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What is behavioral economics?

Is it like Freakonimics or Blink and Tipping Point stuff? I read an article in the NYT today about Obama's economics and he said, "The project of our new President is figuring out how do you create bottom-up economic growth, as opposed to trickle-down economic growth . . ." This is so counter-intuitive for me. I don't get it. I always thought that investment grew the economy. The only way to grow it from the bottom up would seem to require having a huge black market and then, of course, there are problems with that idea. What am I missing? Thanks.

Public Comments

1. Behavior economics is the study of how people make economic decisions. Conventional economics just assume that people have a utility curve that says more is better and the people always decide they want more. Bottom up would be people starting small businesses investing mostly their own labor or improving their skills which are also important to economic growth. Most economic theory is based on the idea of an uniform interchangeable labor working with capital investment to make it productive. In today's economy this is not as important as innovation and the educational level and skills of the labor force.
2. Do not go by what politicians say and theirrhetorics. They talk too much. Empty vessels sounds much. They do not know that they are known by thepeople as self interested dump people in change of national economies. The terms bottoms-up and top down are usual rhetorics used to confuse common voters. You are correct that investments contribute to economic growth. It is the Govt. and politicians who do things top down and it is private enterprise that have investments generated bottoms up. Microsoft did not spread top down: it grew from bottom in a garage. In the world of traditional economics, people are rational actors who dispassionately pursue their self-interest, logically assessing the value of goods and services, and paying accordingly. Traditional economics really can't, since it assumes purely rational consumers wouldn't pay high prices for a product that is so widely available and easily substituted. But a new research center at the Boston Federal Reserve Bank is hoping to find an answer to the coffee question, and many others, and in doing so create a framework for more effective economic policy. The Fed's center specializes in behavioral economics, an emerging field that combines economics with psychology to better understand how people -- passionate, irrational, and sometimes downright silly -- act in the marketplace. To help gain this understanding, behavioral economists are pushing the boundaries of economic research, conducting experiments that range from offering shoppers free samples to making monkeys pay for food. This relatively young field has produced insights that challenge accepted economic principles. For example, traditional economics teaches that choice is good, and the more choices the better. But behavioral economics has shown too many choices can confuse people and ultimately prove ineffective. In one experiment, behavioral economists set out six samples of fruit jams at a grocery store, enticing 30 percent of shoppers to buy jam. The researchers then increased the samples to 24. According to established theory, that should have led to more purchases. Instead, jam buyers fell to 3 percent of shoppers. Another economic principle holds that people always seek to maximize returns. But behavioral economics suggests avoiding loss is a more powerful motivator, and could, via evolution, be deeply ingrained in human nature. At Yale University, Keith Chen, an economist, and Laurie Santos, a psychologist, taught Capuchin monkeys to buy food with metal chips. The monkeys were given a choice: They could buy one grape, with a 50-50 chance of winning a second grape, or get two grapes at the same price, but with a 50-50 chance of losing one. In other words, the chances of ending up with just one grape were the same. Researchers expected the monkeys to simply buy the most food presented to them. But three out of four times, the monkeys chose to buy a single grape. The explanation: The monkeys didn't want to risk a loss. ''When we behave irrationally, are we just making a mistake, or is it hardwired into our nature?" said Chen. ''We are trying to address which aspects of our economic behavior are innate, and which ones we learn from the market." Viewed as an offbeat specialty as recently as a decade ago, behavioral economics is rapidly moving into the mainstream. The specialty is generating some of the most intriguing research in economics, not by focusing on complex mathematical analysis that dominates the social science today, but rather by exploring how people react to snow shovel prices, performance incentives, and even the alarm That's the question the Boston Fed's behavioral economics center hopes to answer. The goal of the center, established earlier this year, is to discover if these insights into individual behavior can lead to a better understanding of how the economy works, and eventually to the more effective use of policy tools, such as interest rates, taxes, and regulation. Jeff Fuhrer, research director at the Boston Fed, said it's still unclear whether jam-buying habits or fear of losses have much effect on broad economic movements. Nonetheless, Fuhrer said, behavioral economics, by providing a ''richer description of the circumstances in which people make decisions," offers a promising avenue of inquiry into key economic forces, such as consumer spending, pricing, and inflation. Already, the specialty is influencing public and private policies on saving. Behavioral economics has found that people put off saving for much the same reason they hit the alarm snooze button: Immediate rewards trump future rewards. Other research has shown this propensity can be overcome by automatically enrolling people into savings plans, then leaving it up to them to opt out. One study found participation in a company 401(k) plan jumped to 86 percent with automatic enrollment from 37 percent when employees enrolled themselves. As a result, many companies are switching to the opt-out model, while Congress is considering legislation to encourage more to adopt automatic enrollment for retirement savings plans. ''This is the most dramatic example of behavioral economics influencing public policy," said Peter Orszag, a senior fellow at the Brookings Institution in Washington, who is studying