Behavioral Economics

“Greed is good.”
Gordon Gekko, Wall Street (1987, Dir. Oliver Stone)

Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. The discipline explores why people make irrational decisions, and why and how their behavior does not follow the predictions of economic models. The two most important questions in this field are:

  1. Are economists’ assumptions of utility or profit maximization good approximations of real people’s behavior?
  2. Do individuals maximize subjective expected utility?

In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction. This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person—or homo oeconomicus—has self-control and is unmoved by emotions and external factors and, hence, knows what is best for themself. Opposing this line of argumentation, behavioral economics explains that humans are not rational and are incapable of consistently making good decisions. Rather, their decision-making process is tainted and impeded by a wide range of factors, such as self-deception, overconfidence, projection bias and other biases, emotion, heuristic simplification or cognitive errors, social factors, and the effects of limited attention.

Only gradually, and in recent years, the arguments of behavioral economics and its subfield of behavioral finance are finding their way into more traditional economic models. Looking at the basic assumptions upon which the legal frameworks and regulatory focus of contemporary financial markets have been established (i.e. the existence of the homo oeconomicus and its perfectly rational behavior), one could argue that the ideas brought forth by behavioral economics have the potential to fundamentally disrupt the markets’ frameworks. However, there are indices in place already to measure behavioral tendencies in the financial markets, such as CNN Money’s famed Fear and Greed Index.

In the context of the project Fabrikanten der Wirklichkeit / Fabricating Reality, the perhaps most interesting of the biases behavioral economics looks into is the narrative fallacy. It points the limits to our ability to evaluate information objectively and complexely, even contradictory. We much prefer (oversimplified) stories that neatly account for results and ignore the unsettling element of randomness and chaos. Nassim Taleb argues that humans seek explanations and causal stories to the point where we manufacture them. Narrative fallacies may be an undesired byproduct of humans’ excellent and evolutionarily crucial ability of pattern recognition. Science writer Michael Schermer has labeled the tendency to find meaningful patterns in meaningless noise as “patternicity.”

Startup culture and tech companies tend to take advantage of the narrative fallacy and produce a variety of narratives to attract venture capital and other investors. Promises like disruption and democratization through technology having become standard containers for stories designed to activate investor interest. In the stock market, stocks of certain (as-of-yet unprofitable) companies rely heavily on well-told stories to fuel investor phantasy. Hence, they are sometimes referred to as “story stocks.”


See also