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Behavioral economics studies the effects of
psychological Psychology is the scientific study of mind and behavior. Psychology includes the study of conscious and unconscious phenomena, including feelings and thoughts. It is an academic discipline of immense scope, crossing the boundaries between ...
,
cognitive Cognition refers to "the mental action or process of acquiring knowledge and understanding through thought, experience, and the senses". It encompasses all aspects of intellectual functions and processes such as: perception, attention, thoug ...
, emotional, cultural and social factors on the decisions of individuals or institutions, such as how those decisions vary from those implied by classical economic theory. Behavioral economics is primarily concerned with the bounds of
rationality Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abil ...
of
economic agent In economics, an agent is an actor (more specifically, a decision maker) in a model of some aspect of the economy. Typically, every agent makes decisions by solving a well- or ill-defined optimization or choice problem. For example, ''buyers'' ...
s. Behavioral models typically integrate insights from psychology,
neuroscience Neuroscience is the scientific study of the nervous system (the brain, spinal cord, and peripheral nervous system), its functions and disorders. It is a multidisciplinary science that combines physiology, anatomy, molecular biology, develo ...
and microeconomic theory. The study of behavioral economics includes how market decisions are made and the mechanisms that drive public opinion. The concepts used in behavioral economics today can be traced back to 18th-century economists, such as Adam Smith, who deliberated how the economic behavior of individuals could be influenced by their desires. The status of behavioral economics as a subfield of economics is a fairly recent development; the breakthroughs that laid the foundation for it were published through the last three decades of the 20th century. Behavioral economics is still growing as a field, being used increasingly in research and in teaching.


History

Early Neoclassical economists included psychological reasoning in much of their writing, though psychology at the time was not a recognized field of study. In '' The Theory of Moral Sentiments,'' Adam Smith wrote on concepts later popularized by modern Behavioral Economic theory, such as
loss aversion Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends o ...
. Jeremy Benthham, another Neoclassical economist in the 1700s conceptualized
utility As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosop ...
as a product of psychology. Other Neoclassical economists who incorporated psychological explanations in their works included Francis Edgeworth,
Vilfredo Pareto Vilfredo Federico Damaso Pareto ( , , , ; born Wilfried Fritz Pareto; 15 July 1848 – 19 August 1923) was an Italian polymath (civil engineer, sociologist, economist, political scientist, and philosopher). He made several important contribu ...
and
Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt de ...
. A rejection and elimination of psychology from economics by the Neoclassical school in the early 1900s brought on a period defined by a reliance on empiricism. There was a lack of confidence in hedonic theories, which saw pursuance of maximum benefit as an essential aspect in understanding human economic behavior. Hedonic analysis had shown little success in predicting human behavior, leading many to question its accuracy. There was also a fear among economists that the involvement of psychology in shaping economic models was inordinate and a departure from contemporary Neoclassical principles. They feared that an increased emphasis on psychology would undermine the mathematic components of the field. William Peter Hamilton, ''Wall Street Journal'' editor from 1907 to 1929, wrote in ''The Stock Market Barometer:'' "We have meddled so disastrously with the law of
supply and demand In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labor ...
that we cannot bring ourselves to the radical step of letting it alone." To boost the ability of economics to predict accurately, economists started looking to tangible phenomena rather than theories based on human psychology. Psychology was seen as unreliable to many of these economists as it was a new field, not regarded as sufficiently scientific. Though a number of scholars expressed concern towards the
positivism Positivism is an empiricist philosophical theory that holds that all genuine knowledge is either true by definition or positive—meaning ''a posteriori'' facts derived by reason and logic from sensory experience.John J. Macionis, Linda M ...
within economics, models of study dependent on psychological insights became rare. Economists instead conceptualized humans as purely rational and self-interested decision makers, illustrated in the concept of '' homo economicus.'' The re-emergence of psychology within economics that allowed for the spread of behavioral economics has been associated with the cognitive revolution. In the 1960s,
cognitive psychology Cognitive psychology is the scientific study of mental processes such as attention, language use, memory, perception, problem solving, creativity, and reasoning. Cognitive psychology originated in the 1960s in a break from behaviorism, which h ...
began to shed more light on the brain as an information processing device (in contrast to
behaviorist Behaviorism is a systematic approach to understanding the behavior of humans and animals. It assumes that behavior is either a reflex evoked by the pairing of certain antecedent stimuli in the environment, or a consequence of that individual' ...
models). Psychologists in this field, such as Ward Edwards,
Amos Tversky Amos Nathan Tversky ( he, עמוס טברסקי; March 16, 1937 – June 2, 1996) was an Israeli cognitive and mathematical psychologist and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his ...
and
Daniel Kahneman Daniel Kahneman (; he, דניאל כהנמן; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarde ...
began to compare their cognitive models of decision-making under risk and uncertainty to economic models of rational behavior. These developments spurred economists to reconsider how psychology could be applied to economic models and theories. Concurrently, the
Expected utility hypothesis The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decisions when the payoff is uncertain. The theory recommends which option rational individuals should choose in a complex situation, based on the ...
and discounted utility models began to gain acceptance. In challenging the accuracy of generic utility, these concepts established a practice foundational in behavioral economics: Building on standard models by applying psychological knowledge. Mathematical psychology reflects a longstanding interest in preference transitivity and the measurement of utility.


Development of Behavioral Economics

In 2017, Niels Geiger, a lecturer in economics at the University of Hohenheim conducted an investigation into the proliferation of behavioral economics. Geiger's research looked at studies that had quantified the frequency of references to terms specific to behavioral economics, and how often influential papers in behavioral economics were cited in journals on economics. The quantitative study found that there was a significant spread in behavioral economics after Kahneman and Tversky's work in the 1990s and into the 2000s.


Bounded rationality

Bounded rationality is the idea that when individuals make decisions, their
rationality Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abil ...
is limited by the tractability of the decision problem, their cognitive limitations and the time available. Decision-makers in this view act as satisficers, seeking a satisfactory solution rather than an optimal one. Herbert A. Simon proposed bounded rationality as an alternative basis for the mathematical modeling of
decision-making In psychology, decision-making (also spelled decision making and decisionmaking) is regarded as the cognitive process resulting in the selection of a belief or a course of action among several possible alternative options. It could be either rati ...
. It complements "rationality as optimization", which views decision-making as a fully rational process of finding an optimal choice given the information available. Simon used the analogy of a pair of scissors, where one blade represents human cognitive limitations and the other the "structures of the environment", illustrating how minds compensate for limited resources by exploiting known structural regularity in the environment. Bounded rationality implicates the idea that humans take shortcuts that may lead to suboptimal decision-making. Behavioral economists engage in mapping the decision shortcuts that agents use in order to help increase the effectiveness of human decision-making. Bounded rationality finds that actors do not assess all available options appropriately, in order to save on search and deliberation costs. As such decisions are not always made in the sense of greatest self-reward as limited information is available. Instead agents shall choose to settle for an acceptable solution. One treatment of this idea comes from Cass Sunstein and
Richard Thaler Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was ...
's '' Nudge''. Sunstein and Thaler recommend that choice architectures are modified in light of human agents' bounded rationality. A widely cited proposal from Sunstein and Thaler urges that healthier food be placed at sight level in order to increase the likelihood that a person will opt for that choice instead of less healthy option. Some critics of ''Nudge'' have lodged attacks that modifying choice architectures will lead to people becoming worse decision-makers.


