The human being imagined by classical economists is smooth, brilliant, calm, and perpetually unastonished by events.
I don’t know about you, but this definitely doesn’t describe my behavior. This person doesn’t exist. This model human does, however, allow economists to build mathematical models that describe our decisions and their effect on the economy. It also makes economics more like physics and less psychology.
Behavioral economists argue that these models are inaccurate in the real world. They leave out the the cognition below the level of awareness – they leave out the subconscious. Rationality and therefore decision-making are bounded by emotion. As a result of our tangled up emotion vs reason struggle, our real-world decision-making can be messy. Self-control is hard. We have biases. We’re influenced by context. We’re extremely prone to group-think. We discount the future.
We store if…then rules in our heads called heuristics that are great shortcuts when they’re appropriate for the situation, but sometimes they’re not. Here’s some examples from the research.
One perception cues a string of downstream thoughts that alters subsequent behavior. If you ask test subjests to read a series of words that vaguely relate to being elderly (“bingo”, “Florida”, “ancient”), when they leave the room they will walk more slowly than when they came in.
No piece of information is processed in isolation. Mental patterns are contagious, and everything is judged in comparison to something else. A $30 bottle of wine may seem expensive when surrounded by $9 bottles of wine but cheap when surrounded by $149 bottles of wine.
Every decision gets framed within certain linguistic context. If a surgeon tells his patients that a procedure has a 15 percent failure rate, they are likely to decide against it. If he tells them the procedure has an 85% success rate, they tend to opt for it.
The mind makes models of what it thinks will happen, which colors its perceptions of what is actually happening. People who are given a prescription pail reliever they are told costs $2.50 a pill experience much more pain relief than those given what they are told is a 10-cent pill (even those both bills are placebos).
The mind doesn’t like to expend mental energy. As a result people have a bias towards the status quo.
Losing money brings more pain than winning money brings pleasure. Investors are quicker to sell stocks that have made them money than they are to sell stocks that have been declining. They’re making self-destructive decisions because they don’t want to admit their losses.