A guide to the study of how and why you really make financial decisions While classical economics is based on the notion that people act with rational self-interest, many key money decisions like splurging on an expensive watch can seem far from rational.

Introduction 1 About This Book 1 Conventions Used in This Book 2 What You’re Not to Read 2 Foolish Assumptions 3 How This Book isOrganized 3 Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 4 Part II: Understanding Choice 4 Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 4 Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 5 Part V: The Part of Tens 5 Icons Used in This Book 6 Where to Go from Here 6 Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 7 Chapter 1: Decoding Behavioral Economics 9 Making Wise Assumptions 9 Why reality matters 10 Why incentives matter — even in behavioral economics 10 Making Sense of Choice 11 Maximizing versus satisficing 11 The effect of emotions 12 The avoidance of loss 12 How options are framed 12 Paternalism versus free choice 13 The role of social context in decision making 14 Relative positioning 14 Growing the Economic Pie 15 Deciphering Bubbles and Busts 15 Inefficient markets and investment behavior 16 Emotions, intuition, animal spirits, and business cycles 16 Understanding Happiness: Money Isn’t Everything 17 Chapter 2: Getting Real about Assumptions 19 Defining an Economic Model 20 Explaining economic phenomena 21 Making simplifying assumptions 21 Discovering the irrelevance of facts 22 Understanding the role of math in model building 23 Considering cause and effect 26 Watching out for spurious correlations 26 Contemplating Conventional Economic Assumptions and Real-World Alternatives 27 Conventional assumption #1: People’s preferences are stable and consistent 27 Conventional assumption #2: People are solitary decision makers 28 Conventional assumption #3: How people form preferences doesn’t matter 28 Conventional assumption #4: People have the same preferences 29 Conventional assumption #5: People are all maximizers 30 Conventional assumption #6: People have perfect knowledge 32 Conventional assumption #7: People have unbounded computational capabilities 33 Conventional assumption #8: People have willpower 34 Conventional assumption #9: People are capable of acting upon their preferences 35 Understanding Rational Economic Behavior 36 You can do no wrong: Errors and biases in decision making 37 Selfishness and the smart society 38 Getting to Know the Behavioral Economics Actor 39 Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis 41 Where Neuroeconomics Fits in the Behavioral Economics Perspective 43 The Brain and Economics 45 The evolution of the human brain 45 The division of labor in the human brain 48 The Emotional Brain 49 Descartes’ error: The somatic marker hypothesis 49 Phineas Gage and the social and emotional side of rational decision making 50 How Emotions Affect Decision Making 53 Fear and decision making 53 Happiness and decision making 54 The Limits of the Human Brain and Homo Economicus 54 The brain isnot a calculating machine 55 The brain isa scarce resource 55 What Brain Sciences Confirm for the Behavioral Economist 57 People prefer the present to the future 57 People’s aversion to loss affects their decision making 58 What people feel isn’t always what they experience 58 People care about keeping up with — and beating —the Joneses 60 People’s brains evolve over their lifetimes 61 People value fairness 62 People like to trust and be trusted 63 Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything 65 The Role of Economic Incentives for Economic Behavior 66 Why money isall that matters in conventional economics 67 Opportunity costs for Homo economicus 69 Decision Making and Opportunity Costs 71 Using up your mind: Bounded rationality 71 Considering costs other than money: Psychological costs 72 Reducing opportunity costs in the real world: Satisficing behavior 73 Weighing the opportunity cost of altruism 75 Supply and Demand and Behavioral Economics 75 Introducing the bandwagon effect 76 Investigating the snob effect 77 Interjecting morals and ethics 78 Introducing sociology to supply and demand 79 Economic Psychology: How Thoughts and Feelings Impact Decisions 84 Loss aversion: How framing, ownership, and control affect economic behavior 85 How the fear of uncertainty influences decisions 85 The warm glow: Why people sacrifice money for fairness or justice 87 Forfeiting money for status 88 Part II: Understanding Choice 89 Chapter 5: Exploring the Limits to Free Choice 91 Free Choice in Economic Decision Making 92 What conventional economics says 92 What behavioral economics says 93 Revealed Preferences: When Choices Reveal Your Inner Self 94 The narrative about preferences 95 False preferences versus true preferences 96 The limits of revealed preferences and free choice 98 The Illusion of Free Choice 99 Advertising and preference distortions 99 Self-control and free choice 101 Defaults as a determinant of choice 102 Herding, the bandwagon effect, and free choice: Are followers irrational? 