Prospect theory

In 1979, Kahneman and Tversky published ''
Prospect Theory Prospect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics. Based ...
: An Analysis of Decision Under Risk'', that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory. Kahneman and Tversky utilising prospect theory determined three generalisations; gains are treated differently than losses, outcomes received with certainty are overweighed relative to uncertain outcomes and the structure of the problem may affect choices. These arguments were proven in part by altering a survey question so that it was no longer a case of achieving gains but averting losses and the majority of respondents altered their answers accordingly. In essence proving that emotions such as fear of loss, or greed can alter decisions, indicating the presence of an irrational decision-making process. Prospect theory has two stages: an editing stage and an evaluation stage. In the editing stage, risky situations are simplified using various
heuristic A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
s. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include: * Reference dependence: When evaluating outcomes, the decision maker considers a "reference level". Outcomes are then compared to the reference point and classified as "gains" if greater than the reference point and "losses" if less than the reference point. *
Loss aversion Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends o ...
: Losses are avoided more than equivalent gains are sought. In their 1992 paper, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses hurt about 2.25 times more than equivalent gains reward.Abstract.
/ref> * Non-linear probability weighting: Decision makers overweigh small probabilities and underweigh large probabilities—this gives rise to the inverse-S shaped "probability weighting function". * Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to the reference point increase in absolute value, the marginal effect on the decision maker's utility or satisfaction falls. Prospect theory is able to explain everything that the two main existing decision theories— expected utility theory and rank dependent utility theory—can explain. Further, prospect theory has been used to explain phenomena that existing decision theories have great difficulty in explaining. These include backward bending labor supply curves, asymmetric price elasticities,
tax evasion Tax evasion is an illegal attempt to defeat the imposition of taxes by individuals, corporations, trusts, and others. Tax evasion often entails the deliberate misrepresentation of the taxpayer's affairs to the tax authorities to reduce the tax ...
and co-movement of stock prices and consumption. In 1992, in the ''Journal of Risk and Uncertainty'', Kahneman and Tversky gave a revised account of prospect theory that they called
cumulative prospect theory Cumulative prospect theory (CPT) is a model for descriptive decisions under risk and uncertainty which was introduced by Amos Tversky and Daniel Kahneman in 1992 (Tversky, Kahneman, 1992). It is a further development and variant of prospect theory. ...
. The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in
John Quiggin John Quiggin (born 29 March 1956) is an Australian economist, a professor at the University of Queensland. He was formerly an Australian Research Council Laureate Fellow and Federation Fellow and a member of the board of the Climate Change Au ...
's rank-dependent utility theory. Psychological traits such as
overconfidence Confidence is a state of being clear-headed either that a hypothesis or prediction is correct or that a chosen course of action is the best or most effective. Confidence comes from a Latin word 'fidere' which means "to trust"; therefore, having ...
,
projection bias Affective forecasting (also known as hedonic forecasting, or the hedonic forecasting mechanism) is the prediction of one's affect (emotional state) in the future. As a process that influences preferences, decisions, and behavior, affective forecas ...
, and the effects of limited attention are now part of the theory. Other developments include a conference at the
University of Chicago The University of Chicago (UChicago, Chicago, U of C, or UChi) is a private research university in Chicago, Illinois. Its main campus is located in Chicago's Hyde Park neighborhood. The University of Chicago is consistently ranked among the b ...
, a special behavioral economics edition of the ''
Quarterly Journal of Economics ''The Quarterly Journal of Economics'' is a peer-reviewed academic journal published by the Oxford University Press for the Harvard University Department of Economics. Its current editors-in-chief are Robert J. Barro, Lawrence F. Katz, Nathan ...
'' ("In Memory of Amos Tversky"), and Kahneman's 2002 Nobel Prize for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." A further argument of Behavioural Economics relates to the impact of the individual's cognitive limitations as a factor in limiting the rationality of people's decisions. Sloan first argued this in his paper 'Bounded Rationality' where he stated that our cognitive limitations are somewhat the consequence of our limited ability to foresee the future, hampering the rationality of decision.
Daniel Kahneman Daniel Kahneman (; he, דניאל כהנמן; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarde ...
further expanded upon the effect cognitive ability and processes have on decision making in his book
Thinking, Fast and Slow ''Thinking, Fast and Slow'' is a 2011 book by psychologist Daniel Kahneman. The book's main thesis is a differentiation between two modes of thought: "System 1" is fast, instinctive and emotional; "System 2" is slower, more deliberative, and mo ...
Kahneman delved into two forms of thought, fast thinking which he considered "operates automatically and quickly, with little or no effort and no sense of voluntary control". Conversely, slow thinking is the allocation of cognitive ability, choice and concentration. Fast thinking utilises heuristics, which is a decision-making process that undertakes shortcuts, and rules of thumb to provide an immediate but often irrational and imperfect solution. Kahneman proposed that the result of the shortcuts is the occurrence of a number of biases such as hindsight bias, confirmation bias and outcome bias among others. A key example of fast thinking and the resultant irrational decisions is the 2008 financial crisis.


Nudge theory

Nudge is a concept in
behavioral science Behavioral sciences explore the cognitive processes within organisms and the behavioral interactions between organisms in the natural world. It involves the systematic analysis and investigation of human and animal behavior through naturalistic o ...
,
political theory Political philosophy or political theory is the philosophical study of government, addressing questions about the nature, scope, and legitimacy of public agents and institutions and the relationships between them. Its topics include politics, ...
and
economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics analyz ...
which proposes
positive reinforcement In behavioral psychology, reinforcement is a consequence applied that will strengthen an organism's future behavior whenever that behavior is preceded by a specific antecedent stimulus. This strengthening effect may be measured as a higher fr ...
and indirect suggestions as ways to influence the behavior and decision making of groups or individuals—in other words, it's "a way to manipulate people's choices to lead them to make specific decisions". Nudging contrasts with other ways to achieve compliance, such as
education Education is a purposeful activity directed at achieving certain aims, such as transmitting knowledge or fostering skills and character traits. These aims may include the development of understanding, rationality, kindness, and honesty. V ...
,
legislation Legislation is the process or result of enrolling, enacting, or promulgating laws by a legislature, parliament, or analogous governing body. Before an item of legislation becomes law it may be known as a bill, and may be broadly referred to a ...
or
enforcement Enforcement is the proper execution of the process of ensuring compliance with laws, regulations, rules, standards, and social norms. Governments attempt to effectuate successful implementation of policies by enforcing laws and regulations. En ...
. The concept has influenced British and American politicians. Several nudge units exist around the world at the national level (UK, Germany, Japan and others) as well as at the international level (OECD, World Bank, UN). The first formulation of the term and associated principles was developed in
cybernetics Cybernetics is a wide-ranging field concerned with circular causality, such as feedback, in regulatory and purposive systems. Cybernetics is named after an example of circular causal feedback, that of steering a ship, where the helmsperson ma ...
by James Wilk before 1995 and described by Brunel University academic D. J. Stewart as "the art of the nudge" (sometimes referred to as micronudges). It also drew on methodological influences from clinical
psychotherapy Psychotherapy (also psychological therapy, talk therapy, or talking therapy) is the use of psychological methods, particularly when based on regular personal interaction, to help a person change behavior, increase happiness, and overcome prob ...
tracing back to Gregory Bateson, including contributions from Milton Erickson, Watzlawick, Weakland and Fisch, and Bill O'Hanlon. In this variant, the nudge is a microtargeted design geared towards a specific group of people, irrespective of the scale of intended intervention. In 2008,
Richard Thaler Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was ...
and Cass Sunstein's book '' Nudge: Improving Decisions About Health, Wealth, and Happiness'' brought nudge theory to prominence. It also gained a following among US and UK politicians, in the private sector and in public health. The authors refer to influencing behavior without coercion as
libertarian paternalism Libertarian paternalism is the idea that it is both possible and legitimate for private and public institutions to affect behavior while also respecting freedom of choice, as well as the implementation of that idea. The term was coined by behav ...
and the influencers as choice architects. Thaler and Sunstein defined their concept as: In this form, drawing on behavioral economics, the nudge is more generally applied to influence behavior. One of the most frequently cited examples of a nudge is the etching of the image of a housefly into the men's room urinals at Amsterdam's Schiphol Airport, which is intended to "improve the aim". Nudging techniques aim to capitalise on the judgemental heuristics of people. In other words, a nudge alters the environment so that when heuristic, or System 1, decision-making is used, the resulting choice will be the most positive or desired outcome. An example of such a nudge is switching the placement of junk food in a store, so that fruit and other healthy options are located next to the cash register, while junk food is relocated to another part of the store. In 2008, the United States appointed Sunstein, who helped develop the theory, as administrator of the Office of Information and Regulatory Affairs. Notable applications of nudge theory include the formation of the British
Behavioural Insights Team The Behavioural Insights Team (BIT), also known unofficially as the "Nudge Unit", is a UK-based global social purpose organisation that generates and applies behavioural insights to inform policy and improve public services, following nudge th ...
in 2010. It is often called the "Nudge Unit", at the British
Cabinet Office The Cabinet Office is a department of His Majesty's Government responsible for supporting the prime minister and Cabinet. It is composed of various units that support Cabinet committees and which co-ordinate the delivery of government objec ...
, headed by David Halpern. In addition, th
Penn Medicine Nudge Unit
is the world's first behavioral design team embedded within a health system. Both Prime Minister
David Cameron David William Donald Cameron (born 9 October 1966) is a British former politician who served as Prime Minister of the United Kingdom from 2010 to 2016 and Leader of the Conservative Party from 2005 to 2016. He previously served as Leader o ...
and President
Barack Obama Barack Hussein Obama II ( ; born August 4, 1961) is an American politician who served as the 44th president of the United States from 2009 to 2017. A member of the Democratic Party, Obama was the first African-American president of the ...
sought to employ nudge theory to advance domestic policy goals during their terms. In Australia, the government of New South Wales established a Behavioural Insights community of practice. Nudge theory has also been applied to
business management Business administration, also known as business management, is the administration of a commercial enterprise. It includes all aspects of overseeing and supervising the business operations of an organization. From the point of view of management ...
and
corporate culture Historically there have been differences among investigators regarding the definition of organizational culture. Edgar Schein, a leading researcher in this field, defined "organizational culture" as comprising a number of features, including a s ...
, such as in relation to health, safety and environment (HSE) and human resources. Regarding its application to HSE, one of the primary goals of nudge is to achieve a "zero accident culture". Leading
Silicon Valley Silicon Valley is a region in Northern California that serves as a global center for high technology and innovation. Located in the southern part of the San Francisco Bay Area, it corresponds roughly to the geographical areas San Mateo Count ...
companies are forerunners in applying nudge theory in a corporate setting. These companies are using nudges in various forms to increase the productivity and happiness of employees. Recently, further companies are gaining interest in using what is called "nudge management" to improve the productivity of their white-collar workers. Behavioral insights and nudges are currently used in many countries around the world.


