Principles of (Behavioral) Economics The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Laibson, David, and John A. List. 2015. “Principles of (Behavioral) Economics.” American Economic Review 105 (5) (May): 385–390. doi:10.1257/aer.p20151047. Published Version doi:10.1257/aer.p20151047 Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:30805504 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Other Posted Material, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#LAA American Economic Review: Papers & Proceedings 2015, 105(5): 385–390 http://dx.doi.org/10.1257/aer.p20151047 BEHAVIORAL ECONOMICS IN THE CLASSROOM Principles of (Behavioral) Economics† By David Laibson and John A. List* There are many great ways to incorporate Our choice of content for a behavioral lecture behavioral economics in a first-year under- is motivated by three factors. First, we include graduate economics class—i.e., the course that ideas that are conceptually important. Second, is typically called “Principles of Economics.” we include material that is practically import- Our preferred approach integrates behavioral ant and personally relevant to our students—we economics throughout the course e.g., see have found that such content resonates long after Acemoglu, Laibson, and List 2015 .( With the the course ends. Third, we include content that integrated approach, behavioral content) plays relates to what has been or will be taught in the a role in many of the chapters of the principles rest of the course, and therefore( serves) as a com- of economics curriculum, including chapters on plement. We want students to see that behavioral optimization, equilibrium, game theory, inter- economics is an integrated part of economics, not temporal choice, probability and risk, social a freak show that is isolated from “the standard preferences, household finance, the labor mar- ingredients” in the rest of the economics course. ket, financial intermediation, monetary policy, This paper summarizes our approach to such economic fluctuations, and financial crises. a focused behavioral lecture. In Section I, we We prefer the integrated approach because it define behavioral economics and place it in his- enables the behavioral insights to show up where torical context. In Section II, we introduce six they are conceptually most relevant. By illustra- modular principles that can be used to teach tion, it is best to combine a discussion of down- behavioral economics. We provide PowerPoint ward nominal wage rigidity i.e., the idea that notes on our home pages, which instructors workers strongly resist nominal( wage declines should feel free to edit and use. with the overall discussion of the labor market.) Whether or not an instructor integrates behav- I. Behavioral Economics Defined ioral economics throughout the principles of economics course, it makes sense to pull cen- Behavioral economics uses variants of tradi- tral materials together and dedicate a lecture tional economic assumptions often with a psy- or more to a focused discussion of behavioral chological motivation to explain( and predict economics.( ) This note describes our approach to behavior, and to provide) policy prescriptions. such a lecture, emphasizing six key principles of behavioral economics. When we teach our students this definition of behavioral economics, we like to emphasize that behavioral economics is a series of amend- * Laibson: Department of Economics, Harvard ments to, not a rejection of, traditional econom- University, Cambridge, MA 02138 and NBER e-mail: ( ics. We illustrate the complementarities between [email protected]); List: University of Chicago, 1126 traditional and behavioral economics with an E. 59th Street, Chicago, IL 60637 and NBER e-mail: [email protected] . We thank Saurabh Bhargava, (Brigitte example: if you want to get from Chicago to the Madrian, and Ted O’Donoghue) for helpful suggestions and bleachers of Fenway Park to watch the Boston feedback. We are also grateful to Daron Acemoglu, who Red Sox, standard economics will get you to directly contributed, as our Economics coauthor, to many of Cambridge, or even Boston University which is the pedagogical approaches discussed here. ( † adjacent to Fenway , but you may need behav- Go to http://dx.doi.org/10.1257/aer.p20151047 to visit ) the article page for additional materials and author disclo- ioral economics to take the final steps and find sure statement s . your seat in the bleachers. ( ) 385 386 AEA PAPERS AND PROCEEDINGS MAY 2015 In this way, behavioral economics augments PRINCIPLE 1: People try to choose the best fea- standard economic analysis. Behavioral eco- sible option, but they sometimes don’t succeed. nomics adopts and refines the three core prin- In other words, people try to make the optimal ciples of economics: optimization, equilibrium, choice—they are optimizers—but they some- and empiricism Acemoglu, Laibson, and List times make mistakes. It’s