Behavioral economics combine methods from economics and psychology, both very large fields of science and so not all psychologists nor all economists will think the same way.

A necessary simplification

Research psychologists think about processes they are interested in the processes of perception attention memory and decision-making that shape how we think and what we do. In contrast research economists think about outcomes, how does a change in one variable influence another, psychological concepts might be useful in explaining some of those outcomes but that’s not what’s critical.

A behavioral economics researcher would likely be interested in both processes and outcomes, why people choose something is as important as what they choose. So the behavioral economists need to set up experiments that reliably evoke specific psychological processes as well specific decisions.

Behavioral economics experiments

Behavioral economics experiments are not quite as simple as you might think, especially if you read about those experiments in popular books or the news media. Setting up an experiment requires careful planning, so the experiment reveals the processes and outcomes in a specific a manner as possible.

Accordingly, behavioral economics experiments are planned with three principles in mind:

  1. first, experiments must be incentive compatible, that is the participant should have some incentive to reveal their true preferences. This is usually accomplished by paying people for their choices.
  2. the second principle of behavioral economics experiments is no deception. When participants come to the laboratory for an experiment well they know that they’re in an experiment.
  3. the third and final principle of behavioral economics is that there should be no external influences. What’s an external influence? Anything other than the decision itself.

So these are the three principles of behavioral economics research: decisions must be incentive compatible, decisions must be free of any external deception and decisions must be free of any outside influences. These three principles allow us to be more confident in behavioral economics experiments.

Behavioral economics is about real world behavior

Behavioral economics experiments observe real behavior, people making decisions that matter to them and then uses that behavior to better understand how people make decisions. But in recent years neuroscientists and economists working together have used the methods of behavioral economics to better understand how our brains make decisions.

Research of this sort is often called neuroeconomics and there are many misconceptions about neuroeconomics. Some neuroscientists think the neuroscience is poised to revolutionize economics, some economists think that understanding the brain is simply irrelevant to answering economic questions. The truth in my view lies in between those extremes.

An analysis of decisions under risk

So behavioral economics integrates experimental methods from psychology and economics and applies those methods to better understand how we make decisions. That simple description covers a very wide range of research: gambling with monetary rewards, risky choices, interpersonal interactions and economic games, consumer purchases, investment decisions and even how patients and doctors make decisions about medical care.

By the late 1970s experiments in the nascent field of behavioral economics had revealed many different anomalies in decision-making, ways in which people’s decisions didn’t quite match what was predicted by rational choice models. These anomalies were compelling often strike but there were easy to dismiss, there wasn’t any sort of underlying theory that could explain why people were biased why we made good decisions in one context but bad decisions in another.

Kahneman and Tversky’s paper was called Prospect theory: an analysis of decisions under risk. This paper became one of the most influential and highly cited papers in the history of economics. Prospect theory uses two concepts: probability waiting and reference dependence to explain what people value. Probability waiting means that people treat some changes in probability as more important than others.