Introduction to Behavioral

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2  Why do sellers often value their goods or assets much higher than buyers?

3  Why are people willing to drive across town to save $5 to purchase a $15 calculator 

but not to purchase a $125 jacket?

4  Why are the fresh fruit and vegetables usually found at the entrance of the 

supermarket when they are easily damaged in the shopping trolley?

5  Why are people delighted to hear they are going to get a 10% raise in salary, and 

then furious to fi nd out that a colleague is going to get 15%?

6  Why do people forever make resolutions to go on a diet or stop smoking, only to 

give in later?

7  Why do people go to the ATM and withdraw a measly $50?

8  Why do people prefer to postpone a treat like a luxury dinner rather than have it 

sooner?

9  Why is someone unwilling to pay $500 for a product, but then delighted when 

their spouse buys them the same product for the same price using their joint bank 

account?

10  Why is someone willing to drive through a blizzard to go to see a ball game when 

they have paid for the ticket, but not when they have been given the ticket for free?

11  Why are people willing to bet long odds on the last race of the day, but not on 

previous races?

None of these questions is readily answerable using the standard model, because of 

the restrictive nature of the assumptions involved. In some cases there are anomalies, 

meaning that the standard model makes inaccurate predictions; in other cases the 

standard model  is incomplete or silent, meaning that it cannot make predictions at all.  

Both aspects together have been key drivers in the rapid development of behavioral 

economics as an emerging subdiscipline of economics.

The relationship between the standard model and behavioral economics in the 

light of those limitations may be described as follows: every model has a 

domain of 

application which comprises those phenomena that it seeks to explain. There is also 

a 

domain of validity, the range of phenomena for which the model offers a valid 

account or explanation. The traditional domain of the standard model, ranging over 

all economic decision-making, is vast. The limitations listed here all indicate that its 

domain of validity may be much smaller than its traditional domain of application. 

Whether and to what extent alternative models from behavioral economics are able 

to offer complementary and even competing accounts of decision-making, depending 

on whether their domain of validity overlaps with or extends to the original domain 

of the standard model, is one of the most hotly debated questions in economics today 

and it has, as we shall see, a long and distinguished trajectory in the history of the 

discipline.

1.2  History and evolution of behavioral economics

As we will see, behavioral economics fi nds its twentieth-century origins in various 

empirical critiques of the standard neoclassical model of economic decision-making. 

That model itself only came to dominate the discipline as economics gradually severed 

its traditional ties to psychological, sociological and historical inquiry. An instrumental 

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factor in this shift has been the so-called formalist revolution in economics during 

the immediate post-World War II era (Blaug, 2001). But in order to appreciate the 

emergence and position of behavioral economics within the wider context of the 

development of economic thought, one needs to bear in mind that for much of its 

history, economic thought has evolved in close proximity to psychological reasoning.

The classical and neoclassical approaches

There tends to be a widespread belief that the economists of the eighteenth and 

nineteenth centuries who pioneered the discipline had no time for psychology. 

The neoclassicists in particular are often portrayed as systematizers who wanted to 

bring mathematical rigor to their subject by imposing some simplifying assumptions 

regarding motivation. A good example is the work of Daniel Bernoulli (1738), who 

might be regarded as the originator of the theory of choice under risk, explaining risk-

aversion in terms of the diminishing marginal utility of money.

However, the portrayal of the classical and early neoclassical schools as economic 

schools of thought that developed in disregard of psychological and sociological insight 

gives a misleading impression. Although Adam Smith is best known for his Wealth of 

Nations, in 1776, he was also the author of a less well-known work, The Theory of Moral 

Sentiments, in 1759. The latter contains a number of vital psychological insights and 

foreshadows many more recent developments in behavioral economics, particularly 

relating to the role of emotions in decision-making.

Similarly, Jeremy Bentham, best known for introducing the concept of utility, 

had much to say about the underlying psychology of consumers. Francis Edgeworth 

wrote Mathematical Psychics in 1881, the title indicating his concern with psychology; 

this is refl ected in the well-known ‘Edgeworth Box’ diagram, named after him, which 

relates to two-person bargaining situations and involves a simple model of social utility. 

However, psychology was in its infancy at this time as an academic discipline, and many 

economists wanted the also-new science of economics (then still largely referred to as 

political economy) to aspire to a more rigorous grounding, comparable to that of the 

natural sciences. Hence the birth of the concept of homo economicus, that embodiment 

of economic rationality as  self-interested utility maximization.

Post-war economic approaches

In the fi rst half of the twentieth century there were still economists who considered 

and discussed psychological factors in their work, for example Irving Fisher, Vilfredo 

Pareto and John Maynard Keynes. The latter famously speculated, both fi guratively 

and literally, on the stock market, with notable success. However, the general trend 

during this time was to ignore psychology, and by World War II psychologists were 

persona non grata in economists’ circles.

This trend continued after the war, aided in many ways by the advent of better 

computational methods. As computers became more powerful it became possible to 

build and estimate mathematical models of both markets and the economic system 

as a whole. The sub-discipline of econometrics became a vital tool for economists as 

a means of both developing and testing theories. Economists became obsessed with 

mensuration, meaning the measurement of variables, and the estimation of economic 

parameters using mathematical equations and econometric methods. Much progress 

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