ways to increase savings. Boston Fed officials say they hope their research center will provide other examples. Dan Ariely, the center's visiting scholar and an MIT professor, is examining why people might pay prices greater than the intrinsic value of a good or service, which could have implications for policies that rely on market forces to deliver equitable results. Ariely's research shows people often don't have a good idea of what something is worth, which makes them susceptible to manipulation. He calls it ''Tom's law," referring to the Mark Twain character, Tom Sawyer, who convinces friends to pay for a chance to do what would otherwise seem an unpleasant chore, whitewashing a fence. ''People's willingness to pay is not always determined by supply and demand," Ariely said. ''Sometimes, they just don't know what to pay." Which perhaps explains $4 coffees. Notes: Behavioral economics and behavioral finance are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Academics are divided between considering Behavioral Finance as supporting some tools of technical analysis by explaining market trends, and considering some aspects of technical analysis as behavioral biases (representativeness heuristic, self fulfilling prophecy). Behavioral analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases. Notes: During the classical period, economics had a close link with psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, an important text describing psychological principles of individual behavior; and Jeremy Bentham wrote extensively on the psychological underpinnings of utility. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a natural science, with explanations of economic behavior deduced from assumptions about the nature of economic agents. The concept of homo economicus was developed, and the psychology of this entity was fundamentally rational. Nevertheless, psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes. Psychology had largely disappeared from economic discussions by the mid 20th century. A number of factors contributed to the resurgence of its use and the development of behavioral economics. Expected utility and discounted utility models began to gain wide acceptance, generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively. Soon a number of observed and repeatable anomalies challenged those hypotheses. Furthermore, during the 1960s cognitive psychology began to describe the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field such as Ward Edwards, Amos Tversky and Daniel Kahneman began to compare their cognitive models of decision making under risk and uncertainty to economic models of rational behavior. In Mathematical psychology, there is a longstanding interest in the transitivity of preference and what kind of measurement scale utility constitutes.. An important paper in the development of the behavioral finance and economics fields was written by Kahneman and Tversky in 1979. This paper, 'Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented divergences of economic decision making from neo-classical theory. Over time many other psychological effects have been incorporated into behavioral finance, such as overconfidence and the effects of limited attention. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987), a special 1997 edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics and the award of the Nobel prize to Daniel Kahneman in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." Prospect theory is an example of generalized expected utility theory. Although not commonly included in discussions of the field of behavioral economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory. Behavioral economics has also been applied to problems of intertemporal choice. The most prominent idea is that of hyperbolic discounting, in which a high rate of discount is used between the present and the near future, and a lower rate between the near future and the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with some models of rational choice, since the rate of discount between time t and t+1 will be low at time t-1, when t is the near future, but high at time t when t is the present and time t+1 the near future. As part of the discussion of hypberbolic discounting, has been animal and human work on Melioration theory and Matching Law of Richard Herrnstein. They suggest that behavior is not based on expected utility of on just previous reinforcement experience. At the outset behavioral economics and finance theories were developed almost exclusively from experimental observations and survey responses, though in more recent times real world data has taken a more prominent position. fMRI has also been used to determine which areas of the brain are active during various steps of economic decision making. Experiments simulating market situations such as stock market trading and auctions are seen as particularly useful as they can be used to isolate the effect of a particular bias upon behavior; observed market behavior can typically be explained in a number of ways, carefully designed experiments can help narrow the range of plausible explanations. Experiments are designed to be incentive compatible, with binding transactions involving real money the norm.. There are three main themes in behavioral finance and economics: Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses. See also cognitive biases and bounded rationality. Framing: The way a problem or decision is presented to the decision maker will affect his action. Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has described specific market anomalies from a behavioral perspective. Recently, Barberis, Shleifer, and Vishny (1998), as well as Daniel, Hirshleifer, and Subrahmanyam (1998) have built models based on extrapolation (seeing patterns in random sequences) and overconfidence to explain security market over- and underreactions, though such models have not been used in the money management industry. These models assume that errors or biases are correlated across agents so that they do not cancel out in aggregate. This would be the case if a large fraction of agents look at the same signal (such as the advice of an analyst) or have a common bias. More generally, cognitive biases may also have strong anomalous effects in aggregate if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology. However, some behavioral models explicitly demonstrate that a small but significant anomalous group can also have market-wide effects .