Preface

The first edition of this book started out by saying that there should not really need to be a book entitled ‘Behavioral Economics’. The same still applies some four years later. All economics is behavioral in the sense of examining how people choose to act and allocate resources in different types of situation. However, over the last three decades the standard model of economic rationality, based largely on the assumption of expected utility maximization, has come under increasing criticism from both outside and inside the economics profession. The recent global financial crisis has exacerbated this situation. There are a large number of empirical anomalies that the standard model fails to explain.

Behavioral economics attempts to answer many of these criticisms by taking a broader approach to studying economic phenomena. It is behavioral in the sense that it combines the approaches of all the behavioral sciences, in particular economics, psychology, sociology and biology. This is currently not easy to do, since these different disciplines have traditionally adopted different and in many ways conflicting approaches. It is the essential philosophy of this book that economics is ‘at its best’ when it takes a cross-disciplinary approach.

Yet, in spite of building criticisms and the considerable interest and debate in the profession, there are still hardly any current texts available on behavioral economics. There are books on behavioral aspects of other disciplines, such as marketing, finance, and even managerial accounting; there are collections of papers on behavioral economics; and there are books on particular aspects of behavioral economics, such as behavioral game theory. Thus there appears to be both high demand and low supply for a text in this area.

Many undergraduate students are now starting to study aspects of behavioral economics. The book is particularly appropriate for students in the third or fourth years of undergraduate study, or in a postgraduate program, once they have become familiar with the standard economics curriculum, its assumptions and methods, and to some extent its limitations. For postgraduate students in particular the text should serve as a foundation of linked themes and materials, providing a jumping-off point for further reading of the original papers on which the book is based.

The objectives of the text remain the same as with the first edition:

1    Present the principles and methods of behavioral economics in a logical and amenable manner, contrasting them with those of standard models.

2    Illustrate how behavioral approaches have begun to supplement standard models and in many contexts offer superior explanations and predictions, using a wide variety of empirical examples from both observational and experimental studies.

3    Provide a critical examination of the rapidly growing literature in behavioral economics.

4    Explain the policy implications of behavioral approaches, particularly when these differ from those of standard economics.

5    Provide a coherent psychological and social scientific framework underpinning the findings of behavioral economics.

6    Indicate the current trajectory of the subject, in terms of future challenges and areas meriting further research.

It should not be inferred from this that there is a single behavioral model that has universal acceptance. Within particular areas, like intertemporal choice and social preferences, there is often a profusion of models. Indeed, one main criticism of behavioral economics has been that there is an excessive number of different models, many of which may apply in a given situation. However, this issue arises in different guises with standard approaches as well, notably in the context of solution concepts in game theory, or more generally in response to ‘ad hoc’ model specifications in applied areas such as industrial organization or the theory of the firm. Economics has a common analytical language but it has certainly moved away from grand unifying frameworks of analysis that general equilibrium theory once promised to offer.

As stated above, the central theme of the book is that it is intended to be highly cross-disciplinary in nature. Any book on behavioral aspects must of course involve psychology, but it is important to consider other areas too, notably evolutionary psychology and neuroscience, social psychology and sociology.

Many economists and psychologists reject the theories of evolutionary psychology as being largely speculative. They are frequently dismissed in the social sciences as being ‘just-so’ stories, meaning that they are not true scientific theories in terms of proposing testable hypotheses. This view is caused by two main factors: (1) it is impossible by definition to perform experiments on the past; and (2) the past record of facts is highly incomplete. But on closer inspection there is considerable evidence in support of key tenets of evolutionary psychology. Furthermore, the tendency of many economists to limit explanations to economic phenomena is even more unsatisfactory as far as ‘just-so’ stories are concerned. For example, many readers would not be satisfied with the explanations that people tend to succumb to temptation because they have short time horizons in decision-making, and that they make bad decisions when they are angry. These can also be regarded as ‘just-so’ stories because they both beg the questions regarding why people have short time horizons, and why we have seemingly harmful emotional responses like anger.

The fast-developing area of neuroscience can also be of great benefit to economics. The conjunction of the two disciplines has led to the birth of neuroeconomics. Economists have traditionally relied on ‘revealed preference’, meaning choice, in market behavior to develop their theories, but this approach has significant limitations. We will examine situations where choice and preference do not coincide, and where intertemporal choice and framing effects cause preference reversals. These anomalies have important welfare implications. Cognitive neuroscience is offering fresh insights into the neurological basis of individual behavior. We now know, for example, that different types of cost and benefit are processed in different areas of the brain, and that both altruistic and spiteful behavior, in the form of punishment, give pleasure, in spite of what the doer might say about their motivation. Admittedly, much of the extant research in neuroscience is not yet fully connecting to economic decision-making as such, and neuroeconomics, like evolutionary psychology, has attracted some strong criticism from within the economics profession. But we feel that students of behavioral economics will benefit from studying the underlying debates to sharpen their understanding of the evidence base and methodological basis of behavioral frameworks of analysis.

This edition of the text has significantly expanded from the first edition, with some 80,000 words of new material. Virtually all the chapters have undergone detailed revision, and two new chapters were added, one on methodology, and one on beliefs, heuristics and biases. The expansion has been caused by several factors: (1) there has been a large amount of relevant research over the last four years, requiring substantial updating of much material; (2) there were some significant omissions in the first edition which needed to be rectified, and many of these were drawn to our attention by reviewers, to whom we are most grateful; (3) experience of teaching various courses in behavioral economics over the last few years has prompted us to change the presentation of some materials for pedagogical reasons; and (4) additional rigor of analysis has been provided in certain areas.

In summary, the intention is to provide a book which is comprehensive, rigorous and up-to-date in terms of reviewing the latest developments in the field of behavioral economics; cross-disciplinary in approach; and user-friendly in terms of exposition, discussing a large number of examples and case studies to which the reader can relate. Typically three case studies are included at the end of each chapter, with questions reviewing the relevant material.

It is also appropriate here to give a note of apology: readers may find some repetitiveness in the materials in the various chapters. We offer the following excuses. Some readers or instructors may wish to skip certain chapters, like the more technical chapter on game theory. Also, many of the themes in different chapters are linked, with the features of prospect theory and mental accounting in particular applying in many different areas. As a final point, it seems appropriate to hammer home certain points of behavioral analysis, especially when these are at variance with other commonly-held theories or beliefs.

Lastly, some words of thanks are in order regarding several people who have helped to improve this edition of the book. Matthew Rablen, from Brunel University, invited the first author to share the teaching of a course in behavioral economics, and discussions with him have aided various aspects, notably the mathematical exposition in the text. The students there, and at other institutions, have also made various suggestions and contributions. In particular, we would like to thank Thomas Matura for drawing attention to the phenomenon of celebrity contagion. Finally, we would like to thank our anonymous reviewers for their comments and suggestions, which have allowed us to improve the text in many respects. Of course, any remaining inaccuracies and oversights are the sole responsibility of the authors.