Behavioral economics acknowledges that psychological factors significantly influence decision-making. People are often driven by emotions, cognitive biases, and social pressures, leading them to make choices that deviate from what would be considered "rational" in an economic sense.

One prominent concept in behavioral economics is loss aversion, which suggests that people fear losses more than they value gains. For instance, an individual might decline a high-return investment opportunity due to the perceived risk of losing money – even when the potential gains significantly outweigh the risks. This phenomenon is closely tied to prospect theory, developed by Daniel Kahneman and Amos Tversky, which demonstrates that individuals evaluate potential losses and gains differently, often leading to decisions that prioritize avoiding loss over acquiring gains.

Another significant factor is bounded rationality, suggesting that individuals make decisions within the limits of their information and cognitive processing abilities. This leads to suboptimal choices, as people rely on mental shortcuts rather than considering all available data. For example, availability bias causes people to overestimate the likelihood of easily recalled events, such as recent market crashes, leading to overly cautious investment decisions. Lastly, due to herd behaviour, individuals mimic others' actions in markets, leading to irrational financial outcomes. This phenomenon can cause market bubbles and crashes.

In sum, behavioral economics sheds light on how real-world decision-making is shaped by psychological factors, challenging the notion of human beings as entirely rational actors in the economic sphere.



References :

Kahneman, Daniel, and Amos Tversky. Prospect Theory: An Analysis of Decision under Risk. Econometrica, vol. 47, no. 2, 1979, pp. 263-291.

https://courses.washington.edu/pbafhall/514/514%20Readings/ProspectTheory.pdf

Bikhchandani, Sushil, and Sunil Sharma. "Herd Behavior in Financial Markets." IMF Staff Papers, vol. 47, no. 3, 2001, pp. 279-310, International Monetary Fund, https://www.imf.org/external/pubs/ft/staffp/2001/01/pdf/bikhchan.pdf.

Thaler, Richard H. Misbehaving: The Making of Behavioral Economics. W. W. Norton & Company, 2015. https://pdfroom.com/books/misbehaving-the-making-of-behavioral-economics/avd94OkA5KD