of the process) for helpful comments. 1 Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations. This book consists of representative recent articles in behavioral economics. 1 This chapter is intended to provide an introduction to the approach and methods of behavioral economics, and to some of its major findings, applications, and promising new directions. It also seeks to fill some unavoidable gaps in the chapters ’ coverage of topics. What Behavioral Economics Tries To Do At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve economics on its own terms--generating theoretical insights, making better predictions of field phenomena, and suggesting better policy. This conviction does not imply a wholesale rejection of the neoclassical approach to economics based on utility maximization, equilibrium, and efficiency. The neoclassical approach is useful because it provides economists with a theoretical framework that can be applied to almost any form of economic (and even non-economic) behavior, and it makes refutable predictions. Many of these predictions are tested in the chapters of this book, and rejections of those predictions suggest new theories. Most of the papers modify one or two assumptions in standard theory in the direction of greater psychological realism. Often these departures are not radical at all because they relax simplifying assumptions that are not central to the economic approach. For example, there is nothing in core neoclassical theory that specifies that people should not care about fairness, that they should weight risky outcomes in a linear fashion, or that they must discount the future exponentially at a constant rate. 2 Other assumptions simply acknowledge human limits on 1 Since it is a book of advances, many of the seminal articles which influenced those collected here are not included, but are noted below and are widely reprinted elsewhere.

We investigate the market for news under two assumptions: that readers hold beliefs that they like to see confirmed, and that newspapers can slant stories toward these beliefs. We show that, on the topics where readers share common beliefs, one should not expect accuracy even from competitive media: competition results in lower prices, but common slanting toward reader biases. However, on topics where reader beliefs diverge (such as politically divisive issues), newspapers segment the market and slant toward the biases of their own audiences, yet in the aggregate a conscientious reader could get an unbiased perspective. Generally speaking, reader heterogeneity is more important for accuracy in media than competition per se.

Many people believe in the "Law of Small Numbers," exaggerating the degree to which a small sample resembles the population from which it is drawn. To model this, I assume that a person exaggerates the likelihood that a short sequence of i.i.d. signals resembles the long-run rate at which those signals are generated. Such a person believes in the "gambler's fallacy", thinking early draws of one signal increase the odds of next drawing other signals. When uncertain about the rate, the person over-infers from short sequences of signals, and is prone to think the rate is more extreme than it is. When the person makes inferences about the frequency at which rates are generated by different sources --- such as the distribution of talent among financial analysts --- based on few observations from each source, he tends to exaggerate how much variance there is in the rates. Hence, the model predicts that people may pay for financial advice from "experts" whose expertise is entirely ...

Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they are optimistic. This paper studies utility-based biases in beliefs by supposing that beliefs maximize average felicity, optimally balancing this benefit of optimism against the costs of worse decision making. A small optimistic bias in beliefs typically leads to first-order gains in anticipatory utility and only second-order costs in realized outcomes. In a portfolio choice example, investors overestimate their return and exhibit a preference for skewness; in general equilibrium, investors ’ prior beliefs are endogenously heterogeneous. In a consumption-saving example, consumers are both overconfident and overoptimistic. (JEL D1, D8, E21, G11, G12) Modern psychology views human behavior as a complex interaction of cognitive and emotional responses to external stimuli that sometimes results in dysfunctional outcomes. Modern economics takes a relatively simple

Abstract: This study undertakes a systematic experimental investigation of hysteresis (path dependency) in an agent-based computational labor market framework. It is shown that capacity asymmetries between work suppliers and employers can result in two distinct hysteresis effects, network and behavioral, when work suppliers and employers interact strategically and evolve their worksite behaviors over time. These hysteresis effects result in persistent heterogeneity in earnings and employment histories across agents who have no observable structural differences. At a more global level, these hysteresis effects are shown to result in a one-to-many mapping between treatment factors and experimental outcomes. These hysteresis effects may help to explain why excess earnings heterogeneity is commonly observed in real-world labor markets.