103 Constraining Choice versus Freedom of Choice 104 Information 104 Education 105 Consumer rights 105 Chapter 6: Quick and Simple Heuristics and Real-World Decision Making 107 A Bird’s-Eye View of Smart Decision Making in Conventional Economics 108 Decision-making norms in conventional economics: The human calculating machine 109 The optimizing decision-making machine in conventional economics 110 Core conventional benchmarks for rational choice: To dream an impossible dream 111 The limits of conventional rationality 112 Rethinking Bounded Rationality and the Limits of the Mind 113 Bounded rationality and satisficing: Rationality within reason 114 The two blades of the decision-making scissors: Ecological rationality 114 Prospect Theory: Describing Average Decision-Making Behavior 116 Introducing prospect theory: Real-world decision making under uncertainty 117 Thinking about prospect theory and conventional norms 118 Exploring emotions as a hot bed of irrationality 118 The fundamentals of prospect theory: Understanding the value function 119 Unveiling Some Implications of Loss Aversion 122 Loss aversion and the certainty effect 122 Risk seeking in losses 123 The endowment effect: Explaining attachment to possessions 124 Uncovering Errors and Biases in Decision Making 125 Overconfidence 125 Herd behavior 125 Confirmation bias 126 Anchoring 126 Generalizing 127 Less isBest in Decision-Making: Fast and Frugal Heuristics 127 Exploring the superiority of heuristics 128 Understanding human rationality: New benchmarks built on human capabilities 130 Chapter 7: How the Framing of Choices Affects Decision Making 131 The Framing Effect 131 Framing and the economic schools of thought 132 The effect of framing on preferences and choices 133 Appreciating the objective unimportance of frames: The errors and biases approach 133 Understanding frames as heuristics 134 Framing in Pictures: The Possibility of Cognitive Illusions 134 Framing the Mona Lisa 135 Distorting the line illusion 135 Framing faces 136 Framing automobiles: Surface beauty versus substance 137 The letter illusion 138 We’re All Framed: Framing and Decision Making 139 Framing and loss aversion: The classic Asian disease experiment 140 When money isn’t everything 142 Saving a penny to lose a bundle: Framing prices through relative positioning 143 Frames as Defaults: How Anchors Sway the Course of Decision Making 144 Changing default options and choices 144 Revisiting choice architecture 146 Framing isimportant, but so are income and prices 147 The Inescapable Frame and Rational Decision Making 148 Understanding frames as an information-generating machine 148 Repairing frames and rational decision making 148 Introducing product labels into the framing arsenal 149 Market Failure and the Framing Effect 149 Chapter 8: How Norms, Peers, History, and Culture Influence Choice 153 Making Decisions in a Bubble, the Conventional Economics Way 154 Making decisions as if other people don’t matter 155 Making decisions as if history doesn’t matter 155 Making decisions as if society doesn’t matter 157 Introducing Social Norms to Decision Making 157 Looking at some norms 158 Identifying how trust impacts economic development 161 Seeing how discriminating norms can lead to a slow economy 162 Studying the role of education in the formation of norms and the shaping of preferences 163 The carrot and the stick: Exploring the enforcement of social norms 163 Peer Pressure: Seeing How Peers Affect Decision Making 164 How History and Culture Affect Choice 165 Rooting choice in history 165 Culture club: How culture affects the formation of preferences and choices 166 Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis 167 How Gender Affects Choice 167 Not tonight, honey: Conventional choice theory 168 Household bargaining power and women’s rights 169 Understanding household choices when women have a voice 171 Exploring population growth when women’s preferences count 172 Understanding why women go on welfare even if they want to work 174 Identifying why women are more risk averse than men 175 Exploring women’s altruistic preferences 176 Examining labor market discrimination 177 The Role of Children in Economic Decision Making 179 News Flash! Preferences Change with Age 179 Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 181 Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law 183 Why Most People Pay Taxes: The Big Stick versus the Warm Glows 183 How the big stick induces tax payments 184 The niceness effect 185 Social norms and taxes 186 A sense of fairness and tax compliance 186 Different Perspectives on Reducing Pollution 187 Exploring the economics of pollution control 187 Thinking about the green corporation 188 Understanding the links between green consumption and green production 189 Studying social norms and the greening of the world 189 Understanding the mix of economic and non-economic variables in determining green production 190 Crime and Punishment 190 The calculating criminal 