Criticisms

Citing the example of restaurant hygiene ratings to 'nudge' consumers towards food safety, it has been argued that mere public disclosure of ratings is not always sufficient to ensure public health safety, with strong variance in effectiveness from country to country. Tammy Boyce, from public health foundation The King's Fund, has said: "We need to move away from short-term, politically motivated initiatives such as the 'nudging people' idea, which is not based on any good evidence and doesn't help people make long-term behaviour changes." Cass Sunstein has responded to critiques at length in his ''The Ethics of Influence'' making the case in favor of nudging against charges that nudges diminish autonomy, threaten dignity, violate liberties, or reduce welfare. Ethicists have debated this rigorously. These charges have been made by various participants in the debate from Bovens to Goodwin. Wilkinson for example charges nudges for being manipulative, while others such as Yeung question their scientific credibility. Some, such as Hausman & Welch have inquired whether nudging should be permissible on grounds of ( distributive) justice; Lepenies & Malecka have questioned whether nudges are compatible with the rule of law. Similarly, legal scholars have discussed the role of nudges and the law. Behavioral economists such as Bob Sugden have pointed out that the underlying normative benchmark of nudging is still homo economicus, despite the proponents' claim to the contrary. It has been remarked that nudging is also a
euphemism A euphemism () is an innocuous word or expression used in place of one that is deemed offensive or suggests something unpleasant. Some euphemisms are intended to amuse, while others use bland, inoffensive terms for concepts that the user wishes ...
for
psychological manipulation Manipulation in psychology is a behavior designed to exploit, control, or otherwise influence others to one’s advantage. Definitions for the term vary in which behavior is specifically included, influenced by both culture and whether referring to ...
as practiced in social engineering. There exists an anticipation and, simultaneously, implicit criticism of the nudge theory in works of Hungarian social psychologists who emphasize the active participation in the nudge of its target (Ferenc Merei and Laszlo Garai). The most comprehensive study of real-world nudges to date has shown that they have, on average, a 1.4% impact on the outcome variable. This is 1/6th of what the academic studies predict (8.7%). This is based on a study from UC Berkeley looking at 126 RCTs from two different nudge units.


Behavioral economics concepts

Conventional economics assumes that all people are both rational and selfish. In practice, this is often not the case, which leads to the failure of traditional models. Behavioral economics studies the biases, tendencies and heuristics that affect the decisions that people make to improve, tweak or overhaul traditional economic theory. It aids in determining whether people make good or bad choices and whether they could be helped to make better choices. It can be applied both before and after a decision is made.


Search heuristics

Before a decision is made, there needs to be a minimum of two options. Behavioral economics employs search heuristics to explain how a person may evaluate their options. Search heuristics is a school of thought that suggests that when making a choice, it is costly to gain information about options and that methods exist to maximise the
utility As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosop ...
that one might get from searching for information. While each heuristic is not wholistic in its explanation of the search process alone, a combination of these heuristics may be used in the decision-making process. There are three primary search heuristics. Satisficing
Satisficing Satisficing is a decision-making strategy or cognitive heuristic that entails searching through the available alternatives until an acceptability threshold is met. The term ''satisficing'', a portmanteau of ''satisfy'' and ''suffice'', was introdu ...
is the idea that there is some minimum requirement from the search and once that has been met, stop searching. Following the satisficing heuristic a person may not necessarily acquire the most optimal product (i.e. the one that would grant them the most utility), but would find one that is "good enough". This heuristic may be problematic if the aspiration level is set at such a level that no products exist that could meet the requirements. Directed cognition Directed cognition is a search heuristic in which a person treats each opportunity to research information as their last. Rather than a contingent plan that indicates what will be done based on the results of each search, directed cognition considers only if one more search should be conducted and what alternative should be researched. Elimination by aspects Whereas satisficing and directed cognition compare choices, elimination by aspects compares certain qualities. A person using the elimination by aspects heuristic first chooses the quality that they value most in what they are searching for and sets an aspiration level. This may be repeated to refine the search. i.e. identify the second most valued quality and set an aspiration level. Using this heuristic, options will be eliminated as they fail to meet the minimum requirements of the chosen qualities.


Heuristics and cognitive effects

Outside of searching, behavioral economists and psychologists have identified a number of other
heuristics A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
and other cognitive effects that affect people's decision making. Some of these include: Mental accounting
Mental accounting Mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. The concept was first named by Richard Thaler. Mental accounting deals with the budgeting and categor ...
refers to the propensity to allocate resources for specific purposes. Mental accounting is a behavioral bias that causes one to separate money into different categories known as mental accounts either based on the source or the intention of the money. Anchoring Anchoring describes when people have a mental reference point with which they compare results to. For example, a person who anticipates that the weather on a particular day would be raining, but finds that on the day it is actually clear blue skies, would gain more utility from the pleasant weather because they anticipated that it would be bad. Herd behavior This is a relatively simple bias that reflects the tendency of people to mimic what everyone else is doing and follow the general consensus. It represents the concept of "wisdom of the crowd". Framing effects The framing effect is when individuals are presented with the same set of choices, but the choices are framed in a different manner, and this leads to different choices. In other words, individuals choose differently depending on the way questions are presented to them. People tend to have little control over their susceptibility to the framing effect as often, their choice-making process is based on intuition.