Experiments with real and computational agents are used to examine the impact of changing the level of a non-employment payoff on the evolution of cooperation between workers and employers participating in a sequential employment game with incomplete contracts. Workers either direct work offers to preferred employers or choose unemployment and receive the non-employment payoff. Subject to capacity limitations, employers either accept work offers from preferred workers or remain vacant and receive the nonemployment payoff. Matched workers and employers participate in an employment relationship modeled as a prisoner's dilemma game. In both types of experiments, increases in the non-employment payoff result in higher unemployment and vacancy rates while at the same time encouraging higher rates of cooperation among the workers and employers who do form matches. However, the behaviors exhibited by the computational agents are coordinated to a higher degree than the behaviors of the human subjects. This difference raises challenging questions for both human-subject and computational experimentalists. Keywords: Labor market; unemployment rate; vacancy rate; evolution of cooperation; efficiency wage; search and matching; endogenous interaction networks; evolutionary game; human-subject experiments; computational experiments; agentbased computational economics. 2 1.

This paper addresses the question of why, in spite of its recent success, behavioral economics does not influence most discussions about how economic policy ought to be made. Failing to penetrate into contemporary discourse on leading policy issues is a serious problem, because behavioral techniques often point to policy prescriptions that are at odds with the prescriptions which follow from models using more standard behavioral assumptions. By comparing how the universe of possible policy implications changes when different methodological approaches are used, this paper demonstrates a systematic link between methodology and the range of policy prescriptions that can be socially desirable. Because of this link, the methodological multiplicity of behavioral economics, and the ideological pluralism which it supports, favor the use of normative behavioral economics. This follows from the basic economic principle of diversification: a policy prescription that reflects averaging over a number of distinct kinds of errors (one for each methodology) is less likely to wander far off target than one generated by a single method.

Abstract: We study the implications of learning in an environment where the true model of the world is a multivariate one, but where agents update only over the class of simple univariate models. If a particular simple model does a poor job of forecasting over a period of time, it is eventually discarded in favor of an alternative—yet equally simple—model that would have done better over the same period. This theory makes several distinctive predictions, which, for concreteness, we develop in a stock-market setting. For example, starting with symmetric and homoskedastic fundamentals, the theory yields forecastable variation in the size of the value/glamour differential, in volatility, and in the skewness of returns. Some of these features mirror familiar accounts of stock-price bubbles.

Context can influence decisions. This malleability of choice is usually invoked as evidence that people do not maximize stable preference orderings. In a market equilibrium, however, context conveys payoff-relevant information to consumers. Consequently, these consumers rationally violate naïve formulations of standard choice theoretic principles. I identify informational asymmetries under which apparently anomalous behaviors, namely the compromise effect and choice overload, arise as market equilibria. Firms respond to consumers’ contextual inference; in case of the compromise effect, a firm may introduce premium loss leaders (expensive goods of overly high quality that increase the demand for other goods). (JEL D11, D83, M31) Numerous studies demonstrate that seemingly irrelevant factors influence people’s decisions. Perhaps the best known examples of such influence are context effects. A consumer exhibits a context effect if her choice between two alternatives systematically depends on the presence of other options. An extensive literature demonstrates context effects in laboratory settings. One of the most widely studied context effects is the compromise effect (Itamar Simonson 1989), 1 which refers to the finding that people tend to choose the middle option. More precisely, when three alternatives are available, the middle alternative is chosen more often than when it is paired with only one other option. Figure 1 shows the compromise effect obtained by Simonson (1989). This tendency to avoid extreme options has been credited with affecting decisions ranging from the demand for wine (Daniel L. McFadden 1999) to voting (Kaisa Herne 1997) and investing (Shlomo Benartzi and Richard H. Thaler 2002). Even more telling of the importance bestowed on the compromise effect is its didactic use in books such as 101 Ways to Increase Sales (Dirk

conference on economic institutions and behavioral economics. This is a very rough working draft for the conference. The Mark Twain apology applies, we wish we had more time to write less. Comments are genuinely appreciated, especially on what to cut, and on important omissions (self-serving ones are expected). Ideas from the NBER Organizational Economics conference in March, 2004, particularly Bob Gibbons’s presentation, was useful, as were discussions with Chip Heath and Sendhil Mullainathan. 0 This essay is about how behavioral economics can be applied to organizations, and can also be enriched by thinking about how individuals behave in organizations. Behavioral economics modifies economic theory to account for normal limits on rational calculation, willpower and greed, and the natural psychophysical properties of preference and judgment (e.g. Mullainathan and Thaler, 2001; Camerer and Loewenstein, 2004). Thinking about organizations naturally extends this definition to include how socialization and identity shape individual behavior. (While little about these extensions will be discussed in this paper, see Akerlof and Kranton, 2003). From a methodological perspective, behavioral economics is simply a humble