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Principles of (Behavioral) Economics
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Laibson, David, and John A. List. 2015. “Principles of (Behavioral) Economics.” American
Economic Review 105 (5) (May): 385–390. doi:10.1257/aer.p20151047.
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doi:10.1257/aer.p20151047
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http://nrs.harvard.edu/urn-3:HUL.InstRepos:30805504
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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
dlaibson@harvard.edu); List: University of Chicago, 1126 traditional and behavioral economics with an
E. 59th Street, Chicago, IL 60637 and NBER (e-mail: example: if you want to get from Chicago to the
jlist@uchicago.edu). We thank Saurabh Bhargava, Brigitte bleachers of Fenway Park to watch the Boston
Madrian, and Ted O’Donoghue for helpful suggestions and
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). Controlling for
(Thaler 1980). time of day, Read and van Leeuwen (1998) show
There are many ways to illustrate this endow- that snacks chosen in advance are overwhelm-
ment effect. For example, give half of your stu- ingly healthy, but snacks chosen for immediate
dents a mug and half of your students a (big) consumption are not.
chocolate bar, randomizing this endowment by
switching every other seat in the classroom. Let PRINCIPLE 4: Although we mostly care about
the students examine their own and their neigh- our own material payoffs, we also care about the
bors’ endowments, and then ask the class who actions, intentions, and payoffs of others, even
wants to trade with you for the good that they people outside our family.
didn’t receive. Fewer than a quarter of the stu- These “social preferences” come in many sys-
dents will take up this offer, but traditional eco- tematic forms, especially negative reciprocity,
nomic theory predicts that half of them should behindness aversion, and social pressure.
(Kahneman, Knetsch, and Thaler 1990; Tversky One way to teach these ideas is to play the
and Kahneman 1991). ultimatum game (Güth, Schmittberger, and
If you wish to go deeper, show your students Schwarze 1982). An anonymous sender and
that market experience reduces the endowment an anonymous recipient are paired. The sender
effect (e.g., List 2003). Or show them how fram- divides an endowment of $10 (any division is
ing manipulations that exploit loss aversion can allowed, rounded off to the nearest penny). The
be used to incent workers to be more produc- recipient either accepts or rejects the division.
tive (e.g., Hossain and List 2012). You could In the event of rejection, both players go home
also show your class loss aversion in gambles: empty-handed. Most senders propose a division
people won’t take an even odds gamble unless in which the recipient receives at least $2.00,
the upside has twice the reward as the downside because the senders correctly anticipate that half
(Kahneman and Tversky 1979). of the recipients will retaliate against an offer
that is less generous than this (even though the
PRINCIPLE 3: People have self-control retaliation hurts the recipient).
problems. Such social preferences respond to incen-
In a traditional economic model there is no tives, just like all other economic decisions. As
gap between a person’s good intentions and the stakes get large, the recipient becomes more
their actions. By contrast, in the model of pres- and more willing to accept unfair offers. For
ent bias, people plan to work hard (or diet, or example, Andersen et al. (2011) find that when
exercise, or quit smoking, or save for retirement, the pot to be divided is nearly a year’s wages,
or stop borrowing on their credit card, etc.) and almost no recipients reject a 20 percent offer
then renege at the last second (Laibson 1997; from the sender. Showing students that prices
O’Donoghue and Rabin 1999). matter in the domain of social preferences helps
Instructors can show how the present-biased them develop a deeper understanding of both
discount function {1, ½, ½, ½, … } leads to pref- social preferences and the traditional model.
erence reversals if studying has an immediate
effort cost of 6 and a delayed benefit of 8. In this PRINCIPLE 5: Sometimes market exchange
case, studying tomorrow looks good in the eyes makes psychological factors cease to matter,
of the student because ½ × [−6 + 8] = 1 > 0, but many psychological factors matter even in
but immediate studying does not (because markets.
−6 + ½ × 8 = −2 < 0). In this simple exam- If investors with behavioral biases are a small
ple, studying never takes place. part of the total stock market, their beliefs will
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