191 Addiction and criminal behavior 193 The role of identity and social networks in determining criminal behavior 193 Why most people don’t commit crimes even when crime pays 194 Chapter 11: Labor Supply in the Real World 197 An Introduction to Labor Supply 197 Decoding the reality of labor supply 197 Mapping out changes to labor supply 198 Uncovering what people do when they aren’t working 201 Labor Supply When People Prefer Leisure: The Conventional Economics Perspective 202 The income-leisure trade-off: Bribing people to work 203 Why economics predicts that more income reduces labor supply: Work as an inferior good 206 How to increase the labor supply when people dislike work: Using the big stick 207 How Economic Necessity, Norms, and Love of Work Determine Labor Supply 207 How target income affects labor supply 208 Why increasing income doesn’t reduce labor supply 209 Labor supply when market employment isa superior good 210 Social welfare programs and labor supply 210 Norms, anchors, default retirement age, and labor supply 213 Chapter 12: The Black Box of the Firm: Human Relationships and Productivity 215 Survival of the Fittest, the Firm, and Contemporary Economic Theory 216 Doing the best we can: From slave to free labor to the big boss 216 Determining industrial relations through market forces 217 Maximizing profits and minimizing costs in the calculating firm 218 Understanding why the behavioral firm wins out 221 When People Don’t Behave According to Conventional Economics: X-Inefficiency 221 Types of x-inefficiency 221 When product markets aren’t competitive enough 222 Increasing inefficiency, managerial slack, and the art of lobbying 223 Preferences, managerial slack, and x-inefficiency 223 How low wages produce x-inefficiency and high wages contribute to x-efficiency 224 Efficiency wages: Connecting wages, effort, and productivity 226 Exploring fairness and gift exchange inside the firm 227 Understanding the relationship between conventional, x-efficiency, and efficiency wage theories 227 Chapter 13: The Good Economy: How Ethical Behavior Can Grow the Economy 229 Ethical Behavior: An Introduction 229 The Conventional Perspective on Ethical Behavior and the Economy 231 The Good Company 233 The Compatibility between Ethics and Profits 236 Examining x-efficiency and the socially responsible firm 236 How ethical consumers sustain and grow ethical production 239 Chapter 14: Why Institutions Matter 243 What Behavioral Economics Has to Say about Institutions 244 The decision-making context 245 The theory of the firm 245 The New Institutional Economics 246 Institutions and Wealth Creation 250 Governance 251 Culture 255 Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 257 Chapter 15: Deciphering Behavioral Finance 259 What Behavioral Finance is259 The Efficient Asset Market Models and Their Limits 260 The efficient market hypothesis 261 The random walk hypothesis 262 Irrational Exuberance: Smells Like Animal Spirit 264 Bubbles and Busts: A Preface to Inefficient Markets 266 The Dutch tulip bulb bubble 266 Contemporary bubbles: Evidence of inefficient markets 268 The causes of financial bubbles 271 Chapter 16: Looking into Recessions and Depressions 275 Introducing Psychology in Business Cycle Narratives 276 Grasping the meaning of macroeconomics, recessions, and depressions 276 Understanding animal spirits 279 Deconstructing business cycles: The tango between psychology and “real” factors 284 Economic Psychology and Government Policy 285 How Fairness, Reciprocity, and Punishment Influence Wages, Effort, and the Business Cycle 286 How efficiency wages cause sticky wages and involuntary unemployment 287 Why businesspeople don’t like to cut wages over the business cycle 287 Insights on money illusion: Tricking workers into cutting their wages 288 Why high wages don’t necessarily cause higher unemployment 289 How unemployment undermines confidence and destroys productivity 289 Chapter 17: The Art and Science of Happiness: Can You Be Happy without More Money? 291 Happiness and Conventional Economics 291 How happiness ismeasured 292 The art of being happy 292 Why conventional economics assumes that money makes you happy 294 Diminishing returns for income and wealth 295 What increasing per-capita income ignores 295 Happiness and Behavioral Economics 296 What makes us happy: The individual versus the expert 297 Why money alone can’t make you happy (at least if you’re well off) 298 The new empirics of the happiness debate 301 What money can’t buy (at least not easily) 303 How Government Policy Affects Happiness 306 Part V: The Part of Tens 309 Chapter 18: Ten (Or So) Key Public Policy Implications of Behavioral Economics 311 Consumer Rights and Protection and the Framing of Information 312 Product Labeling and Consumer Choice 312 Financial Markets and Information Deceit 313 Saving for the Future 313 Organ Donations 314 Weakness of Will and Self-Control 315 Labor Market Regulation and Economic Efficiency 316 Big Brother and Behavioral Economics: Does Government Know Best? 316 