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We would always make optimal decisions. The theory assumes that human actors have stable preferences and engage in maximizing behavior. The decade of the s, however, also witnessed the beginnings of the opposite flow of thinking, as discussed in the next section. While economic rationality influenced other fields in the social sciences from the inside out, through Becker and the Chicago School, psychologists offered an outside-in reality check to prevailing economic thinking.

Most notably, Amos Tversky and Daniel Kahneman published a number of papers that appeared to undermine ideas about human nature held by mainstream economics. Our willingness to take risks is influenced by the way in which choices are framed, i. Have a look at the following classic decision problem:. When faced with the first type of decision, a greater proportion of people will opt for the riskless alternative A , while for the second problem people are more likely to choose the riskier D.

This happens because we dislike losses more than we like an equivalent gain: Giving something up is more painful than the pleasure we derive from receiving it. According to this view, our minds must be understood relative to the environment in which they evolved. Decisions are not always optimal. There are restrictions to human information processing, due to limits in knowledge or information and computational capacities Simon, ; Kahneman, About 30 years later, their thinking entered the mainstream, resulting in a growing appreciation in scholarly, public, and commercial spheres.

Thaler coined the concept of mental accounting. According to Thaler, people think of value in relative rather than absolute terms. In addition, humans often fail to fully consider opportunity costs tradeoffs and are susceptible to the sunk cost fallacy. Why are people more likely to spend a small inheritance and invest a large one Thaler, ? An important term underlying the theory is fungibility, the fact that all money is interchangable and has no labels.

In mental accounting, people treat assets as less fungible than they really are.

In doing so, they make decisions on each mental account separately, losing out the big picture of the portfolio. We experience pain of paying Zellermayer, , because we are loss averse. This pain is thought to be reduced in credit card purchases, because plastic is less tangible than cash, the depletion of resources money is less visible and payment is deferred. Different types of people experience different levels of pain of paying, which can affect spending decisions.

Tightwads, for instance, experience more of this pain than spendthrifts. As a result, tightwads are particularly sensitive to marketing contexts that make spending less painful Rick, Choice overload can be counteracted by simplifying choice attributes or the number of available options Johnson et al.

In the book, Thaler and Sunstein point to experience, good information, and prompt feedback as key factors that enable people to make good decisions. Consider climate change, for example, which has been cited as a particularly challenging problem in relation to experience and feedback. Climate change is invisible, diffuse, and a long-term process.

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Pro-environmental behavior by an individual, such as reducing carbon emissions, does not lead to a noticeable change. The same is true in the domain of health. Feedback in this area is often poor, and we are more likely to get feedback on previously chosen options than rejected ones. The impact of smoking, for example, is at best noticeable over the course of years, while its effect on cells and internal organs is usually not evident to the individual. Traditionally, generic feedback aimed at inducing behavioral change has been limited to information ranging from the economic costs of the unhealthy behavior to its potential health consequences Diclemente et al.

More recent behavior change programs, such as those employing smartphone apps to stop smoking, now usually provide positive and personalized behavioral feedback, which may include the number of cigarettes not smoked and money saved, along with information about health improvement and disease avoidance. Behavioral economics assumes that people are boundedly rational actors with a limited ability to process information.

While a great deal of research has been devoted to exploring how available information affects the quality and outcomes of decisions, a newer strand of research has also explored situations where people avoid information altogether. Information avoidance in behavioral economics Golman et al. Active information avoidance includes physical avoidance, inattention, the biased interpretation of information see also confirmation bias and even some forms of forgetting.

The economic forecast is simple: the next 10 years are going to be a drag

In behavioral finance, for example, research has shown that investors are less likely to check their portfolio online when the stock market is down than when it is up, which has been termed the ostrich effect Karlsson et al. More serious cases of avoidance happen when people fail to return to clinics to get medical test results, for instance Sullivan et al.

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While information avoidance is sometimes strategic, it can have immediate hedonic benefits for people if it prevents the negative usually psychological consequences of knowing the information. It usually carries negative utility in the long term, because it deprives people of potentially useful information for decision making and feedback for future behavior. Furthermore, information avoidance can contribute to a polarization of political opinions and media bias. A good portion of the research he discusses involves prices and value perception.


One study asked participants whether they would buy a product e. They were then asked about the maximum they would be willing to pay. Finally, price is often taken as an indicator of quality, and it can even serve as a cue with physical consequences, just like a placebo in medical studies. One experiment, for instance, gave participants a drink that purportedly helped mental acuity. Price can also be an ingredient for a decoy effect.

Ariely illustrates this with subscription options advertised by The Economist newspaper. Ariely asked his students. The field associated with this stream of research and theory is behavioral economics BE , which suggests that human decisions are strongly influenced by context, including the way in which choices are presented to us. Behavior varies across time and space, and it is subject to cognitive biases, emotions, and social influences.

Decisions are the result of less deliberative, linear, and controlled processes than we would like to believe. Daniel Kahneman uses a dual-system theoretical framework which established a foothold in cognitive and social psychology of the s to explain why our judgments and decisions often do not conform to formal notions of rationality.


System 1 consists of thinking processes that are intuitive, automatic, experience-based, and relatively unconscious. System 2 is more reflective, controlled, deliberative, and analytical. Judgments influenced by System 1 are rooted in impressions arising from mental content that is easily accessible.

JEL Classification:

System 2, on the other hand, monitors or provides a check on mental operations and overt behavior—often unsuccessfully. One of the most universal heuristics is the availability heuristic. Readily available information in memory is also used when we make similarity-based judgments, as evident in the representativeness heuristic.

Applying the affect heuristic can lead to black-and-white thinking, which is particularly evident when people think about an object under conditions that hamper System 2 reflection, such as time pressure. The risk-as-feelings perspective explains behavior in situations where emotional reactions to risk differ from cognitive evaluations. In these situations, behavior tends to be influenced by anticipatory feelings, emotions experienced in the moment of decision making.

Current highlights

Availability and affect are processes internal to the individual that may lead to bias. The external equivalent of these processes is salience , whereby information that stands out, is novel, or seems relevant is more likely to affect our thinking and actions Dolan et al. Salience also underlies heuristic judgments that rely on external cues. Some psychologists have derived effort-reducing heuristics that simplify consumer decision making. While many heuristics and biases are the result of quick impressions, the automatic character of System 1 is also reflected in a human aversion to change.

One aspect in this respect is evident in the formation of habits , automatic behavioral patterns that are the result of repetition and associative learning Duhigg, In this case, an effective way to increase enrolment rates is to change the default —what happens when people do not make an active choice.

System 1 is dominated by gut feelings and a limits to information processing, which may lead people to be overly optimistic.

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  • People often overestimate the probability of positive events and underestimate the probability of negative events happening to them in the future Sharot, For example, we may underestimate our risk of getting cancer and overestimate our future success on the job market. It is frequently measured by having experimental participants answer general knowledge test questions.

    They are then asked to rate how confident they are in their answers on a scale. A big range of issues have been attributed to overconfidence. Among investors, for example, overconfidence has been associated with excessive risk-taking e. Odean, and overtrading e. Another important domain of BE introduces a time dimension to human evaluations and preferences. This area acknowledges that people are biased towards the present and poor predictors of future experiences, value perceptions, and behavior.