Behavioral Economics

In spirit, neo-classical economic models are akin to those of Newtonian physics – elegant and theoretically useful abstractions, which leave out the many of the details that make real life more complex. Such abstractions work pretty well as long as the details that are left out don’t make much of a difference. The theoretical edifice of neo-classical micro-economics is built on the simplifying assumption that people are generally capable of making economic decisions consistently to maximize their own interests. Departures from rational maximization are considered largely to be random errors that disappear as people learn to behave more rationally or are eliminated from market competition if they don’t.

Over the last twenty-five years, the new interdisciplinary field of behavioral economics has emerged to challenge this assumption. Building on research in cognitive and social psychology and sociology, behavioral economists have shown that there are persistent, systematic departures from rationality in economic decision making, which are not purged by market forces, and which may well shape the way markets operate, rendering them less efficient than textbook market models. Behavioral economics has taken up the difficult task of working out how cognitive biases, mental rules of thumb, interpersonal relationships and social networks and norms can cause real-life economic decisions to deviate from the standards of rational, self-interested maximization. While the results still fall far short of a fully worked out theoretical alternative to standard micro-economics, behavioral economic principles have become increasingly useful in suggesting explanations of aspects of market behavior that defy standard explanations, and they are beginning to prove valuable guides to formulating economic policy.

The Russell Sage Foundation was an early force in the development of this field, launching the Behavioral Economics program in 1986 as a joint activity with the Alfred P. Sloan Foundation. During the first eight years of the program, the Foundation made 60 research awards, hosted three groups of Visiting Scholars, and established several working groups: one in behavioral finance, one on time preference (or intertemporal choice), and another on economic sociology. These early activities resulted in a number of seminal books on behavioral economics published by the Foundation,all of which remain key texts in the field today. Quasi Rational Economics (1991), by Richard Thaler, and Advances in Behavioral Finance(1993), also edited by Thaler, examine why standard economic models so often fail to predict market behavior accurately. According to Thaler, the shortcomings of the standard approach arise from its failure to take into account systematic mental biases that color all human judgments and decisions. For example, Thaler finds an explanation for superior price performance of firms with poor recent earnings histories in the tendencies of investors to overreact to recent information. Choice Over Time (1992), edited by George Loewenstein and Jon Elster,presents research on intertemporal choice – how people choose between immediate and delayed consequences – and why people seem to discount future benefits in favor of immediate gratification. Understanding such behavior is particularly salient with regard to such public policy concerns as the ballooning public and private debt, inadequate retirement savings rates, diminished educational achievement, and long-term environmental issues such as global warming.

The Behavioral Economics Roundtable
In 1992 the Foundation launched the Behavioral Economics Roundtable, whose initial members were elected by participants in the program and given Foundation support to devise activities designed to advance this new interdisciplinary field. The results have been so consistently successful that the Roundtable has become the Foundation’s principal means of supporting behavioral economics. Now made up of 28 prominent behavioral economists, the Roundtable currently sponsors three main activities: a small grants program for younger scholars undertaking behaviorally oriented research; a two-week summer workshop taught by Roundtable members for graduate students and junior faculty interested in entering this new interdisciplinary field; and a book series in a behavioral economics co-published by RSF and Princeton University Press.

The Roundtable’s small grants program was launched in 1993 to help make the field more accessible to young investigators. Behavioral research often requires funds for running experiments or acquiring other kinds of behavioral data, the cost of which can be a significant barrier to young researchers. Since its inception, the small grants program has awarded over 140 grants of up to $7,500 each to help young researchers with the start-up costs of behavior projects. In the past year, twelve small grants were made, covering a variety of subjects, including peer effects on savings, the impact of culture on trust in information sharing, and the role of commitments in overcoming procrastination. A complete list of grants can be found here. Entry-level researchers interested in applying for a small grant in the Roundtable’s program can find out how to do so on our "How to Apply" page. 

The Roundtable’s second effort to make behavioral economics more accessible to prospective entrants into the field has been a highly successful Summer Institute held biennially since 1994. Designed to accommodate about thirty advanced graduate students or junior faculty who want a concise introduction to recent trends in behavioral research, each Summer Institute is organized by two or three Roundtable members who offer a core curriculum of lectures and seminars, while other Roundtable members provide guest lectures. The Roundtable's most recent summer institute was held in June 2010 in Trento, Italy. A competitively selected group of young scholars gathered to learn about a variety of behavioral topics, including behavioral finance, behavioral game theory, neuro-economics, consumer finance, libertarian paternalism, and behavioral macro-economics. The next Summer Institute will be held in Waterville Valley, New Hampshire, from July 1 to July 13, 2012. Click here for application requirements.

