What is Behavioral Economics?

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Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. Behavioral economics is often related with normative economics. It draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models.

Definition

Behavioral economics is the study of the relevance of psychology to the economic decision-making processes of individuals and institutions. It explores why people sometimes make irrational decisions and why and how their behavior does not align with economic model predictions.

Origin

Behavioral economics originated in the 1970s, pioneered by psychologist Daniel Kahneman and economist Amos Tversky. Their research revealed systematic biases in human decision-making, challenging the traditional economic assumption of rational actors.

Categories and Features

Behavioral economics is mainly divided into two categories: descriptive economics and normative economics. Descriptive economics focuses on how people actually make decisions, while normative economics studies how people should make decisions. The features of behavioral economics include the focus on psychological factors, emotions, and social influences on decision-making.

Case Studies

A typical case is the "endowment effect," where people assign higher value to items they own. A famous experiment by Kahneman involved participants valuing their own mugs higher than the price they were willing to pay. Another case is the "framing effect," where different presentations of the same information affect decisions. For example, consumers are more likely to choose a product labeled "90% lean meat" over "10% fat."

Common Issues

Common issues investors face when applying behavioral economics include overconfidence and loss aversion. Overconfidence can lead to excessive trading, while loss aversion may cause investors to hold onto losing stocks. Understanding these behavioral biases can help investors make more rational decisions.

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