Biases and fallacies

While heuristics are tactics or mental shortcuts to aid in the decision-making process, people are also affected by a number of
biases Bias is a disproportionate weight ''in favor of'' or ''against'' an idea or thing, usually in a way that is closed-minded, prejudicial, or unfair. Biases can be innate or learned. People may develop biases for or against an individual, a group ...
and
fallacies A fallacy is the use of invalid or otherwise faulty reasoning, or "wrong moves," in the construction of an argument which may appear stronger than it really is if the fallacy is not spotted. The term in the Western intellectual tradition was in ...
. Behavioral economics identifies a number of these biases that negatively affect decision making such as: Present bias Present bias reflects the human tendency to want rewards sooner. It describes people who are more likely to forego a greater payoff in the future in favour of receiving a smaller benefit sooner. An example of this is a smoker who is trying to quit. Although they know that in the future they will suffer health consequences, the immediate gain from the nicotine hit is more favourable to a person affected by present bias. Present bias is commonly split into people who are aware of their present bias (sophisticated) and those who are not (naive). Gambler's fallacy The gambler's fallacy stems from law of small numbers. It is when an individual believes that an event that has occurred frequently in the past is less likely to occur in the future, despite the probability remaining constant. For example, if a coin had been flipped three times and turned up heads every single time, a person influenced by the gambler's fallacy would predict that the next one ought to be tails because of the abnormal number of heads flipped in the past, even though the probability of a heads occurring is still 50%. Hot hand fallacy The hot hand fallacy is the opposite of the gambler's fallacy. It is when an individual believes that an event that has occurred frequently in the past is more likely to occur again in the future such that the streak will continue. This fallacy is particularly common within sport. For example, if a football team has consistently won the last few games they have participated in, then it is often said that they are 'on form' and thus, it is expected that the football team will maintain their winning streak. Narrative fallacy Narrative fallacy refers to when people use narratives to connect the dots between random events to make sense of arbitrary information. The term stems from Nassim Taleb's book '' The Black Swan: The Impact of the Highly Improbable''. Narrative fallacy can be problematic as it can lead to individuals making false cause-effect relationships between events. For example, a startup may get funding because investors are swayed by a narrative that sounds plausible, rather than by a more reasoned analysis of available evidence. Loss aversion
Loss aversion Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends o ...
refers to the tendency to place greater weight on losses compared to equivalent gains. In other words, this means that when an individual receives a loss, this will cause their utility to decline more so than the same-sized gain. This means that they are far more likely to try to assign a higher priority on avoiding losses than making investment gains. As a result, some investors might want a higher payout to compensate for losses. If the high payout is not likely, they might try to avoid losses altogether even if the investment's risk is acceptable from a rational standpoint. Recency bias When a person places greater expectation on a particular outcome simply because that outcome had just occurred, that person may be affected by recency bias. To return to the coin flipping example, given that the previous one or two flips were heads, a person affected by recency bias would continue to predict that heads would be flipped. Confirmation bias
Confirmation bias Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values. People display this bias when they select information that supports their views, ignoring ...
reflects the tendency to positively favour information this is consistent with one's beliefs, and to negatively favour evidence that is inconsistent with one's beliefs. Familiarity bias Familiarity bias simply describes the tendency of people to return to what they know and are comfortable with. Familiarity bias discourages affected people from exploring new options and may limit their ability to find an optimal solution. Status quo bias Status quo bias describes the tendency of people to keep things the way they are. It is a particular aversion to change in favor of remaining comfortable with what is known.


Behavioral finance

Behavioral finance is the study of the influence of
psychology Psychology is the scientific study of mind and behavior. Psychology includes the study of conscious and unconscious phenomena, including feelings and thoughts. It is an academic discipline of immense scope, crossing the boundaries betwee ...
on the behavior of investors or financial analysts. It assumes that investors are not always
rational Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abi ...
, have limits to their self-control and are influenced by their own
biases Bias is a disproportionate weight ''in favor of'' or ''against'' an idea or thing, usually in a way that is closed-minded, prejudicial, or unfair. Biases can be innate or learned. People may develop biases for or against an individual, a group ...
. For example, behavioral law and economics scholars studying the growth of financial firms' technological capabilities have attributed decision science to irrational consumer decisions. It also includes the subsequent effects on the markets. Behavioral Finance attempts to explain the reasoning patterns of investors and measures the influential power of these patterns on the investor's decision making. The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants. Such errors affect prices and returns, creating market inefficiencies.


Traditional finance

The accepted theories of finance are referred to as traditional finance. The foundation of traditional finance is associated with the
modern portfolio theory Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificat ...
(MPT) and the
efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
(EMH). Modern portfolio theory is a stock or portfolio's expected return, standard deviation, and its correlation with the other stocks or mutual funds held within the portfolio. With these three concepts, an efficient portfolio can be created for any group of stocks or bonds. An efficient portfolio is a group of stocks that has the maximum (highest) expected return given the amount of risk assumed, contains the lowest possible risk for a given expected return. The efficient-market hypothesis states that all information has already been reflected in a security's price or market value, and that the current price of the stock or bond always trades at its fair value. The proponents of the traditional theories believe that "investors should just own the entire market rather than attempting to outperform the market". Behavioral finance has emerged as an alternative to these theories of traditional finance and the behavioral aspects of psychology and sociology are integral catalysts within this field of study.


Evolution

The foundations of behavioral finance can be traced back over 150 years. Several original books written in the 1800s and early 1900s marked the beginning of the behavioral finance school. Originally published in 1841, MacKay's ''
Extraordinary Popular Delusions and the Madness of Crowds ''Extraordinary Popular Delusions and the Madness of Crowds'' is an early study of crowd psychology by Scottish journalist Charles Mackay, first published in 1841 under the title ''Memoirs of Extraordinary Popular Delusions''. The book was p ...
'' presents a chronological timeline of the various panics and schemes throughout history. This work shows how group behavior applies to the financial markets of today. Le Bon's important work, '' The Crowd: A Study of the Popular Mind'', discusses the role of "crowds" (also known as
crowd psychology Crowd psychology, also known as mob psychology, is a branch of social psychology. Social psychologists have developed several theories for explaining the ways in which the psychology of a crowd differs from and interacts with that of the individ ...
) and group behavior as they apply to the fields of behavioral finance, social psychology, sociology, and history. Selden's 1912 book ''Psychology of The Stock Market'' was one of the first to apply the field of psychology directly to the stock market. This classic discusses the emotional and psychological forces at work on investors and traders in the financial markets. These three works along with several others form the foundation of applying psychology and sociology to the field of finance. The foundation of behavioral finance is an area based on an interdisciplinary approach including scholars from the social sciences and business schools. From the liberal arts perspective, this includes the fields of psychology, sociology, anthropology, economics and behavioral economics. On the business administration side, this covers areas such as management, marketing, finance, technology and accounting. Critics contend that behavioral finance is more a collection of anomalies than a true branch of
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of ...
and that these anomalies are either quickly priced out of the market or explained by appealing to
market microstructure Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstruct ...
arguments. However, individual
cognitive bias A cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the objective input, ...
es are distinct from social biases; the former can be averaged out by the market, while the other can create positive
feedback loop Feedback occurs when outputs of a system are routed back as inputs as part of a chain of cause-and-effect that forms a circuit or loop. The system can then be said to ''feed back'' into itself. The notion of cause-and-effect has to be handled ...
s that drive the market further and further from a "
fair price In accounting and in most schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. The derivation takes into account such objective factors as the costs associated ...
" equilibrium. It is observed that, the problem with the general area of behavioral finance is that it only serves as a complement to general economics. Similarly, for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profits; this is not the case for many anomalies. A specific example of this criticism appears in some explanations of the
equity premium puzzle The equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been obse ...
. It is argued that the cause is entry barriers (both practical and psychological) and that the equity premium should reduce as electronic resources open up the stock market to more traders. In response, others contend that most personal investment funds are managed through superannuation funds, minimizing the effect of these putative entry barriers. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials.


Quantitative behavioral finance

Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. Financial models Some financial models used in money management and asset valuation incorporate behavioral finance parameters. Examples: * Thaler's model of price reactions to information, with three phases (underreaction, adjustment, and overreaction), creating a price
trend A fad or trend is any form of collective behavior that develops within a culture, a generation or social group in which a group of people enthusiastically follow an impulse for a short period. Fads are objects or behaviors that achieve short-l ...
. :* One characteristic of overreaction is that average returns following announcements of good news is lower than following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to news, thus requiring an adjustment in the opposite direction. As a result, outperforming assets in one period is likely to underperform in the following period. This also applies to customers' irrational purchasing
habit A habit (or wont as a humorous and formal term) is a routine of behavior that is repeated regularly and tends to occur subconsciously.
s. :* The stock image coefficient.


