1. Introduction to Behavioral Economics

1.1 How to Learn Behavioral Economics

Behavioral economics is revolutionary: as opposed to standard economics, which typically assumes that perfectly rational agents always solve maximization problems, behavioral economics admits the bounded rationality of agents to better understand the anomalies happening in daily life. But this doesn't mean behavioral economics is "better" or "more correct". Keep the following three things in mind.

• In 1776, Adam Smith's The Wealth of Nations was published, which marks the beginning of this period.
• Between the late 18th century and the middle 19th century, classical economics was developed primarily in Britain.
• This period features ideas such as demand-supply analysis, the market as the invisible hand, and a theory of value based on labor time.
• Representative economists: Adam Smith, David Ricardo, John Stuart Mill, Thomas Malthus.
• One thing notable: as early as Adam Smith's time, he already had thoughts of behavioral economics in his argument that human struggles between their "impartial spectator" (the rational part) and "passions" (the irrational part).

1.2.2 Neoclassical Economics

• A "marginal revolution" moved economics into a new period around 1870, called neoclassical economics.
• Neoclassical economics relies heavily on rigorous math with axioms, and assumes that individuals with admissible preferences maximize their own utility in every decision. This idea focuses purely on the "impartial spectator" (rational) part, which is easier to model.
• In 1948, Paul Samuelson published the famous textbook Economics: An Introductory Analysis, which further changed people's understanding of canonical economics; since then a new norm in economics academia took shape, emphasizing rigorous math derivations and proofs.
• Topics where the neoclassical approach turns out to be very good (a partial list): consumer and producer problems, game theory, trade problems, finance, externality and public-good problems.
• Representative economists: Léon Walras, Alfred Marshall, Vilfredo Pareto, John Hicks, Paul Samuelson, John von Neumann.

1.2.3 Extending Neoclassical Economics to Other Fields

• Gary Becker and other economists applied the neoclassical approach to other disciplines such as crime, marriage, drug, education and so on: Becker → sociology; George Stigler → regulations; Eugene Fama and Lars Hansen → finance; Ronald Coase and Richard Posner → law.
• These "Chicago School" economists pushed the idea of neoclassical economics to its limit, extending it to almost everywhere outside economics, which is called "economics imperialism".

1.2.4 Behavioral Economics

In the early years (1950–1960), some doubts were cast upon the neoclassical approach.

Table 1.1 (Experiment 1)

Table 1.2 (Experiment 2)

The early doubts also include:

• Simon (1955) proposed the idea of bounded rationality, believing that agents make stochastic errors in decision making, but he did not identify the underlying reasons for those errors.
• Ellsberg (1961) discussed ambiguity aversion: uncertain uncertainty is worse than certain uncertainty, so it is preferable to know what uncertainty it is. This is in contrast to neoclassical analysis, in which people only care about the probability distribution of the final outcome.

However, most standard economists (referred to as "they" below) rejected irrationality with reasons summarized by Matthew Rabin as "explainawaytions":

Starting from the 1970s, systematic bias began to be discussed, which is a major advance in behavioral economics (footnote: a systematic bias is not just a stochastic error parameter, but a bias a lot of people have and that is predictable).

• Tversky and Kahneman (1974) proposed three fundamental heuristics and biases (footnote: even now these biases are still thought to be driven by these three underlying heuristics; e.g. projection bias — people tend to project the current status to the future — is driven by anchoring):
• Representativeness: people pay attention only to the part of a thing they think is representative, and ignore information they don't think represents the thing. Example: when asked a question, people tend to pick the answer that sounds correct and ignore the other part.
• Availability: people's responses are determined by what is available in their mind. Example: when asked about murders in Michigan people have nothing dangerous in mind, so they say small numbers; but when asked about murders in Detroit they have dangerous scenes in mind, so they say an even bigger number than for Michigan — which can't be rational, since Detroit is part of Michigan.
• Anchoring: it's hard to move away from an anchor. Example: give people a random number between 1 and 100, then ask about a percentage in a problem they don't know (e.g. the percentage of African countries in the United Nations); they report answers strongly correlated to the random number even though they know it's random.
• Starting in 1987, Richard Thaler wrote anomalies columns, which gradually convinced traditional economists that standard economics did fail sometimes.

References

• Allais, M. (1953). Le comportement de l'homme rationnel devant le risque. Econometrica, 503–546. (the Allais paradox)
• Ellsberg, D. (1961). Risk, Ambiguity, and the Savage Axioms. Quarterly Journal of Economics, 643–669. (ambiguity aversion)
• Lacetera, N., Macis, M., & Slonim, R. (2011). Rewarding Altruism? A Natural Field Experiment. NBER. (the blood-donation incentive field experiment)
• Simon, H. A. (1955). A Behavioral Model of Rational Choice. Quarterly Journal of Economics, 69(1), 99–118. (bounded rationality)
• Tversky, A., & Kahneman, D. (1974). Judgment under Uncertainty: Heuristics and Biases. Science, 185(4157), 1124–1131. (heuristics and biases)