Where psychology meets economics: how people actually make decisions.
The Rational Actor Model
Traditional economics assumes people are "rational."
Homo Economicus
| Assumption | What It Means |
|---|
| Rational | Consistent preferences, logical choices |
| Self-interested | Maximize own welfare |
| Fully informed | Know all relevant information |
| Unlimited processing | Can analyze any problem |
| Stable preferences | Wants don't change randomly |
Why This Model Is Useful
| Benefit | Explanation |
|---|
| Tractable | Math works, predictions clear |
| Often accurate | Works well for repeated, simple choices |
| Benchmarks | Shows what "optimal" looks like |
| Incentives | Predicts responses to prices, penalties |
Why This Model Fails
| Reality | How People Actually Behave |
|---|
| Bounded rationality | Limited time, brainpower, information |
| Present bias | Overweight immediate gratification |
| Social preferences | Care about others, fairness |
| Reference dependence | Choices depend on framing |
| Limited attention | Focus on salient features |
Cognitive Biases
Heuristics: Mental Shortcuts
| Heuristic | Description | Example |
|---|
| Availability | Judge by ease of recall | Overestimate plane crash risk |
| Representativeness | Match to stereotypes | Ignore base rates |
| Anchoring | Stick near initial number | First price affects negotiation |
| Affect | Judge by feelings | Like = good, dislike = risky |
Common Biases
| Bias | Description | Example |
|---|
| Confirmation | Seek confirming evidence | Read news you agree with |
| Overconfidence | Too sure of abilities | 80% think they're above average drivers |
| Hindsight | "Knew it all along" | 2008 crisis was "obvious" |
| Status quo | Prefer current state | Stay with default options |
| Loss aversion | Losses hurt more than gains please | $100 loss feels worse than $100 gain feels good |
| Sunk cost | Consider past investments | Keep watching bad movie |
Framing Effects
| Same Choice, Different Frame | Preferred Option |
|---|
| "90% survival rate" | Sounds good |
| "10% mortality rate" | Sounds bad |
| "$2 discount for cash" | Take cash |
| "$2 surcharge for credit" | Avoid credit |
| "Keep $20 of $50" | Take the gamble |
| "Lose $30 of $50" | Take the sure thing |
Prospect Theory
Nobel Prize-winning alternative to expected utility theory.
Key Insights
| Concept | Description |
|---|
| Reference dependence | Evaluate gains/losses relative to reference point |
| Loss aversion | Losses weigh ~2x as much as equivalent gains |
| Diminishing sensitivity | Each additional gain/loss matters less |
| Probability weighting | Overweight small probabilities |
The Value Function
| Gain/Loss | Psychological Value |
|---|
| +$100 | +1.0 utility |
| +$200 | +1.6 utility (not +2.0) |
| -$100 | -2.0 utility (loss aversion) |
| -$200 | -3.2 utility |
Implication: People are risk-averse for gains, risk-seeking for losses.
Probability Weighting
| Actual Probability | Psychological Weight |
|---|
| 0% | 0% |
| 1% | ~5% (overweight) |
| 50% | ~40% (underweight) |
| 99% | ~95% (underweight) |
| 100% | 100% |
Implication: We buy lottery tickets (overweight small win probability) and insurance (overweight small loss probability).
Time Inconsistency
Present Bias
We overweight immediate rewards compared to future rewards.
| Choice | Now | Later | What People Choose |
|---|
| A | $100 today | $110 in a week | $100 today |
| B | $100 in a year | $110 in a year and a week | $110 later |
Inconsistency: Same trade-off (wait 1 week for $10), different choices based on timing.
Hyperbolic Discounting
| Model | How Future Is Discounted |
|---|
| Exponential (rational) | Constant rate over time |
| Hyperbolic (actual) | Sharp discount for now, slower later |
Consequences of Present Bias
| Domain | Present Bias Effect |
|---|
| Saving | Undersave for retirement |
| Health | Overeat, under-exercise |
| Procrastination | Delay important tasks |
| Debt | Borrow too much for consumption |
| Addiction | Immediate pleasure over long-term harm |
Commitment Devices
| Device | How It Works | Example |
|---|
| Pre-commitment | Remove future choice | Automatic savings deduction |
| Ulysses contract | Bind yourself | Give friend $500 to return if you exercise |
| Deadlines | External accountability | Tax filing date |
| Temptation removal | Eliminate triggers | Don't buy junk food |
Social Preferences
Types of Social Preferences
| Preference | Description |
|---|
| Altruism | Care about others' welfare |
| Fairness | Prefer equitable outcomes |
| Reciprocity | Reward kindness, punish meanness |
| Trust | Believe others will cooperate |
| Social image | Care what others think |
Ultimatum Game
| Setup | Result |
|---|
| $10 to split | Proposer offers split |
| Responder can accept or reject | If reject, both get $0 |
| Rational prediction | Accept any positive offer |
| Actual behavior | Reject offers below 20-30% |
Implication: Fairness matters; people punish unfairness even at personal cost.
Dictator Game
| Setup | Result |
|---|
| $10 to split | Dictator chooses split |
| Recipient has no choice | Must accept |
| Rational prediction | Give $0 |
| Actual behavior | Average gift ~25% |
Implication: People are somewhat generous even when not required.