Economic reasoning in animals

A handful of comparative psychologists have attempted to demonstrate quasi-economic reasoning in non-human animals. Early attempts along these lines focus on the behavior of rats and pigeons. These studies draw on the tenets of comparative psychology, where the main goal is to discover analogs to human behavior in
experiment An experiment is a procedure carried out to support or refute a hypothesis, or determine the efficacy or likelihood of something previously untried. Experiments provide insight into cause-and-effect by demonstrating what outcome occurs when ...
ally-tractable non-human animals. They are also methodologically similar to the work of Ferster and Skinner. Methodological similarities aside, early researchers in non-human economics deviate from
behaviorism Behaviorism is a systematic approach to understanding the behavior of humans and animals. It assumes that behavior is either a reflex evoked by the pairing of certain antecedent stimuli in the environment, or a consequence of that individual' ...
in their
terminology Terminology is a group of specialized words and respective meanings in a particular field, and also the study of such terms and their use; the latter meaning is also known as terminology science. A ''term'' is a word, compound word, or multi-wor ...
. Although such studies are set up primarily in an
operant conditioning chamber An operant conditioning chamber (also known as a Skinner box) is a laboratory apparatus used to study animal behavior. The operant conditioning chamber was created by B. F. Skinner while he was a graduate student at Harvard University. The c ...
using food rewards for pecking/bar-pressing behavior, the researchers describe pecking and bar-pressing not in terms of
reinforcement In behavioral psychology, reinforcement is a consequence applied that will strengthen an organism's future behavior whenever that behavior is preceded by a specific antecedent stimulus. This strengthening effect may be measured as a higher fr ...
and stimulus-response relationships but instead in terms of work,
demand In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific ite ...
,
budget A budget is a calculation play, usually but not always financial, for a defined period, often one year or a month. A budget may include anticipated sales volumes and revenues, resource quantities including time, costs and expenses, environmen ...
, and labor. Recent studies have adopted a slightly different approach, taking a more
evolution Evolution is change in the heritable characteristics of biological populations over successive generations. These characteristics are the expressions of genes, which are passed on from parent to offspring during reproduction. Variatio ...
ary perspective, comparing economic behavior of humans to a species of non-human
primate Primates are a diverse order of mammals. They are divided into the strepsirrhines, which include the lemurs, galagos, and lorisids, and the haplorhines, which include the tarsiers and the simians ( monkeys and apes, the latter includin ...
, the
capuchin monkey The capuchin monkeys () are New World monkeys of the subfamily Cebinae. They are readily identified as the "organ grinder" monkey, and have been used in many movies and television shows. The range of capuchin monkeys includes some tropical forest ...
.


Animal studies

Many early studies of non-human economic reasoning were performed on rats and pigeons in an operant conditioning chamber. These studies looked at things like peck rate (in the case of the pigeon) and bar-pressing rate (in the case of the rat) given certain conditions of reward. Early researchers claim, for example, that response pattern (pecking/bar-pressing rate) is an appropriate analogy to human labor supply. Researchers in this field advocate for the appropriateness of using animal economic behavior to understand the elementary components of human economic behavior. In a paper by Battalio, Green, and Kagel, they write,


Labor supply

The typical laboratory environment to study labor supply in pigeons is set up as follows. Pigeons are first deprived of food. Since the animals become hungry, food becomes highly desired. The pigeons are then placed in an operant conditioning chamber and through orienting and exploring the environment of the chamber they discover that by pecking a small disk located on one side of the chamber, food is delivered to them. In effect, pecking behavior becomes reinforced, as it is associated with food. Before long, the pigeon pecks at the disk (or stimulus) regularly. In this circumstance, the pigeon is said to "work" for the food by pecking. The food, then, is thought of as the currency. The value of the currency can be adjusted in several ways, including the amount of food delivered, the rate of food delivery and the type of food delivered (some foods are more desirable than others). Economic behavior similar to that observed in humans is discovered when the hungry pigeons stop working/work less when the reward is reduced. Researchers argue that this is similar to labor supply behavior in humans. That is, like humans (who, even in need, will only work so much for a given wage), the pigeons demonstrate decreases in pecking (work) when the reward (value) is reduced.


Demand

In human economics, a typical
demand curve In economics, a demand curve is a graph depicting the relationship between the price of a certain commodity (the ''y''-axis) and the quantity of that commodity that is demanded at that price (the ''x''-axis). Demand curves can be used either for t ...
has negative slope. This means that as the price of a certain good increase, the amount that consumers are willing and able to purchase decreases. Researchers studying the demand curves of non-human animals, such as rats, also find downward slopes. Researchers have studied demand in rats in a manner distinct from studying labor supply in pigeons. Specifically, in an operant conditioning chamber containing rats as experimental subjects, we require them to press a bar, instead of pecking a small disk, to receive a reward. The reward can be food (reward pellets), water, or a commodity drink such as cherry cola. Unlike in previous pigeon studies, where the work analog was pecking and the monetary analog was a reward, the work analog in this experiment is bar-pressing. Under these circumstances, the researchers claim that changing the number of bar presses required to obtain a commodity item is analogous to changing the price of a commodity item in human economics. In effect, results of demand studies in non-human animals show that, as the bar-pressing requirement (cost) increase, the number of times an animal presses the bar equal to or greater than the bar-pressing requirement (payment) decreases.


Applied issues


Intertemporal choice

Behavioral economics has been applied to intertemporal choice, which is defined as making a decision and having the effects of such decision happening in a different time. Intertemporal choice behavior is largely inconsistent, as exemplified by George Ainslie's
hyperbolic discounting In economics, hyperbolic discounting is a time-''inconsistent'' model of delay discounting. It is one of the cornerstones of behavioral economics and its brain-basis is actively being studied by neuroeconomics researchers. According to the disc ...
—one of the prominently studied observations—and further developed by David Laibson, Ted O'Donoghue and Matthew Rabin. Hyperbolic discounting describes the tendency to discount outcomes in the near future more than outcomes in the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with basic models of rational choice, since the rate of discount between time ''t'' and ''t+1'' will be low at time ''t-1'' when ''t'' is the near future, but high at time ''t'' when ''t'' is the present and time ''t+1'' is the near future. This pattern can also be explained through models of sub-additive discounting that distinguish the delay and interval of discounting: people are less patient (per-time-unit) over shorter intervals regardless of when they occur.


Behavioral game theory

Behavioral game theory, invented by Colin Camerer, analyzes interactive
strategic Strategy (from Greek στρατηγία ''stratēgia'', "art of troop leader; office of general, command, generalship") is a general plan to achieve one or more long-term or overall goals under conditions of uncertainty. In the sense of the "art ...
decisions and behavior using the methods of
game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appli ...
,
experimental economics Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic expe ...
, and
experimental psychology Experimental psychology refers to work done by those who apply experimental methods to psychological study and the underlying processes. Experimental psychologists employ human participants and animal subjects to study a great many topics, in ...
. Experiments include testing deviations from typical simplifications of economic theory such as the independence axiom and neglect of
altruism Altruism is the principle and moral practice of concern for the welfare and/or happiness of other human beings or animals, resulting in a quality of life both material and spiritual. It is a traditional virtue in many cultures and a core ...
,
fairness Fairness or being fair can refer to: * Justice * The character in the award-nominated musical comedy '' A Theory of Justice: The Musical.'' * Equity (law), a legal principle allowing for the use of discretion and fairness when applying justice ...
, and framing effects. On the positive side, the method has been applied to interactive learning and social preferences. As a research program, the subject is a development of the last three decades.


Artificial intelligence

Much of the decisions are more and more made either by human beings with the assistance of artificial intelligent machines or wholly made by these machines.
Tshilidzi Marwala Tshilidzi Marwala (born 28 July 1971) is a South African artificial intelligence engineer, a computer scientist, a mechanical engineer and a university administrator. Early life and education Marwala was born at Duthuni Village in the Lim ...
and Evan Hurwitz in their book, studied the utility of behavioral economics in such situations and concluded that these intelligent machines reduce the impact of bounded rational decision making. In particular, they observed that these intelligent machines reduce the degree of
information asymmetry In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which ca ...
in the market, improve decision making and thus making markets more rational. The use of AI machines in the market in applications such as online trading and decision making has changed major economic theories. Other theories where AI has had impact include in
rational choice Rational choice theory refers to a set of guidelines that help understand economic and social behaviour. The theory originated in the eighteenth century and can be traced back to political economist and philosopher, Adam Smith. The theory postula ...
,
rational expectations In economics, "rational expectations" are model-consistent expectations, in that agents inside the model are assumed to "know the model" and on average take the model's predictions as valid. Rational expectations ensure internal consistency i ...
,
game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appli ...
,
Lewis turning point The Lewis turning point is a situation in economic development where surplus rural labor is fully absorbed into the manufacturing sector. This typically causes agricultural and unskilled industrial real wages to rise. The term is named after econ ...
,
portfolio optimization Portfolio optimization is the process of selecting the best portfolio (asset distribution), out of the set of all portfolios being considered, according to some objective. The objective typically maximizes factors such as expected return, and minim ...
and
counterfactual thinking Counterfactual thinking is a concept in psychology that involves the human tendency to create possible alternatives to life events that have already occurred; something that is contrary to what actually happened. Counterfactual thinking is, as it ...
.


