescriptive, as
opposed to descriptive. Prescriptive statements can be
considered as policy implications, for individuals, firms
or governments, in terms of being guides to behavior,
assuming a particular objective or set of values.
• Thus, such statements, or ‘normative theories’ as they
are often referred to, tend to involve some kind of
optimization.
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Prescriptive vs Descriptive Statements
• A fundamental example is the theory of expected
utility maximization. Prescriptive statements in the
above sense always follow logically from descriptive
statements; for example, Statement 3 can be restated
as follows:
– Statement 4: In Firm A’s situation, a higher wage
will maximize profit.
• A more precise prescription would determine the
specific level of wage that would maximize profit.
Thus, such prescriptive statements can also always be
evaluated empirically.
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Prescriptive Statements
• Normative, in the sense of prescriptive,
statements have various sources of appeal to
social scientists:
– Throughout evolutionary history animal
behavior has been shaped and constrained by
its influence on fitness, so a reasonable
starting point for theory or model
development is to view a particular behavior
as an optimal or near-optimal adaptation to
some set of problems.
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Prescriptive Statements
– Discrepancies between observed behavior and the
predictions of normative models are often
illuminating. They can shed light on the neural and
informational constraints under which animals
make decisions, relating to Simon’s concept of
bounded rationality, leading to heuristics and
biases. Alternatively, they may suggest that
animals are in fact optimizing something other
than what the model assumed.
– Treating behavior as optimal allows for the
generation of computationally explicit hypotheses
that are directly testable. A simple example is the
marginal cost equals marginal revenue rule for
profit maximization.
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Value Judgement in Normative Statements
• When referring to normative statements as value
judgments, it should be noted that sciences in general,
including social sciences like economics, are not in any
privileged position in terms of making such
statements. The privilege which scientists enjoy is that
they are better able to understand the factual
implications of value judgments.
• Thus, while an economist may not have any superior
‘moral authority’ in judging whether Firm A is acting
fairly, she may be able to point out that its existing
low-wage strategy is likely to cause more labor unrest,
higher labor turnover, and higher recruiting and
training costs.
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Value Judgement
• Our interest is not the validity of normative
statements as value judgments but the question of
why people make certain value judgments; this is a
psychological issue that has important policy
implications in the prescriptive sense. No theory of
choice can be both normatively adequate and
descriptively accurate.
• For example, in tic-tac-toe, rational strategies ensure a
draw, but most economic situations are more
complex, and purely rational models fail to explain
actual behavior.
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Rationality vs Irrationality
• Instead, understanding choices requires examining
actual-response strategies, which often deviate
from the best-response path, making individuals
appear irrational.
• The terms "rationality" and "irrationality" are
central to economics, particularly behavioral
economics, which explores why people act
irrationally.
• In tic-tac-toe, knowingly deviating from the best-
response strategy is irrational, but this view limits
understanding by treating such behavior as an
aberration rather than a valid phenomenon.
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Economic Rationality
• Rationality is used differently across disciplines;
in everyday terms, it means using reason, but
economists define it more narrowly within a
means-end framework of instrumental
rationality.
• This framework assumes individuals have
complete and transitive preferences, enabling
them to choose their most preferred outcome.
• Additional economic assumptions, like
monotonicity and convexity, are often added.
32
Economic Rationality under Uncertainty
• However, this model applies only to decisions
under certainty. For uncertain outcomes,
frameworks like expected utility maximization
and Bayesian probability estimation are used.
• Behavioral uncertainty, arising from strategic
interactions, introduces further complexity,
requiring assumptions like common knowledge.
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Economic Rationality
• Some economists, like Vernon Smith, judge rationality
by systemic outcomes, equating it with market
efficiency. Others, like Kahneman and Tversky, use the
standard model as a benchmark, finding frequent
irrationality but arguing that systematic errors and
biases do not necessarily constitute irrational
behavior.
• This highlights a shift from the standard model to
alternative conceptions of rationality that better
explain observed behavior.
34
Rationality in Psychology
• Psychologists approach rationality differently.
Baumeister defines a rational being as one who
pursues "enlightened self-interest," emphasizing
three key concepts: "pursue," "enlightened," and
"self-interest." However, these require further
examination. "Enlightened" implies perfect
knowledge, which is unrealistic.
• Terms like "long-run self-interest" or "perceived self-
interest" are more useful, as they account for
conflicts between short-run and long-run
considerations and cognitive limitations.
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Rationality in Psychology
• Misjudging self-interest is not necessarily irrational or
a failure of "bounded rationality," which refers to
decision-making under constraints like incomplete
knowledge or time pressure. Bounded rationality
focuses on "satisficing" rather than optimizing.
• The second concept is whether "pursuing" self-
interest equates to maximizing. The normative
model equates pursuing self-interest with
maximizing expected utility, but bounded rationality
often leads to heuristic decision-making—using
simple rules-of-thumb under uncertainty and time
constraints.
36
Rationality in Psychology
Above-average Effect: well
• This can result in suboptimal outcomes but is not over half of survey
irrational. Misjudgments of self-interest, such as self-
serving biases (e.g., the "above average" effect), may respondents typically rate
be considered irrational by some economists and themselves in the top 50%
psychologists. of drivers, ethics,
managerial prowess,
• The third concept, "self-interest," is often measured in productivity and health.
terms of utility, reflecting subjective value. It does not
exclude considering interests, as cooperation in social
environments often furthers one’s own interests.
Behavioral economics distinguishes between "self-
regarding" and "other-regarding" preferences, both of
which can be combined in a utility function.
37
Behavioral Perspectives on Economic Rationality
• Actions without deliberation, such as instinctive or
subconscious behaviors, are neither rational nor
irrational but "arational."
• This suggest that brain activity precedes conscious
decisions, implying that many actions may be
arational, with conscious deliberation merely
accompanying rather than causing them.
• This raises the question of whether rationality
pertains only to decision-making and actions or also to
attitudes and beliefs.
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Behavioral Perspectives on Economic Rationality
• Economists focus on decision-making, while
psychologists note that belief formation may
be beyond conscious control.
• If decisions are also outside conscious
control, attitudes and beliefs may similarly be
arational.
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Nature of the Neoclassical Model
• Economists generally try to eliminate the
many ambiguities surrounding the notion of
‘pursuing enlightened self-interest’ by using
the more precise and formal model of
rational behavior described in the NM.
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