Introduction

If economics is the study of how scarce resources are allocated given unlimited wants, behavioral economics may be said to focus more specifically on how scarce decision resources are allocated. Standard microeconomic modeling supposes that people make decisions with the sole purpose of making themselves better off. Behavioral economics often focuses on how people systematically deviate from the best possible decisions and what it will mean for the allocation of scarce resources. Behavioral economics is the study of how observed human behavior affects the allocation of scarce resources. Although the majority of microeconomic theory has focused on developing a unifying theory of behavior based on how one can logically obtain one’s goal (e.g., through utility maximization) or the market forces one is likely to encounter, behavioral economics may more rightly be termed the odds and ends of economic theory. We often refer to the standard model of an economic decision maker as the rational choice model or simply rational model. To the extent that people are observed to behave according to the rational model, behavioral economics does not deviate from standard microeconomic analysis. Were this all that was ever observed, behavioral economics would not have any use as a subdiscipline (and this would be a very short course indeed).

Fortunately for us, economists have often noted a set of systematic deviations from the rational model that are either difficult to explain or model through an appeal to economic theory or that outright violate the standard economic model. We call any such deviations a behavioral anomaly or simply an anomaly. In such a situation, economic models might not be appropriate by themselves. In this case, behavioral economists seek to explain behavior by augmenting the rational choice model with principles developed in the fields of psychology, sociology, or, to a lesser extent, anthropology. Unfortunately, because behavioral economics draws from a disparate set of disciplines, there is no unifying theory of behavioral economics. Rather, the tools of behavioral economics are an eclectic and diverse set of principles that must be applied with care. Some theories are appropriate for some circumstances, but none apply generally to all decisions. This presents a challenge for the student first embarking on the journey to becoming a behavioral economist. Unlike the rest of economics, there is no single key to understanding behavioral economics. Rather, the student is responsible for learning to use a number of diverse tools that may be loosely grouped by the particular failings in rational choice theory they seek to address.

Because behavioral economics focuses so much on how people deviate from the rational choice model, it is important that the beginning student first have a clear understanding of this model and its roots. Rightly, this is the first theory that a behavioral economist seeks to apply when describing individual behavior. It is only when using a rational model becomes impractical or inaccurate that behavioral economists seek alternative explanations. Nonetheless, these alternative explanations may be very important depending on the purpose of the modeling exercise. For example, if, as an individual, you discover that you systematically make decisions that are not in your best interest, you may be able to learn to obtain a better outcome. In this way, behavioral economics tools may be employed therapeutically to improve personal behavior and outcomes. Alternatively, if a retailer discovers that customers do not fully understand all relevant product information, the retailer might improve profits by altering the types and availability of product information. In this case, behavioral economics tools may be employed strategically to take advantage of the behavior of others. An economics researcher might also be interested in finding general theories of decision making that can be applied and tested more broadly. In this case, behavioral economics tools may be applied academically. The motivation for employing behavioral economics, be it therapeutic, strategic, or academic, in large part determines the types of models and phenomena that are important to the interested student. To this end, we employ three types of economic models: rational, behavioral, and procedurally rational. Throughout this course, we use these distinctions in discussing the uses and applications for behavioral economic modeling. Finally, the roots and history of behavioral economics are inextricably linked to experimental economics. Although this text tries to avoid becoming one on experimental methods, it is important to discuss some of the basics of experimental economics, why it is so useful in behavioral economics, and what this might mean for the wider use of behavioral economic concepts.