Behavioral economicsBehavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors in the decisions of individuals or institutions, and how these decisions deviate from those implied by classical economic theory. Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory. The study of behavioral economics includes how market decisions are made and the mechanisms that drive public opinion.
Decision-makingIn psychology, decision-making (also spelled decision making and decisionmaking) is regarded as the cognitive process resulting in the selection of a belief or a course of action among several possible alternative options. It could be either rational or irrational. The decision-making process is a reasoning process based on assumptions of values, preferences and beliefs of the decision-maker. Every decision-making process produces a final choice, which may or may not prompt action.
Expected utility hypothesisThe expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion. The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities).
Heuristic (psychology)Heuristics is the process by which humans use mental short cuts to arrive at decisions. Heuristics are simple strategies that humans, animals, organizations, and even machines use to quickly form judgments, make decisions, and find solutions to complex problems. Often this involves focusing on the most relevant aspects of a problem or situation to formulate a solution. While heuristic processes are used to find the answers and solutions that are most likely to work or be correct, they are not always right or the most accurate.
Prospect theoryProspect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics. Based on results from controlled studies, it describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion). For example, for some individuals, the pain from losing 1,000couldonlybecompensatedbythepleasureofearning2,000. Decision theoryDecision theory (or the theory of choice; not to be confused with choice theory) is a branch of applied probability theory and analytic philosophy concerned with the theory of making decisions based on assigning probabilities to various factors and assigning numerical consequences to the outcome. There are three branches of decision theory: Normative decision theory: Concerned with the identification of optimal decisions, where optimality is often determined by considering an ideal decision-maker who is able to calculate with perfect accuracy and is in some sense fully rational.
Cognitive biasA cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the objective input, may dictate their behavior in the world. Thus, cognitive biases may sometimes lead to perceptual distortion, inaccurate judgment, illogical interpretation, and irrationality. While cognitive biases may initially appear to be negative, some are adaptive.
Bounded rationalityBounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal. Limitations include the difficulty of the problem requiring a decision, the cognitive capability of the mind, and the time available to make the decision. Decision-makers, in this view, act as satisficers, seeking a satisfactory solution, with everything that they have at the moment rather than an optimal solution.
Framing (social sciences)In the social sciences, framing comprises a set of concepts and theoretical perspectives on how individuals, groups, and societies organize, perceive, and communicate about reality. Framing can manifest in thought or interpersonal communication. Frames in thought consist of the mental representations, interpretations, and simplifications of reality. Frames in communication consist of the communication of frames between different actors. Framing is a key component of sociology, the study of social interaction among humans.
RiskIn simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environment), often focusing on negative, undesirable consequences. Many different definitions have been proposed. The international standard definition of risk for common understanding in different applications is "effect of uncertainty on objectives".
Rational choice theoryRational choice theory refers to a set of guidelines that help understand economic and social behaviour. The theory originated in the eighteenth century and can be traced back to political economist and philosopher, Adam Smith. The theory postulates that an individual will perform a cost-benefit analysis to determine whether an option is right for them. It also suggests that an individual's self-driven rational actions will help better the overall economy. Rational choice theory looks at three concepts: rational actors, self interest and the invisible hand.
Loss aversionLoss aversion is a psychological and economic concept which refers to how outcomes are interpreted as gains and losses where losses are subject to more sensitivity in people's responses compared to equivalent gains acquired. Kahneman and Tversky (1992) have suggested that losses can be twice as powerful, psychologically, as gains. When defined in terms of the utility function shape as in the Cumulative Prospect Theory (CPT), losses have a steeper utility than gains, thus being more "painful" than the satisfaction from a comparable gain as shown in Figure 1.
Sunk costIn economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future.
Risk aversionIn economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff.
HeuristicA heuristic (hjʊˈrɪstɪk; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, short-term goal or approximation. Where finding an optimal solution is impossible or impractical, heuristic methods can be used to speed up the process of finding a satisfactory solution. Heuristics can be mental shortcuts that ease the cognitive load of making a decision.
Framing effect (psychology)The framing effect is a cognitive bias where people decide between options based on whether the options are presented with positive or negative connotations. Individuals have a tendency to make risk-avoidant choices when options are positively framed, while selecting more loss-avoidant options when presented with a negative frame. In studies of the bias, options are presented in terms of the probability of either losses or gains. While differently expressed, the options described are in effect identical.
Mental accountingMental accounting (or psychological accounting) is a model of consumer behaviour developed by Richard Thaler that attempts to describe the process whereby people code, categorize and evaluate economic outcomes. Mental accounting incorporates the economic concepts of prospect theory and transactional utility theory to evaluate how people create distinctions between their financial resources in the form of mental accounts, which in turn impacts the buyer decision process and reaction to economic outcomes.
SatisficingSatisficing is a decision-making strategy or cognitive heuristic that entails searching through the available alternatives until an acceptability threshold is met. The term satisficing, a portmanteau of satisfy and suffice, was introduced by Herbert A. Simon in 1956, although the concept was first posited in his 1947 book Administrative Behavior. Simon used satisficing to explain the behavior of decision makers under circumstances in which an optimal solution cannot be determined.
Representativeness heuristicThe representativeness heuristic is used when making judgments about the probability of an event under uncertainty. It is one of a group of heuristics (simple rules governing judgment or decision-making) proposed by psychologists Amos Tversky and Daniel Kahneman in the early 1970s as "the degree to which [an event] (i) is similar in essential characteristics to its parent population, and (ii) reflects the salient features of the process by which it is generated".
Availability heuristicThe availability heuristic, also known as availability bias, is a mental shortcut that relies on immediate examples that come to a given person's mind when evaluating a specific topic, concept, method, or decision. This heuristic, operating on the notion that, if something can be recalled, it must be important, or at least more important than alternative solutions not as readily recalled, is inherently biased toward recently acquired information. The mental availability of an action's consequences is positively related to those consequences' perceived magnitude.