Other areas of research

Other branches of behavioral economics enrich the model of the utility function without implying inconsistency in preferences. Ernst Fehr, Armin Falk, and Rabin studied
fairness Fairness or being fair can refer to: * Justice * The character in the award-nominated musical comedy '' A Theory of Justice: The Musical.'' * Equity (law), a legal principle allowing for the use of discretion and fairness when applying justice ...
, inequity aversion and
reciprocal altruism In evolutionary biology, reciprocal altruism is a behaviour whereby an organism acts in a manner that temporarily reduces its fitness while increasing another organism's fitness, with the expectation that the other organism will act in a similar m ...
, weakening the neoclassical assumption of perfect selfishness. This work is particularly applicable to wage setting. The work on "intrinsic motivation by Uri Gneezy and Aldo Rustichini and "identity" by
George Akerlof George Arthur Akerlof (born June 17, 1940) is an American economist and a university professor at the McCourt School of Public Policy at Georgetown University and Koshland Professor of Economics Emeritus at the University of California, Berkeley. ...
and Rachel Kranton assumes that agents derive utility from adopting personal and social norms in addition to conditional expected utility. According to Aggarwal, in addition to behavioral deviations from rational equilibrium, markets are also likely to suffer from lagged responses, search costs, externalities of the commons, and other frictions making it difficult to disentangle behavioral effects in market behavior. "Conditional expected utility" is a form of reasoning where the individual has an
illusion of control The illusion of control is the tendency for people to overestimate their ability to control events. It was named by U.S. psychologist Ellen Langer and is thought to influence gambling behavior and belief in the paranormal. Along with illusory supe ...
, and calculates the probabilities of external events and hence their utility as a function of their own action, even when they have no causal ability to affect those external events. Behavioral economics caught on among the general public with the success of books such as Dan Ariely's '' Predictably Irrational.'' Practitioners of the discipline have studied quasi-public policy topics such as broadband mapping. Applications for behavioral economics include the modeling of the consumer decision-making process for applications in
artificial intelligence Artificial intelligence (AI) is intelligence—perceiving, synthesizing, and inferring information—demonstrated by machines, as opposed to intelligence displayed by animals and humans. Example tasks in which this is done include speech ...
and
machine learning Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence. Machine ...
. The Silicon Valley-based start-up Singularities is using the AGM postulates proposed by Alchourrón, Gärdenfors, and Makinson—the formalization of the concepts of beliefs and change for rational entities—in a symbolic logic to create a "machine learning and deduction engine that uses the latest
data science Data science is an interdisciplinary field that uses scientific methods, processes, algorithms and systems to extract or extrapolate knowledge and insights from noisy, structured and unstructured data, and apply knowledge from data across a bro ...
and
big data Though used sometimes loosely partly because of a lack of formal definition, the interpretation that seems to best describe Big data is the one associated with large body of information that we could not comprehend when used only in smaller am ...
algorithms in order to generate the content and conditional rules (counterfactuals) that capture customer's behaviors and beliefs." The
University of Pennsylvania The University of Pennsylvania (also known as Penn or UPenn) is a private research university in Philadelphia. It is the fourth-oldest institution of higher education in the United States and is ranked among the highest-regarded universit ...
's Center for Health Incentives & Behavioral Economics (CHIBE) looks at how behavioral economics can improve health outcomes. CHIBE researchers have found evidence that many behavioral economics principles (incentives, patient and clinician nudges, gamification, loss aversion, and more) can be helpful to encourage vaccine uptake, smoking cessation, medication adherence, and physical activity, for example. Applications of behavioral economics also exist in other disciplines, for example in the area of supply chain management.


Natural experiments

From a biological point of view, human behaviors are essentially the same during crises accompanied by stock market crashes and during bubble growth when share prices exceed historic highs. During those periods, most market participants see something new for themselves, and this inevitably induces a stress response in them with accompanying changes in their endocrine profiles and motivations. The result is quantitative and qualitative changes in behavior. This is one example where behavior affecting economics and finance can be observed and variably-contrasted using behavioral economics. Behavioral economics' usefulness applies beyond environments similar to stock exchanges. Selfish-reasoning, 'adult behaviors', and similar, can be identified within criminal-concealment(s), and legal-deficiencies and neglect of different types can be observed and discovered. Awareness of indirect consequence (or lack of), at least in potential with different experimental models and methods, can be used as well—behavioral economics' potential uses are broad, but its reliability needs scrutiny. Underestimation of the role of novelty as a stressor is the primary shortcoming of current approaches for market research. It is necessary to account for the biologically determined diphasisms of human behavior in everyday low-stress conditions and in response to stressors. Limitations of experimental methods (e.g. randomized control trials) and their use in economics were famously analyzed by Angus Deaton.


Honors and Awards


Nobel Prize


1978 - Herbert Simon

In 1978 Herbert Simon was awarded the
Nobel Memorial Prize in Economic Sciences The Nobel Memorial Prize in Economic Sciences, officially the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel ( sv, Sveriges riksbanks pris i ekonomisk vetenskap till Alfred Nobels minne), is an economics award administered ...
"for his pioneering research into the decision-making process within economic organizations". Simon earned his Bachelor of Arts and his Ph.D. in Political Science from the University of Chicago before going on to teach at Carnegie Tech. Herbert was praised for his work on bounded rationality, a challenge to the assumption that humans are rational actors.


2001 - George Akerlof, Michael Spence, and Joseph Stiglitz

The Royal Swedish Academy of Sciences stated George Akerlof, Michael Spence and Joseph Stiglitz received the Nobel Memorial Prize in Economic Sciences in 2001 "for their analyses of markets with asymmetric information." Akerlof's work looked into adverse selection, emphasizing the importance of information within markets, while Spence and Stiglitz made insights on signalling and screening, respectively. Their work on markets challenged standard theories within economics.


2002 - Daniel Kahneman and Vernon L. Smith

In 2002, psychologist
Daniel Kahneman Daniel Kahneman (; he, דניאל כהנמן; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarde ...
and economist
Vernon L. Smith Vernon Lomax Smith (born January 1, 1927) is an American economist and professor of business economics and law at Chapman University. He was formerly a professor of economics at the University of Arizona, professor of economics and law at George ...
were awarded the Nobel Memorial Prize in Economic Sciences. Kahneman was awarded the prize "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty", while Smith was awarded the prize "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms."


2013 - Robert J. Shiller

In 2013, economist Robert J. Shiller received the Nobel Memorial Prize in Economic Sciences along with Eugene Fama and Lars Peter "for their empirical analysis of asset prices" within the field of behavioral finance, as according to the press release from the Royal Swedish Academy of Sciences. Shiller discovered that one can more accurately predict stock prices in the long-run compared to the short run. He also hypothesized that rational actors cannot be responsible for stock prices in the short-run due to uniquely large fluctuations.


2017 - Richard Thaler

In 2017, economist
Richard Thaler Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was ...
was awarded the Nobel Memorial Prize in Economic Sciences for "his contributions to behavioral economics and his pioneering work in establishing that people are predictably irrational in ways that defy economic theory." Thaler was especially recognized for presenting inconsistencies in standard Economic theory and for his formulation of
mental accounting Mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. The concept was first named by Richard Thaler. Mental accounting deals with the budgeting and categor ...
and liberal paternalism.


Other Awards


1999 - Andrei Shleifer

The work of Andrei Shleifer focused on behavioral finance and made observations on the limits of the
efficient market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...
. Shleifer received the 1999 John Bates Clark Medal from the
American Economic Association The American Economic Association (AEA) is a learned society in the field of economics. It publishes several peer-reviewed journals acknowledged in business and academia. There are some 23,000 members. History and Constitution The AEA was esta ...
for his work.


2001 - Matthew Rabin

Matthew Rabin received the "genius" award from the MarArthur Foundation in 2000. The American Economic Association chose Rabin as the recipient of the 2001 John Bates Clark medal. Rabin's awards were given to him primarily on the basis of his work on fairness and reciprocity, and on present bias.


2003 - Sendhil Mullainathan

Sendhil Mullainathan was the youngest of the chosen MacArthur Fellows in 2002, receiving a fellowship grant of $500,000 in 2003. Mullainathan was praised by the MacArthur Foundation as working on economics and psychology as an aggregate. Mullainathan's research focused on the salaries of executives on Wall Street; he also has looked at the implications of racial discrimination in markets in the United States.