Public Goods Game
| Setup | Result |
|---|
| Each player has $10 | Contribute to public pot |
| Pot multiplied by 2 | Divided equally |
| Rational prediction | Contribute $0 (free ride) |
| Actual behavior | Average ~50% initially, declines |
Implication: Cooperation is common but fragile without enforcement.
Mental Accounting
How It Works
People treat money differently based on arbitrary categories.
| Category | Behavior |
|---|
| Income sources | Treat windfall differently from salary |
| Spending buckets | Separate "fun money" from "bills" |
| Accounts | Treat savings account as untouchable |
| Timing | "Monthly budget" resets each month |
Mental Accounting Examples
| Scenario | Behavior |
|---|
| Lost $50 bill | Skip the $40 purchase |
| Lost $50 ticket | Buy another ticket anyway |
| Tax refund | Spend on luxuries |
| Same amount as bonus | Treat more cautiously |
| Won $100 gambling | Gamble more freely |
| Earned $100 working | Save more carefully |
Implications
| Domain | Mental Accounting Effect |
|---|
| Credit cards | Doesn't feel like "real" spending |
| Gift cards | Spent more freely than cash |
| Sunk costs | "Can't waste" past investment |
| House money | Spend winnings more readily |
Nudge Theory
What Is a Nudge?
A nudge changes behavior without forbidding options or significantly changing incentives.
| Nudge Characteristic | Explanation |
|---|
| Choice architecture | Design of how choices are presented |
| Libertarian paternalism | Preserve freedom, guide toward better |
| Easy to avoid | Not a mandate |
| Low cost | Not a big incentive |
Common Nudges
| Nudge | Application | Effect |
|---|
| Default options | Opt-out retirement savings | 90% enrollment vs. 30% opt-in |
| Simplification | One-page forms | Higher completion rates |
| Social norms | "Most people pay taxes on time" | Increased compliance |
| Reminders | Text message about appointments | Reduced no-shows |
| Salience | Calorie labels | Healthier choices |
| Commitment | Sign pledge | Higher follow-through |
Nudge Examples
| Domain | Nudge | Outcome |
|---|
| Retirement | Auto-enroll in 401(k) | 90% participation |
| Organ donation | Opt-out system | 80%+ donation rate |
| Energy use | Compare to neighbors | 2% reduction |
| Food choices | Healthy options first | Healthier eating |
| Debt repayment | Snowball vs. avalanche | Higher completion |
Nudge Criticisms
| Criticism | Response |
|---|
| Manipulation | Transparent, easy to override |
| Ineffective | Evidence shows they work |
| Paternalistic | Preserves choice |
| Slippery slope | Clear limits on government power |
| Ignores root causes | Complements, doesn't replace policy |
Behavioral Finance
Market Anomalies
| Anomaly | Description | Rational Explanation Difficulty |
|---|
| Equity premium puzzle | Stocks return too much | Risk aversion should be extreme |
| Momentum | Past winners keep winning | Markets should be random walk |
| January effect | Higher returns in January | Should be arbitraged away |
| Home bias | Overinvest in home country | Should diversify globally |
| Dividend preference | Prefer dividends to buybacks | Tax-inefficient preference |
Investor Biases
| Bias | Behavior | Cost |
|---|
| Overconfidence | Trade too much | Transaction costs, worse performance |
| Disposition effect | Sell winners, hold losers | Tax-inefficient, miss gains |
| Recency | Extrapolate recent trends | Buy high, sell low |
| Herding | Follow the crowd | Bubbles and crashes |
| Narrow framing | Evaluate stocks individually | Miss diversification benefits |
Bubbles and Crashes
| Phase | Psychology |
|---|
| Displacement | New opportunity sparks interest |
| Boom | Prices rise, attract more buyers |
| Euphoria | "This time is different" |
| Profit-taking | Smart money exits |
| Panic | Everyone tries to sell |
| Revulsion | Overshooting to downside |
Applications
Retirement Saving
| Problem | Behavioral Insight | Solution |
|---|
| Undersaving | Present bias | Auto-enrollment |
| Inertia | Status quo bias | Default to high rate |
| Complexity | Choice overload | Target-date funds |
| Regret | Loss aversion | "Save More Tomorrow" |
Health Behaviors
| Problem | Behavioral Insight | Solution |
|---|
| Overeating | Present bias | Smaller plates |
| Under-exercise | Hyperbolic discounting | Commitment devices |
| Non-adherence | Forgetfulness | Pill reminders |
| Risky behavior | Optimism bias | Graphic warnings |
Consumer Protection
| Problem | Behavioral Insight | Solution |
|---|
| Hidden fees | Complexity | Disclosure requirements |
| Predatory lending | Present bias | Cooling-off periods |
| Over-borrowing | Optimism | Affordability checks |
| Fine print | Limited attention | Summary boxes |
Key Takeaways
People aren't fully rational - Systematic biases affect decisions in predictable ways
Loss aversion is powerful - Losses hurt about twice as much as equivalent gains please
Present bias undermines goals - We discount the future too steeply, harming long-term wellbeing
Framing matters - How choices are presented affects what people choose
Social preferences are real - People care about fairness, reciprocity, and social image
Nudges can help - Small changes in choice architecture can improve outcomes while preserving freedom
Markets aren't always efficient - Behavioral biases create anomalies that persist despite arbitrage