What Is Behavioral Economics?

The marketplace is always trying to drive consumers into making decisions, often on irrational premises.
The marketplace is always trying to drive consumers into making decisions, often on irrational premises.

Consumers have a tendency to purchase customized products that will meet their demands and needs. However, most consumers settle for a popular brand or the one they already owned in the past. In an ideal world, consumers make choices after weighing the cost and benefits of a product and the existing preferences and market trends. Behavioral economics, therefore, studies the psychological, social, emotional, and cognitive effects of any economic decision-making process of either an individual or an institution and the consequences of such decisions on resource allocation, market price, and revenue. Different kinds of economic behaviors have different impacts on different environments. Thus, the impact is never uniform. The study of behavioral economics comprises of a market decision-making process and the factors that drive the choices.

History of Behavioral Economics

During the "classical period" of economics, the study of microeconomics was often associated with that of psychology because of the fact that a given individual’s behavior when it came to making transactions often hinges upon their perceptions of fairness and justice. However, the discipline was reshaped as a natural science during the neo-classical economic period by developing the concept of economic humans (Homo economicus), which deduced economic behaviors based on their assumptions. In the 20th Century, Expected utility and Discounted utility became popular acceptance through the efforts of Gabriel Tarde and Laszlo Garai. Cognitive psychology began to explore the brain as an information processing device in the 1960s contrasting the behavioral model. In 1979, prospect theory was developed to explain everything that the two utility theories could explain. However, economists agree that the prospect theory could only explain a range of phenomena that could not be explained by the utility theories. The prospect theory was revised to cumulative prospect theory which focused on the evaluation phase by allowing for non-linear probability.

Application of Behavioral Economics

Behavioral economics has been used to explain the concept of inter-temporal choice, which is a situation where the effects of the decision made are felt at a different, later time. Consumers make decisions with an expectation of a positive result to be realized at a different time from the time the decision is made. Conditional expected utility is an application of behavioral economics and explains why individuals have illusions of control and determines the probability of the external factors with their utility being a function of the choices and actions they make even when they cannot change or affect the external factors. Behavioral economics also explains the difference between the positional consumption which is consumption in relation to other people and the non-positional consumption which is absolute. For example, living in a good house is positional while saving for retirement is non-positional. Robert H Frank in his book “The Darwin Economy” suggests that tax policies must reflect these consumption patterns.


Behavioral economics has limited applications in many market situations as competition and the limited nature of opportunities demands a closer approximation of rational behaviors. The market situation thus applies rationality as opposed to behavior in decision making. Prospect theory is a model decision making and not a general economic behavior and is only applicable in a one-off situation presented to a market participant. Traditional economists prefer revealed preference overstated preference in determining any economic value. There is also no real consistent behavioral theory or unified theory to support the basis for behavioral economics


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