Criticism

Experimental psychological work by Kahneman and Tversky published in Armen Alchian's 1950 paper " Uncertainty, Evolution, and Economic Theory" and Gary Becker's 1962 paper "Irrational Behavior and Economic Theory", both of which were published in the ''
Journal of Political Economy The ''Journal of Political Economy'' is a monthly peer-reviewed academic journal published by the University of Chicago Press. Established by James Laurence Laughlin in 1892, it covers both theoretical and empirical economics. In the past, the ...
'',Alchian, A. (1950). 'Uncertainty, Evolution, and Economic Theory', ''Journal of Political Economy'', 58(1), 211-221. Available at: https://www.jstor.org/stable/1827159?seq=1 (Accessed: June 9, 2021).Becker, G. (1962). 'Irrational Behavior and Economic Theory', ''Journal of Political Economy'', 70(1), 1–13. Available at: https://www.jstor.org/stable/1827018?seq=1 (Accessed: June 9, 2021). provide a justification for standard neoclassical economic analysis. Alchian's 1950 paper uses the logic of natural selection, stochastic processes, probability theory, and several other lines of reasoning to justify many of the results derived from standard supply analysis assuming firms which maximizing their profits, are certain about the future, and have accurate foresight without having to assume any of those things. Becker's 1962 paper shows that downward sloping market demand curves do not actually require an assumption that the consumers in that market are rational, as is claimed by behavioral economists and they also follow from a wide variety of irrational behavior as well. The two papers laid the groundwork for Richard Thaler's work. Critics of behavioral economics typically stress the
rationality Rationality is the quality of being guided by or based on reasons. In this regard, a person acts rationally if they have a good reason for what they do or a belief is rational if it is based on strong evidence. This quality can apply to an abil ...
of economic agents. A fundamental critique is provided by Maialeh (2019) who argues that no behavioral research can establish an economic theory. Examples provided on this account include pillars of behavioral economics such as satisficing behavior or prospect theory, which are confronted from the neoclassical perspective of utility maximization and expected utility theory respectively. The author shows that behavioral findings are hardly generalizable and that they do not disprove typical mainstream axioms related to rational behavior. Others, such as the essayist and former trader Nassim Taleb note that cognitive theories, such as
prospect theory Prospect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics. Based ...
, are models of
decision-making In psychology, decision-making (also spelled decision making and decisionmaking) is regarded as the cognitive process resulting in the selection of a belief or a course of action among several possible alternative options. It could be either rati ...
, not generalized economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment participants or survey respondents. Others argue that decision-making models, such as the endowment effect theory, that have been widely accepted by behavioral economists may be erroneously established as a consequence of poor experimental design practices that do not adequately control subject misconceptions. Despite a great deal of rhetoric, no unified behavioral theory has yet been espoused: behavioral economists have proposed no alternative unified theory of their own to replace neoclassical economics with.
David Gal David Gal iProfessor of Marketingat the University of Illinois at Chicago. He is best known for his critiques of behavioral economics, and in particular his critique of the behavioral economics concept of loss aversion. His forthcoming book is tit ...
has argued that many of these issues stem from behavioral economics being too concerned with understanding ''how'' behavior deviates from standard economic models rather than with understanding ''why'' people behave the way they do. Understanding why behavior occurs is necessary for the creation of generalizable knowledge, the goal of
science Science is a systematic endeavor that builds and organizes knowledge in the form of testable explanations and predictions about the universe. Science may be as old as the human species, and some of the earliest archeological evidence f ...
. He has referred to behavioral economics as a "triumph of marketing" and particularly cited the example of loss aversion. Traditional economists are skeptical of the experimental and survey-based techniques that behavioral economics uses extensively. Economists typically stress
revealed preference Revealed preference theory, pioneered by economist Paul Anthony Samuelson in 1938, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume th ...
s over stated preferences (from surveys) in the determination of economic value. Experiments and surveys are at risk of
systemic bias Systemic bias, also called institutional bias, and related to structural bias, is the inherent tendency of a process to support particular outcomes. The term generally refers to human systems such as institutions. Institutional bias and structur ...
es, strategic behavior and lack of incentive compatibility. Some researchers point out that participants of experiments conducted by behavioral economists are not representative enough and drawing broad conclusions on the basis of such experiments is not possible. An acronym WEIRD has been coined in order to describe the studies participants—as those who come from Western, Educated, Industrialized, Rich, and Democratic societies.


Responses

Matthew Rabin dismisses these criticisms, countering that consistent results typically are obtained in multiple situations and geographies and can produce good theoretical insight. Behavioral economists, however, responded to these criticisms by focusing on field studies rather than lab experiments. Some economists see a fundamental schism between
experimental economics Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic expe ...
and behavioral economics, but prominent behavioral and experimental economists tend to share techniques and approaches in answering common questions. For example, behavioral economists are investigating neuroeconomics, which is entirely experimental and has not been verified in the field. The epistemological, ontological, and methodological components of behavioral economics are increasingly debated, in particular by historians of economics and economic methodologists. According to some researchers, when studying the mechanisms that form the basis of decision-making, especially financial decision-making, it is necessary to recognize that most decisions are made under stress because, "Stress is the nonspecific body response to any demands presented to it."


Related Fields


Experimental economics

Experimental economics is the application of experimental methods, including
statistical Statistics (from German: '' Statistik'', "description of a state, a country") is the discipline that concerns the collection, organization, analysis, interpretation, and presentation of data. In applying statistics to a scientific, industri ...
, econometric, and computational, to study economic questions.
Data In the pursuit of knowledge, data (; ) is a collection of discrete values that convey information, describing quantity, quality, fact, statistics, other basic units of meaning, or simply sequences of symbols that may be further interpret ...
collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in order to mimic real-world incentives. Experiments are used to help understand how and why markets and other exchange systems function as they do. Experimental economics have also expanded to understand institutions and the law (experimental law and economics). A fundamental aspect of the subject is
design of experiments The design of experiments (DOE, DOX, or experimental design) is the design of any task that aims to describe and explain the variation of information under conditions that are hypothesized to reflect the variation. The term is generally associ ...
. Experiments may be conducted in the field or in laboratory settings, whether of
individual An individual is that which exists as a distinct entity. Individuality (or self-hood) is the state or quality of being an individual; particularly (in the case of humans) of being a person unique from other people and possessing one's own need ...
or group behavior. Variants of the subject outside such formal confines include
natural Nature, in the broadest sense, is the physical world or universe. "Nature" can refer to the phenomena of the physical world, and also to life in general. The study of nature is a large, if not the only, part of science. Although humans are ...
and
quasi-natural experiment A quasi-experiment is an empirical interventional study used to estimate the causal impact of an intervention on target population without random assignment. Quasi-experimental research shares similarities with the traditional experimental design ...
s.


Neuroeconomics

Neuroeconomics is an
interdisciplinary Interdisciplinarity or interdisciplinary studies involves the combination of multiple academic disciplines into one activity (e.g., a research project). It draws knowledge from several other fields like sociology, anthropology, psychology, ec ...
field that seeks to explain human decision making, the ability to process multiple alternatives and to follow a course of action. It studies how economic behavior can shape our understanding of the
brain A brain is an organ (biology), organ that serves as the center of the nervous system in all vertebrate and most invertebrate animals. It is located in the head, usually close to the sensory organs for senses such as Visual perception, vision. I ...
, and how neuroscientific discoveries can constrain and guide models of economics. It combines research methods from
neuroscience Neuroscience is the scientific study of the nervous system (the brain, spinal cord, and peripheral nervous system), its functions and disorders. It is a multidisciplinary science that combines physiology, anatomy, molecular biology, develo ...
, experimental and behavioral economics, and
cognitive Cognition refers to "the mental action or process of acquiring knowledge and understanding through thought, experience, and the senses". It encompasses all aspects of intellectual functions and processes such as: perception, attention, thoug ...
and
social Social organisms, including human(s), live collectively in interacting populations. This interaction is considered social whether they are aware of it or not, and whether the exchange is voluntary or not. Etymology The word "social" derives from ...
psychology. As research into decision-making behavior becomes increasingly computational, it has also incorporated new approaches from theoretical biology,
computer science Computer science is the study of computation, automation, and information. Computer science spans theoretical disciplines (such as algorithms, theory of computation, information theory, and automation) to practical disciplines (includi ...
, and
mathematics Mathematics is an area of knowledge that includes the topics of numbers, formulas and related structures, shapes and the spaces in which they are contained, and quantities and their changes. These topics are represented in modern mathematics ...
. Neuroeconomics studies decision making by using a combination of tools from these fields so as to avoid the shortcomings that arise from a single-perspective approach. In
mainstream economics Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to ...
,
expected utility The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decisions when the payoff is uncertain. The theory recommends which option rational individuals should choose in a complex situation, based on the ...
(EU) and the concept of rational agents are still being used. Many economic behaviors are not fully explained by these models, such as
heuristics A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
and framing. Behavioral economics emerged to account for these anomalies by integrating social, cognitive, and emotional factors in understanding economic decisions. Neuroeconomics adds another layer by using neuroscientific methods in understanding the interplay between economic behavior and neural mechanisms. By using tools from various fields, some scholars claim that neuroeconomics offers a more integrative way of understanding decision making.


