Introduction to Behavioral

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was made in terms of theoretical development, and the emphasis on mathematical 

treatment led to greater rigor and more precise, if not accurate, results. 

Some economists realized that the behavioral assumptions underlying their models 

were unrealistic, but there has been a methodological approach, typifi ed by Milton 

Friedman, that economic theory had little to do with the accuracy of these behavioral 

assumptions, or with understanding why individuals behave as they do. This approach 

is discussed in the next chapter.

The resurgence of behaviorism in economics

Some heretics, like Herbert Simon, viewed the standard approach as somewhat 

blinkered. He was not prepared to accept the host of ready excuses that were 

offered when predictions went astray: temporary ‘blips’, the introduction of new and 

unpredictable factors, measurement discrepancies, and so on. He believed it important 

to understand the underlying motivation behind the behavior of economic agents in 

order to improve existing theories and make more accurate predictions. Simon (1955) 

introduced the term ‘bounded rationality’ to refer to the cognitive limitations facing 

decision-makers in terms of acquiring and processing information.

There were a number of seminal papers written in the 1950s and 1960s which 

complemented the work of Simon. These papers all pointed to various anomalies in 

individual decision-making if seen through the lens of the standard model, and suggested 

theoretical improvements. Notable contributions included those by Markowitz (1952), 

Allais (1953), Strotz (1955), Schelling (1960) and Ellsberg (1961).

However, it was really at the end of the 1970s that behavioral economics was born. 

Two papers were largely responsible for this. The fi rst, in 1979, was entitled ‘Prospect 

theory: An analysis of decision under risk’, and was written by two psychologists, 

Daniel Kahneman and Amos Tversky, being published in the prestigious and technical 

economic journal Econometrica. Both Kahneman and Tversky had already published a 

number of papers relating to heuristic decision-making, but prospect theory introduced 

several new and fundamental concepts relating to reference points, loss-aversion, 

utility measurement and subjective probability judgments. 

The second paper, ‘Toward a positive theory of consumer choice’, was published 

by the economist Richard Thaler in 1980. In particular he introduced the concept of 

‘mental accounting’, closely related to the concepts of Kahneman and Tversky, and this 

is discussed at length in Chapter 6.

Since 1980 the fi eld of behavioral economics has become a burgeoning one, as both 

economists and psychologists have expanded and developed the work of the pioneers 

mentioned above. As more success has been achieved in explaining the anomalies of the 

standard model and in developing a more complete body of theory, the fi eld has now 

become a more respectable one, with a variety of journals publishing relevant research. 

However, it should be made clear that behavioral economists do not conform to 

a uniform school of thought. Although they all are concerned with the psychological 

foundations of economic behavior, they may have quite confl icting beliefs regarding 

fundamental aspects. For example, we will see that the views of Kahneman and 

Tversky, Vernon Smith and Gigerenzer all differ substantially regarding the role and 

nature of assumptions, appropriate methods of investigation, the value of various kinds 

of empirical evidence, and conclusions regarding issues such as rationality, effi ciency 

and optimization. 

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1.3  Relationship with other disciplines

One of the main criticisms of behavioral economics that has been leveled at it ever 

since its inception has been that it is essentially an ad hoc collection of observations 

relating to behavioral biases that has no underlying uniform theoretical foundation. At 

fi rst sight this criticism may seem to have some justifi cation, in that over the last three 

decades many biases have been discovered that present themselves as anomalies within 

the confi nes of the standard model, some working in opposite directions from each 

other, and many researchers have been content to record and model these in a narrow 

behavioral context. However, it is a fundamental objective of this book to examine not 

only how people behave in ‘idiosyncratic’ ways, but also why they behave in these ways. 

This approach is discussed in more detail in the next chapter, but at this point it is 

suffi cient to propose the idea that our behavior is determined by a mixture of biological 

and environmental factors, sometimes inextricably blended together. It is, therefore, 

necessary to have a basic understanding of some of the fundamental concepts related 

to biology, psychology and sociology.

Evolutionary biology

Theodosius Dobzhanksy, a fi eld naturalist and evolutionary biologist, once famously 

said ‘nothing in biology makes sense except in the light of evolution’ (Dobzhansky, 

1973). Scientists in this fi eld have for several decades reached a general consensus 

regarding evolutionary theory, sometimes referred to as ‘the modern synthesis’ or the 

‘neo-Darwinian synthesis’ (NDS). There are four main features of this synthesis:

1  Inheritance – genes are the unit of inheritance, and are transferred from parents 

to offspring.

2  Variation – there is a diversity of genes in any population, sometimes referred to 

as the ‘gene pool’.

3  Change – the mixing of genes from parents (recombination), and mutation 

from one generation to another, result in offspring having different genes from 

parents.

4  Natural selection – the genes of those members of a population best able to survive 

and reproduce tend to spread and predominate over time, leading to adaptations 

to the environment.

The last feature has tended to be the most controversial among biologists, and is 

what distinguishes the general theory of evolution from the more specifi c ‘Darwinian’ 

theory, although these terms are often used interchangeably. While no serious scientist 

doubts the process of evolution, some have questioned the relative importance of 

natural selection in relation to other factors that cause intergenerational change, such 

as ‘genetic drift’.

Closely related to the discipline of evolutionary biology is evolutionary psychology. 

Evolutionary psychology is a relatively new discipline, and it is fundamentally an 

offshoot of evolutionary biology. While it may be hazardous to try and condense all 

psychological explanations into a universal protocol, we believe that evolutionary 

psychology can be a signifi cant aid in understanding and relating many of the different 

fi ndings from empirical studies. The foundation of this area of science is that, just as our 

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