important to empha- 2015 . Both traditional( and behavioral econo- size that these mistakes are partially predictable. mists) believe that i people try to choose their One of the key explanatory factors is experi- best feasible option( ) optimization ; ii people ence and training: experienced decision-makers try to choose their best( feasible )option( ) when tend to make better choices than inexperienced interacting with others equilibrium ; and iii decision-makers. models need to be tested (with data empiricism) ( ). To illustrate these ideas, we use a range of In the next section we provide some( examples) examples. If students play the p-beauty contest of how behavioral economics refines economic game twice, they will see behavior converging analysis. toward the Nash equilibrium. The game is sim- From a historical perspective, the big bang ple enough to be played in class or on the web for behavioral economics was a paper on pref- before class . But even if you don’t( actually play erences over gambles written by two psycholo- the game in )class, you’ll be able to show the stu- gists, Daniel Kahneman and Amos Tversky, in dents easy to understand data e.g., Nagel 1995 1979. So modern behavioral economics is a lot that illustrates this convergence.( ) younger than the rest of the field of economics. If you prefer to teach the first principle using However, behavioral concepts have always field data, you could explain that credit card played a part in economic analysis though users pay fewer and fewer fees—for instance, they didn’t always have that headline (name . late payment fees—the more experience they As Ashraf, Camerer, and Loewenstein 2005) have with their card Agarwal et al. 2013 . point out, Adam Smith frequently wrote( about) Likewise, consumers switch( telephone plans,) the psychology of decision-making, including moving toward the best one, as they gain experi- the tension between a person’s “passions” and ence Miravete 2003 . their rational deliberations, which Smith refers These( examples all) illustrate that “everyone to as the “impartial spectator.” The impar- choosing optimally” is a better prediction for tial spectator is the source of “self-denial, of experienced decision-makers than for inexperi- self-government, of that command of the pas- enced decision-makers. sions which subjects all the movements of our The first principle should also be used to nature to what our own dignity and honour, explain why learning economics is so useful and the propriety of our own conduct require” to students. Economics courses have the tan- Smith 1759 1984 , I, i, v, 23 . Psychological gible benefit of increasing the optimality of assumptions( are[ as ]old as economics) itself. the students’ own decisions. We tell our stu- dents that “learning economics turns you into a decision-maker who is more likely to choose the II. Six Principles of Behavioral Economics best feasible alternative. By taking economics, you become a more skilled optimizer.” These principles are modular, so instructors can pick whatever subset matches their interests PRINCIPLE 2: People care in part about how and their time budget. In our experience, all six their circumstances compare( to reference) points. principles can be covered in a 1.5 hour lecture, For example, a reference point could be the but that is not what we recommend. If you wish amount of money a person expected to earn to cover all six principles, we suggest allotting during summer break, or the amount of money two lectures. that she started with when she entered a casino, or After each principle we present a series of the price she paid for 100 shares of Apple stock, or examples that illustrate and explain the princi- the price she paid for her home. It matters whether ple and engage first-year economics students. a person is losing or gaining relative to their refer- We’ve included more examples than you will ence point. Losses get far more weight than gains, probably be able to use, so we encourage you to which is called loss aversion Kahneman and pick among them. Tversky 1979 . In practice, people( suffer from a ) VOL. 105 NO. 5 PRINCIPLES OF (BEHAVIORAL) ECONOMICS 387 loss about twice as much as they benefit from a Fun evidence-based examples include post- gain of equal absolute magnitude. poning planned work tasks Augenblick, These phenomena have implications for Niederle, and Sprenger 2014 , placing( savings market transactions. Loss aversion discourages in a lockbox Ashraf, Karlan,) and Yin 2006; trade, since each trade generates two losses and Beshears et al.( 2013 , workplace productivity two gains the buyer has a loss and a gain and commitments Kaur, Kremer,) and Mullainathan the seller has( a loss and a gain , and the losses forthcoming , (and committing to not smoke are weighted more than the gains.) Accordingly, cigarettes or) drink alcohol Giné, Karlan, and people are prone to hold on to their endowments Zinman 2010; Schilbach 2015( .