Behavioral Economics Concepts to Know for Principles of Microeconomics

Behavioral economics looks at how real people make decisions, often influenced by emotions and cognitive limits. Concepts like bounded rationality, loss aversion, and social preferences show that our choices can be less than rational, impacting economic outcomes.

1. Bounded rationality

   • Individuals have cognitive limitations that affect their decision-making capabilities.
   • People often rely on simplified models of reality rather than exhaustive analysis.
   • Decisions are made based on the information available, which may be incomplete or imperfect.

2. Loss aversion

   • Losses are perceived as more significant than equivalent gains; losing $100 feels worse than gaining$100 feels good.
   • This concept explains why people may avoid risks even when potential gains outweigh potential losses.
   • Loss aversion can lead to suboptimal decision-making, such as holding onto losing investments.

3. Prospect theory

   • Describes how people make choices in uncertain situations, emphasizing the value of potential gains and losses.
   • It introduces the idea of a value function that is steeper for losses than for gains, reflecting loss aversion.
   • Suggests that people evaluate outcomes based on perceived changes from a reference point rather than absolute outcomes.

4. Framing effects

   • The way information is presented can significantly influence decision-making and preferences.
   • People may react differently to the same choice depending on whether it is framed in terms of potential gains or losses.
   • Framing can lead to inconsistent choices, highlighting the importance of context in economic decisions.

5. Anchoring

   • Individuals rely heavily on the first piece of information encountered (the "anchor") when making decisions.
   • This initial reference point can skew perceptions and lead to biased judgments in subsequent evaluations.
   • Anchoring can affect pricing, negotiations, and estimates, often leading to irrational outcomes.

6. Mental accounting

   • People categorize and treat money differently based on subjective criteria, such as the source of funds or intended use.
   • This can lead to irrational financial behaviors, such as treating a tax refund differently than regular income.
   • Mental accounting can affect savings, spending, and investment decisions, often leading to suboptimal financial outcomes.

7. Heuristics and biases

   • Heuristics are mental shortcuts that simplify decision-making but can lead to systematic errors or biases.
   • Common biases include overconfidence, availability bias, and representativeness, which can distort rational judgment.
   • Understanding these heuristics is crucial for predicting consumer behavior and market outcomes.

8. Endowment effect

   • People tend to assign more value to items they own compared to identical items they do not own.
   • This can lead to reluctance to trade or sell possessions, even when it would be economically rational to do so.
   • The endowment effect illustrates how ownership can distort perceived value and decision-making.

9. Present bias

   • Individuals often prioritize immediate rewards over future benefits, leading to procrastination and poor long-term planning.
   • This bias can result in behaviors such as overspending or under-saving for retirement.
   • Understanding present bias is essential for designing policies that encourage better long-term decision-making.

10. Social preferences and fairness

    • People care about fairness and the welfare of others, which can influence their economic decisions.
    • Social preferences can lead to altruistic behavior, cooperation, and a willingness to sacrifice personal gain for perceived fairness.
    • These preferences challenge traditional economic models that assume purely self-interested behavior.