What is 'Behavioral Economics'

Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. The two most important questions in this field are:

1. Are economists' assumptions of utility or profit maximization good approximations of real people's behavior?

2. Do individuals maximize subjective expected utility?

BREAKING DOWN 'Behavioral Economics'

In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction. This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. Alas behavioral economics explains that humans are not rational and are incapable of making good decisions.

Behavioral economics draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models. Decisions such as how much to pay for a cup of coffee, whether to go to graduate school, whether to pursue a healthy lifestyle, how much to contribute towards retirement, etc. are the sorts of decisions that most people make at some point in their lives. Behavioral economics seeks to explain why an individual decided to go for choice A, instead of choice B.

Because humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if Charles wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories. Behavioral economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall out of the weight loss bandwagon, showing his lack of self-control.


One application of behavioral economics is heuristics, which is the use of rules of thumb or mental shortcuts to make a quick decision. However, when the decision made leads to error, heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game theory, can also be applied to behavioral economics as game theory runs experiments and analyzes people’s decisions to make irrational choices. Another field in which behavioral economics can be applied to is behavioral finance, which seeks to explain why investors make rash decisions when trading in the capital markets.

Companies are increasingly incorporating behavioral economics to increase sales of their products. In 2007, the price of the 8GB iPhone was introduced for $600 and quickly reduced to $400. What if the intrinsic value of the phone was $400 anyway? If Apple introduced the phone for $400, the initial reaction to the price in the smartphone market might have been negative as the phone might be thought to be too pricey. But by introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal and sales surged for Apple. Also, consider a soap manufacturer who produces the same soap but markets them in two different packages to appeal to multiple target groups. One package advertises the soap for all soap users, the other for consumers with sensitive skin. The latter target would not have purchased the product if the package did not specify that the soap was for sensitive skin. They opt for the soap with the sensitive skin label even though it’s the exact same product in the general package.

As companies begin to understand that their consumers are irrational, an effective way to embed behavioral economics in the company’s decision-making policies that concern its internal and external stakeholders may prove to be worthwhile if done properly.

Notable individuals in the study of behavioral economics are Nobel laureates Gary Becker (motives, consumer mistakes; 1992), Herbert Simon (bounded rationality; 1978), Daniel Kahneman (illusion of validity, anchoring bias; 2002) and George Akerlof (procrastination; 2001).

  1. Rational Behavior

    A decision-making process that is based on making choices that ...
  2. Behavioral Funds

    Definition of behavioral funds.
  3. Rational Choice Theory

    An economic principle that assumes that individuals always make ...
  4. Behavioral Finance

    A field of finance that proposes psychology-based theories to ...
  5. Behaviorist

    1. One who accepts or assumes the theory of behaviorism (behavioral ...
  6. Financial Economics

    A branch of economics that analyzes the use and distribution ...
Related Articles
  1. Financial Advisor

    A Quick Guide On Behavioral Funds

    Investopedia explores the working of behavioral funds, their benefits and risks, and an analysis of their past returns.
  2. Financial Advisor

    Who is Richard Thaler, Economics Nobel Prize Winner?

    Thaler, one of the founding behavioral economists, won the 2017 Nobel Prize in Economic Sciences.
  3. Trading

    Leading Indicators Of Behavioral Finance

    Discover how put-call ratios and moving averages can be used to analyze investor behavior.
  4. Financial Advisor

    8 Common Biases That Impact Investment Decisions

    Behavioral biases hit us all as investors and can vary depending upon our investor personality type.
  5. Investing

    9 Cognitive Biases That Affect Your Business

    Human beings often act irrationally when it comes to business decisions. Behavioral finance explains the difference between what we should do and what we do.
  6. Investing

    Are Your Emotions Getting the Best of Your Investments?

    Behavioral finance studies the emotional side of investing and its effects on investor returns.
  7. Financial Advisor

    Behavioral Finance: How Bias Can Hurt Investing

    Here are three cognitive biases from behavioral finance that investors would do well to be aware of to avoid making poor investment decisions.
  8. Personal Finance

    How to Think About College as an Investment

    If you view college as an investment, the costs and risks must be weighed against potential returns.
  9. Investing

    The Behavior That Helps You Increase Your Returns

    Has your financial advisor talked to you about the factor that makes or breaks financial success?
  1. What are some of the limitations and drawbacks of economics as a field?

    Find out why the field of economics is full of controversy. Policy decisions, political campaigns and personal finances are ... Read Answer >>
  2. What is the homo economicus?

    Homo economicus or "economic man" is the characterization of man in some economic theories as a rational person who pursues ... Read Answer >>
  3. Does the law of demand in economics describe real human behavior?

    Learn how the law of demand can be used to describe human nature, even if it cannot always produce accurate predictions about ... Read Answer >>
  4. Can the Efficient Market Hypothesis explain economic bubbles?

    Learn about the nuanced relationship between the efficient market hypothesis and economic bubbles and the requirements and ... Read Answer >>
Hot Definitions
  1. Liquidity

    Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's ...
  2. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  3. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  4. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  5. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center