Introduction to Behavioral

2

I N T R O D U C T I O N

PT

•

I

At the time of writing (August 2011), fi nancial markets around the world have been 

leaping up and down with wild abandon for four years. The fi nancial crisis, normally 

dated from 2007 to 2009, is certainly not yet over. Many markets, certainly in the US, 

made a good recovery after 2009, only to plunge once more this summer. For the fi rst 

time in history the US lost its AAA rating for Treasury bonds, as the government teetered 

on the edge of default. Currencies also have been subject to violent fl uctuations in 

value, as the European Monetary Union has been threatened by the fi nancial problems 

of various European governments, notably Greece.

But how can the world’s stock markets lose 5% or more in value in a single 

day? According to standard economic theory market value should be a refl ection of 

companies’ long-term economic prospects in terms of output and growth, referred to 

as their economic fundamentals, and these cannot possibly change so quickly. There 

must be something else happening here. Financial markets are notoriously fi ckle, 

and while much of this may have to do with ever-changing expectations of investors 

regarding uncertain future prospects, at times of crisis one cannot help but surmise 

more systematic failings of economic rationality. In the 1930s, Keynes coined the term 

‘animal spirits’ as an emotive urge to action in the absence of that action’s justifi cation 

on conventional grounds of economic rationality.

Similar factors have also affected commodity and housing markets. Many 

countries experienced a property boom in the years leading up to 2007. Not only 

have prices fallen substantially since then, but house owners have also been reluctant 

to sell at these lower prices, as banks have been reluctant to write off bad debt 

in time. This displays another psychological phenomenon known as the endowment 

effect: individuals are reluctant to part with what they have acquired even if this is the 

economically rational thing to do. 

We cannot hope to understand these anomalies in standard economic theory 

unless we also consider the behavioral factors involved. This, in a nutshell, is the focus 

of behavioral economics, and this textbook.

1.1   Behavioral economics and the standard model

What is behavioral economics?

Economic phenomena relate to any aspect of human behavior that involves the 

allocation of scarce resources; thus economics is very wide-ranging in its subject area. 

For example, all of the following can be described as economic phenomena, although 

they may also of course involve other disciplines of study: searching for a future spouse 

on the internet, watching a documentary on television, making a charitable donation, 

giving a lift to one’s neighbor in order to make it easier to ask them for a favor later, 

deciding to take a nap rather than mow the lawn, teaching one’s child to play tennis, 

and going to church.

Economics, like any other social science, is concerned with developing theories 

whose ultimate aim it is to help us better understand the world we live in. Economic 

theories attempt to describe and explain relationships between economic phenomena. 

I N T R O D U C T I O N

---

3

N AT U R E   O F   B E H A V I O R A L   E C O N O M I C S

CH

•

1

In order to do this they need to proceed on the basis of a number of assumptions or 

premises. Sometimes these assumptions are made explicit, but in many cases they are 

implicit, and it is often important to tease out these implicit assumptions: if a theory 

proves to be inaccurate in its empirical implications this tells us that if we have deduced 

these implications correctly from the underlying assumptions of the theory, we should 

query those assumptions themselves. 

This is where behavioral economics is relevant. As Camerer and Loewenstein 

(2004) succinctly put it: 

Behavioral economics increases the explanatory power of economics by 

providing it with more realistic psychological foundations (p. 3).

Hence, behavioral economics is not seeking to replace the standard framework of 

analysis. It seeks to add to this framework:

It is important to emphasize that the behavioral economics approach extends 

rational choice and equilibrium models; it does not advocate abandoning these 

models entirely (Ho, Lim and Camerer, 2006, p. 308).

In order to understand these claims, and also to understand various critiques of 

behavioral economics, let us examine the major assumptions underlying the standard 

model, and then consider various important and widespread phenomena that this 

model has run into some diffi culty to explain. 

As we will also see, however, unrealistic assumptions as such may still yield 

useful empirical insights. It is diffi cult to conceive of economic theories that are not 

built on some kind of abstraction from the rich complexity of economic phenomena. 

In many ways, debates in economics on the strengths and weaknesses of the standard 

model are debates on useful and less useful ways of arriving at economic concepts 

and theories through abstraction from concrete phenomena. Methodological 

considerations are thus at the heart of many debates in behavioral economics, and 

the best starting point for understanding these debates is to look at some of the 

methodological foundations of economic rationality and how they are captured 

within the standard model.

Economic rationality

Throughout this book we will make reference to a ‘standard model’ of economic 

rationality, and we will draw comparisons between this model and various theories in 

behavioral economics. Two points of caution should be noted at this stage:

1   While we refer to a standard model of economic rationality as if it were a static and 

monolithic body of theory, regarding which economists are in universal agreement, 

there are numerous controversies within that model and its boundaries are not 

precisely delineated.

2   The various approaches and analytical frameworks in behavioral economics also 

constitute a dynamic, shifting body of theory; many economists would agree that 

behavioral economics, instead of offering a single coherent behavioral model of 

rationality as an alternative to the standard model, currently resembles a somewhat 

ad hoc collection of hypotheses, many of which are mutually confl icting in terms of 

their premises and predictions.

---