ABSTRACT
People systematically deviate from how they should behave according to neoclassical economics. For example, the context in which we make decisions is often more important than the informational content that we receive. The focus of this chapter is how people actually form judgements and make decisions according to psychological insights. Heuristics and biases are central to this discussion – heuristics can be thought of as mental shortcuts that are automatic, intuitive and do not require conscious thought. Tversky and Kahneman initially outlined three heuristics in 1974: availability, representativeness, and anchoring and adjustment, and others have been identified since. The formulation of Prospect Theory by Kahneman and Tversky in 1979 proved especially influential by combining psychological insights with economic phenomena. It provides an elegant explanation of why people dislike losses more than they value equivalent gains. In particular, Prospect Theory calls attention to the importance of reference points: we do not look at things in absolute terms but, rather, we focus on relative changes around a reference point, and these can be influenced in various ways. The chapter also explores how behavioral economic phenomena are the result of specific brain–mind cognitive and affective systems that are specialized for different functions.