Crime, Punishment, and Identity 317 Population Growth and the Empowerment of Women 318 Tax Compliance: The Carrot isas Important as the Stick 319 Trust and Economic Efficiency in an Imperfect World 319 Chapter 19: Ten (Or So) Experiments in Behavioral Economics 321 The Ultimatum Game: Fairness and Punishment 321 The Dictator Game: Being Fair Because It’s the Right Thing to Do 323 Fair Wage Experiments: Adventures into Labor Market Dynamics 324 Public Goods Games: Sacrificing for the Public Good 325 The Dark Side of Humanity: It Isn’t All about Lovingkindness 327 The Endowment Effect: How Ownership Affects Behavior 327 Market Games: Markets Work Even When They’re “Irrational” 329 Bubble Experiments: How Smart People Produce Economic Bubbles 330 Experiments on Bounded Rationality 331 Chapter 20: Ten Decision-Making Lessons from Behavioral Economics 333 Be Wary of Overconfidence 333 You Can’t Believe Everything You Read 334 Avoid Situations That Require More Self-Control Than You Can Muster 335 Don’t Blindly Follow the Herd 336 You Can’t Trust Everyone 336 Invest Simply 337 Pay Attention to Sample Size 337 Read the Fine Print 338 Being Nice Pays 338 Educate Yourself 339 Index 341

The guide to understanding why people really make economic and financial decisions The field of behavioral economics sheds light on the many subtle and not-so-subtle factors that contribute to financial and purchasing choices. This friendly guide explores how socialand psychological factors, such as instinctual behavior patterns, social pressure, and mental framing, can dramatically affect our day-to-day decision making and financial choices. Based on psychology and sociology and rooted in real-world examples, Behavioral Economics For Dummies offers the sort of insights designed to help investors avoid impulsive mistakes, companies understand the mechanisms behind individual choices, and governments and nonprofits make public decisions. Make realistic assumptions for economic analysis — investigate the assumptions conventional economics makes, and discover how behavioral economists introduce social, psychological, and cultural considerations Explore the relationship between the brain and economics — understand how human behavior and surroundings affect economic phenomena Examine the role of free choice in economic decision making — review the conditions that are necessary in order for people to make choices that reflect their true preferences, given the constraints they face Get happy — recognize that factors other than wealth and money are critically important to a person's happiness, as defined by behavioral economics Learn to: Understand how social and psychological factors affect our economic and financial decisions Grasp how governments and experts influence our choices Avoid making impulsive and uninformed decisions Appreciate why ethics are important to our choices Open the book and find: The many subtle factors that contribute to our financial and purchasing choices Why people really make financial decisions Real-world examples of how behavioral economics affects our lives What social and psychological factors affect our decision making How to use behavioral economics to be happier Why government policies affect the economy Helpful consumer tips Go to Dummies.com for videos, step-by-step examples, how-to articles, or to shop!

Introduction 1 Part I: Introducing Behavioral Economics: The Science of Making Real-World Choices 7 Chapter 1: Decoding Behavioral Economics 9 Chapter 2: Getting Real about Assumptions 19 Chapter 3: Neuroeconomics: Exploring the Brain for Economic Analysis 41 Chapter 4: Why Incentives and Markets Matter, but Money Isn’t Everything 65 Part II: Understanding Choice 89 Chapter 5: Exploring the Limits to Free Choice 91 Chapter 6: Quick and Simple Heuristics and Real-World Decision Making 107 Chapter 7: How the Framing of Choices Affects Decision Making 131 Chapter 8: How Norms, Peers, History, and Culture Influence Choice 153 Chapter 9: Why Gender, Children, and Age Matter for Economic Analysis 167 Part III: Growing the Economic Pie: The Economic Importance of Ethics, Well-Being, and Culture 181 Chapter 10: Why Smart People Pay Taxes, Recycle, and Even Break the Law 183 Chapter 11: Labor Supply in the Real World 197 Chapter 12: The Black Box of the Firm: Human Relationships and Productivity 215 Chapter 13: The Good Economy: How Ethical Behavior Can Grow the Economy 229 Chapter 14: Why Institutions Matter 243 Part IV: When Bubbles and Busts and Inefficiencies Are Possible: Some Behavioral Insights into the Strange World of Economic Reality 257 Chapter 15: Deciphering Behavioral Finance 259 Chapter 16: Looking into Recessions and Depressions 275 Chapter 17: The Art and Science of Happiness: Can You Be Happy without More Money? 291 Part V: The Part of Tens 309 Chapter 18: Ten (Or So) Key Public Policy Implications of Behavioral Economics 311 Chapter 19: Ten (Or So) Experiments in Behavioral Economics 321 Chapter 20: Ten Decision-Making Lessons from Behavioral Economics 333 Index 341