Evolutionary psychology

An
evolutionary psychology Evolutionary psychology is a theoretical approach in psychology that examines cognition and behavior from a modern evolutionary perspective. It seeks to identify human psychological adaptations with regards to the ancestral problems they evolv ...
perspective states that many of the perceived limitations in rational choice can be explained as being rational in the context of maximizing biological fitness in the ancestral environment, but not necessarily in the current one. Thus, when living at subsistence level where a reduction of resources may result in death, it may have been rational to place a greater value on preventing losses than on obtaining gains. It may also explain behavioral differences between groups, such as males being less risk-averse than females since males have more variable
reproductive success Reproductive success is an individual's production of offspring per breeding event or lifetime. This is not limited by the number of offspring produced by one individual, but also the reproductive success of these offspring themselves. Reproduct ...
than females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially increase their reproductive success from successful risk-seeking much more than females can.Paul H. Rubin and C. Monica Capra. The evolutionary psychology of economics. In


Notable people


Economics

*
George Akerlof George Arthur Akerlof (born June 17, 1940) is an American economist and a university professor at the McCourt School of Public Policy at Georgetown University and Koshland Professor of Economics Emeritus at the University of California, Berkeley. ...
* Werner De Bondt * Paul De Grauwe * Linda C. Babcock * Douglas Bernheim * Colin Camerer * Armin Falk * Urs Fischbacher *
Tshilidzi Marwala Tshilidzi Marwala (born 28 July 1971) is a South African artificial intelligence engineer, a computer scientist, a mechanical engineer and a university administrator. Early life and education Marwala was born at Duthuni Village in the Lim ...
* Susan E. Mayer * Ernst Fehr * Simon Gächter * Uri Gneezy * David Laibson * Louis Lévy-Garboua * John A. List * George Loewenstein *
Sendhil Mullainathan Sendhil Mullainathan () (born c. 1973) is an American professor of Computation and Behavioral Science at the University of Chicago Booth School of Business and the author of '' Scarcity: Why Having Too Little Means So Much'' (with Eldar Sha ...
*
John Quiggin John Quiggin (born 29 March 1956) is an Australian economist, a professor at the University of Queensland. He was formerly an Australian Research Council Laureate Fellow and Federation Fellow and a member of the board of the Climate Change Au ...
* Matthew Rabin * Reinhard Selten * Herbert A. Simon *
Vernon L. Smith Vernon Lomax Smith (born January 1, 1927) is an American economist and professor of business economics and law at Chapman University. He was formerly a professor of economics at the University of Arizona, professor of economics and law at George ...
*
Robert Sugden Robert Sugden (also Sugden-Dingle) is a fictional character from the British ITV soap opera ''Emmerdale''. The character originally appeared on the show regularly between 22 April 1986 and 3 October 2005. During that time he was first played ...
* Larry Summers *
Richard Thaler Richard H. Thaler (; born September 12, 1945) is an American economist and the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business. In 2015, Thaler was ...
*
Abhijit Banerjee Abhijit Vinayak Banerjee (; born 21 February 1961) is an Indian-American economist who is currently the Ford Foundation International Professor of Economics at Massachusetts Institute of Technology. Banerjee shared the 2019 Nobel Memorial Priz ...
*
Esther Duflo Esther Duflo, FBA (; born 25 October 1972) is a French–American economist who is a professor of Poverty Alleviation and Development Economics at the Massachusetts Institute of Technology (MIT). She is the co-founder and co-director of the A ...
* Kevin Volpp * Katy Milkman


Finance

* Malcolm Baker * Nicholas Barberis * Gunduz Caginalp * David Hirshleifer *
Andrew Lo Andrew Wen-Chuan Lo () (born 1960) is the Charles E. and Susan T. Harris Professor of Finance at the MIT Sloan School of Management. Lo is the author of many academic articles in finance and financial economics. He founded AlphaSimplex Group in ...
* Michael Mauboussin * Terrance Odean * Richard L. Peterson * Charles Plott * Robert Prechter * Hersh Shefrin *
Robert Shiller Robert James Shiller (born March 29, 1946) is an American economist, academic, and author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management's International Center fo ...
* Andrei Shleifer * Robert Vishny


Psychology

* George Ainslie * Dan Ariely * Ed Diener * Ward Edwards * Laszlo Garai * Gerd Gigerenzer *
Daniel Kahneman Daniel Kahneman (; he, דניאל כהנמן; born March 5, 1934) is an Israeli-American psychologist and economist notable for his work on the psychology of judgment and decision-making, as well as behavioral economics, for which he was awarde ...
* Ariel Kalil * George Katona * Walter Mischel * Drazen Prelec * Eldar Shafir * Paul Slovic * John Staddon *
Amos Tversky Amos Nathan Tversky ( he, עמוס טברסקי; March 16, 1937 – June 2, 1996) was an Israeli cognitive and mathematical psychologist and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his ...
* Moran Cerf


See also

*
Adaptive market hypothesis The adaptive market hypothesis, as proposed by Andrew Lo,Lo, 2004. is an attempt to reconcile economic theories based on the efficient market hypothesis (which implies that markets are efficient) with behavioral economics, by applying the princi ...
* Animal Spirits (Keynes) * Behavioralism * Behavioral operations research * Behavioral Strategy *
Big Five personality traits The Big Five personality traits is a suggested taxonomy, or grouping, for personality traits, developed from the 1980s onward in psychological trait theory. Starting in the 1990s, the theory identified five factors by labels, for the US English ...
*
Confirmation bias Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values. People display this bias when they select information that supports their views, ignoring ...
* Cultural economics *
Culture change Culture change is a term used in public policy making that emphasizes the influence of cultural capital on individual and community behavior. It has been sometimes called repositioning of culture, which means the reconstruction of the cultural conce ...
*
Economic sociology Economic sociology is the study of the social cause and effect of various economic phenomena. The field can be broadly divided into a classical period and a contemporary one, known as "new economic sociology". The classical period was concerned ...
* Emotional bias * Fuzzy-trace theory * Hindsight bias * '' Homo reciprocans'' * Important publications in behavioral economics *
List of cognitive biases Cognitive biases are systematic patterns of deviation from norm and/or rationality in judgment. They are often studied in psychology, sociology and behavioral economics. Although the reality of most of these biases is confirmed by reproducible ...
* Methodological individualism *
Nudge theory Nudge theory is a concept in behavioral economics, decision making, behavioral policy, social psychology, consumer behavior, and related behavioral sciences that proposes adaptive designs of the decision environment ( choice architecture) as way ...
* Observational techniques * Praxeology * Priority heuristic * Regret theory * Repugnancy costs *
Socioeconomics Socioeconomics (also known as social economics) is the social science that studies how economic activity affects and is shaped by social processes. In general it analyzes how modern societies progress, stagnate, or regress because of their lo ...
* Socionomics


References


Citations


Sources

* * * * * * * * ** ** ** ** * * * * * * * * * *
Description
* * Chapter-previe
links
* * *
Description
* * * * * *
The Behavioral Economics GuideOverview of Behavioral FinanceThe Institute of Behavioral FinanceStirling Behavioural Science Blog
of the Stirling Behavioural Science Centre at University of Stirling
Society for the Advancement of Behavioural EconomicsBehavioral Economics: Past, Present, Future
– Colin F. Camerer and George Loewenstein
A History of Behavioural Finance / Economics in Published Research: 1944–1988MSc Behavioural Economics
MSc in Behavioural Economics at the University of Essex

{{Authority control Behavioral finance Financial economics Market trends Microeconomics Prospect theory