In 2001, the Roundtable established a new book series as a outlet for behavioral work that could benefit from more lengthy treatment than is permitted in standard journals. The Roundtable Series in Behavioral Economics publishes books in economics that are deeply rooted in empirical findings or methods from one or more of the neighboring sciences and advance economics on its own terms – generating theoretical insights, making more accurate predictions of field phenomena, and suggesting better policy. The series is edited by Roundtable members Colin Camerer and Ernst Fehr, and co-published by Russell Sage and the Princeton University Press. Four titles have been published in the series to date: Behavioral Game Theory(2003) by ColinCamerer; Microeconomics: Behavior, Institutions and Evolutions(2003)by Samuel Bowles; Advances in Behavioral Finance, Vol. II(2005) edited by Richard Thaler; and Advances in Behavioral Economics(2003), a collection of foundational papers in the field edited by Colin Camerer, George Loewenstein, and Matthew Rabin. Several more titles are scheduled for publication over the next few years. A full list of the Foundation’s behavioral economics publications appears here.

Current Activities
Standard economic approaches to the regulation of retail finance assume that consumers are capable of understanding the terms of financial contracts and selecting those that maximize their self-interest. On this assumption, consumers need only be fully informed of the terms of a contract in order assure their well-being. Yet the recent sub-prime mortgage debacle provides abundant evidence of flawed consumer decision-making, and financial contracts increasingly seem to have features like low initial teaser rates, hidden penalties and fees, and lock-in provisions that make it difficult for consumers to assess their true costs and benefits.

The current major initiative in the Behavioral Economics program is a Working Group on Consumer Finance, which aims to bring behavioral economics research to bear on analyzing consumers’ financial decision-making in order to inform regulatory strategies designed to improve consumer welfare. Among the questions the group plans to address: How well do consumers understand the various kinds of loan contracts they enter into? Might different contractual formats improve consumer understanding? Is understanding alone sufficient to maximize consumer welfare, or do consumers need further protection against their own behavioral weaknesses (like impatience or overconfidence), which may get them into trouble even when they fully understand contractual terms? If so, what form should those protections take? Are warnings sufficient? Could default options be usefully deployed? Or, are some credit products so dangerous that outright bans are necessary, and if so, how do we decide which products those are? In addition to fostering basic research on these and related questions, the working group will explore the implications of this research for potential regulatory strategies to protect consumers from financial products and services that may prove dangerous to their financial well-being.

The Working Group on Consumer Finance, launched in November 2009 with an award of $250,000 and co-sponsored with the Alfred P. Sloan Foundation, is made up of an interdisciplinary group of twenty economists, cognitive psychologists, and legal scholars. In its first phase, the group is sponsoring a number of pilot research projects. To cite a few examples: David Laibson and Brigitte Madrian (both of Harvard University) will conduct a web-based experiment to assess consumers’ willingness to save money in “commitment accounts” that restrict liquidity in order to protect savings from the “present bias” – consumers’ psychological tendency to value immediate consumption disproportionately over consumption in the future. Paige Marta Skiba (Vanderbilt University) will explore why the urban poor tend to use expensive check-cashing services instead of standard checking accounts. Using both administrative data from a cooperating check-cashing company and a survey of its customers, Skiba will try to determine whether the use of check-cashing is a rational response to income uncertainty (living paycheck to paycheck) or whether “present bias” plays a role. Justin Sydnor (Case Western Reserve) will run a field experiment to explore whether prospective home buyers have difficulty estimating the amount they can afford to pay for a house and therefore use the size of the mortgage loan that is pre-approved by the lender as a guideline to anchor their decision. Sydnor will test whether a simple computerized decision aid that gives purchasers an alternate source of information about what they can afford might counteract thetendency to accept the bank’s pre-approved amount. These three exploratory projects provide a good early illustration of the kind of behavioral research the working group hopes to develop. The Working Group on Consumer Finance will meet in late 2010 to discuss the early stages of research already underway and to explore funding future projects.

If you have any questions about the Behavioral Economics program, please contact us at programs@rsage.org.

Behavioral Economics Roundtable Members

Members of the Roundtable are elected by standing membership, which currently include three Nobel laureates. The members are: Henry Aaron, Brookings Institution; George Akerlof, University of California at Berkeley; Linda Babcock, Carnegie Mellon University; Nicholas C. Barberis, Yale University; Marianne Bertrand, University of Chicago; Roland J. M. Benabou, Princeton University; Colin Camerer, California Institute of Technology; Peter Diamond, Massachusetts Institute of Technology; Jon Elster, Columbia University; Ernst Fehr, University of Zurich; Robert H. Frank, Cornell University; Christine Jolls, Harvard University; Daniel Kahneman, Princeton University; David Laibson, Harvard University; George Loewenstein, Carnegie Mellon University; Brigitte Madrian, University of Pennsylvania; Sendhil Mullainathan, Massachusetts Institute of Technology; Edward D. O'Donoghue, Cornell University; Terrance Odean, University of California at Berkeley; Drazen Prelec, Massachusetts Institute of Technology; Matthew Rabin, University of California, Berkeley; Thomas Schelling, University of Maryland; Eldar Shafir, Princeton University; Robert Shiller, Yale University, Cass Sunstein, University of Chicago; Richard Thaler, University of Chicago; Jean Tirole, Universite des Sciences Sociales at Toulouse, Richard Zeckhauser, Harvard University.