Über die Autorin bzw. den Autor

Peter Diamond is Institute Professor and Professor of Economics at Massachusetts Institute of Technology. Hannu Vartiainen is Docent of the Helsinki School of Economics and Research Director of the Yrjö Jahnsson Foundation

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"This is an excellent and important volume outlining cutting-edge developments in behavioral economics and its applications. It is coherent, substantive, and topical. Indeed, it could serve as a leading text or reader on behavioral economics."--Geoffrey Hodgson, University of Hertfordshire, England

"I learned a substantial amount from reading this thought-provoking book, which contains several pioneering attempts to broaden behavioral economics from positive to normative analyses. I congratulate the editors on having collected so many intriguing contributions from so many prominent scholars."--Martin Dufwenberg, University of Arizona

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Behavioral Economics and Its Applications

Princeton University Press

Chapter One

By Peter Diamond and Hannu Vartiainen

Over the last decade or so, behavioral economics has fundamentally changed the way economists conceptualize the world. Behavioral economics is an umbrella of approaches that seek to extend the standard economics framework to account for relevant features of human behavior that are absent in the standard economics framework. Typically, this calls for borrowing from the neighboring social sciences, particularly from psychology and sociology. The emphasis is on well-documented empirical findings: at the core of behavioral economics is the conviction that making our model of an economic man more accurate will improve our understanding of economics, thereby making the discipline more useful.

It is natural for such an endeavor to begin as a subdiscipline-one that catalogs anomalies and explores alternative ways to model choice, with applications illustrating the workings of such models. A more ambitious role for behaviorally based insights is to effect how researchers in applied fields make both positive and normative analyses. By and large, this is the arena in which the usefulness of new ideas is eventually evaluated. In the long run, one expects the arguments, if useful, to be integrated into the mainstream literature.

An example of such development in the behavioral context is finance. Success of behavioral finance, a thriving area which has produced enough material to warrant a handbook treatment (Thaler 1993), is partly explained by the fact that the conflict between the standard benchmark model and a rich supply of data is particularly clear. Accounting for behavioral tendencies fills a disturbing gap in understanding financial markets, and institutions therein.

While other applied fields have not gone nearly so far, there is no reason why behavioral ideas could not, and should not, be applied to other domains too. Indeed, behavioral tendencies concern human behavior in general and there is no reason to tie the arguments to a particular field. It is hoped that this volume will contribute to the integration of behavioral insights into applied fields. The contributors to this volume take for granted the fact that behavioral ideas have an important future in economics and hope, through this book, to promote developments that will make good use of them. Our aim is not to engage in the debate between the standard modeling and behavioral approaches, but to move on to applications.

The chapters in this volume examine behavioral dimensions of six fields of economics (public economics, development, law and economics, health, wage determination, and organization economics) in which behavioral argumentation has proven to be useful but has not yet been integrated as a part of the established framework. We have left out finance as being beyond the phase where contributions such as the ones in this volume can shift a field.

Interest in behavioral economics has been stimulated by accumulating evidence that the standard model of consumer decision-making provides an inadequate positive description of human behavior for some questions. According to the evidence (and contrary to the standard economic model), individuals are bounded in many dimensions, in particular in their rationality, self-control and self-interest.

Bounded rationality manifests itself in incomplete information processing ability. Individuals appeal to heuristics and rules of thumb when making their decisions. They make biased probability judgments and are often overconfident. Moreover, individuals tend to anchor to seemingly irrelevant information or to the status quo, and they are loss aversive. In general, they do not maximize expected utility (Kahneman and Tversky 1979).

Incomplete self-control refers to the tendency of economic agents to make decisions that are in conflict with their long-term interest. Self-control problems may lead to addictive behavior, undersaving, or procrastination. As opposed to the neoclassical view, restricting the choice set can be beneficial for an agent with bounded willpower (see, for example, Laibson 1997).

Lack of self-interest refers to the idea that preferences have a social dimension. Individuals care, or act as if they care, about other individuals' well-being (see, for example, Kahneman et al. 1986). They are also reciprocal: they care about being treated fairly and want to treat others fairly if those others are themselves behaving fairly. As a result, agents are both nicer and (when they are not treated fairly) more spiteful than postulated by the neoclassical theory.

Beyond this familiar trilogy of bases for deviations from the standard model, economists are exploring additional psychological and sociological factors that shape economic decision-making. They are also examining decision processes to view and model the black box of human decision-making; very recent work in neuroeconomics focuses directly on the question of how decisions are made. This is an important development, since it may help to address the fundamental difficulty of constructing welfare criteria based on individual choices.

In addition to revised models of individual choice, alternative behavioral models of individual choice can help us to understand the functioning of economic institutions. On the normative side, behavioral modeling can help us to design better institutions. This can take place not only through better understanding of how the institutions work, but also through better understanding of individual needs and the concept of welfare.

One cannot evaluate the ultimate goodness of a behavioral model of an economic man without seeing how useful the model is in structuring our thinking of general economics. Applicability requires that the models and stylized facts compound to an integrated theory that is flexible, adequately parsimonious, and permits us to construct testable hypotheses. This suggests enhancing communication between applications and the underlying theory. To develop the theory further it helps to have feedback from areas where the theory could be applied. Studying applications may give a sharper view of the behavioral tendencies that really matter.

The chapters in this volume describe both realized and potential opportunities for applications of behavioral economics. Each chapter includes updated versions of a presentation at the conference and the remarks of the discussants. The final chapter consists of a modified transcript of a round-table discussion. Summaries of the highlights of the general discussion have been prepared by Botond Koszegi and Emmanuel Saez.

This volume consists of the following chapters.

Douglas Bernheim and Antonio Rangel discuss emerging methods for normative policy analysis in behavioral economics, with a particular focus on issues in public economics. They argue against the view that a departure from the doctrine of revealed preference, which is unavoidable in the presence of bounded rationality, necessarily renders welfare analysis infeasible or entirely subjective. Instead, they argue that it is sometimes possible to replace revealed preference by other compelling normative principles. For example, if one knows enough about the nature of decision-making malfunctions, it may be possible to recover tastes by relying on a selective application of the revealed-preference principle....