Behavioral economics is an emerging branch of economics that blends elements of economics and psychology. One of the main reasons I find the subject so intriguing is that it challenges traditional economic theory. 

Traditional economics assumes that individuals behave rationally to maximize the highest satisfaction and utility when making economic decisions. Behavioral economics argues otherwise, claiming that individuals behave irrationally, not rationally, during decision-making.

Unlike traditional economics, behavioral economics emphasizes the importance of psychology in the decision-making process; factors like environment, cognitive biases, relationships, and emotions can skew an individual’s ability to make rational decisions. 

For example, a popular cognitive bias often referred to in behavioral economics is the endowment effect, a term coined by Richard Thaler. The endowment effect states that individuals place a higher value on objects they own than on objects they don’t – even if the goods are of equal value. 

A simple illustration of the endowment effect could be not wanting to donate a shirt you no longer wear. Although the shirt is of no use, you overvalue it, causing you to make the irrational decision to keep it.

A more extreme example of the endowment effect is listing your home at an inflated price point, above what a house in your area would typically sell for. In this case, you’re falling victim to the endowment effect, which may cause you to make an irrational decision that may prevent you from selling your home.

The endowment effect explains loss aversion, another key concept in behavioral economics. Loss aversion is a cognitive bias in which the pain of loss is greater than the benefits of a gain – even if they are of equal value. For example, losing $100 is more painful than gaining $100. This asymmetry occurs because of the endowment effect since we overvalue the things we own versus those we don’t.

Thankfully, because of the emerging research from behavioral economics, we have a greater understanding of how we act irrationally when making economic or personal decisions. Beyond academic and personal pursuits, behavioral economics can help economists, policymakers, and businesses understand the biases and limitations of human decision-making, nudging individuals into making smarter decisions.

By understanding behavioral economics, we can make smarter economic decisions, design more effective governing policies, improve consumer welfare, and develop strategies that align with how people behave in economic situations.

If you want to learn more about behavioral economics, check out my book recommendations here.