Behavioral economics and emotion

Abstract

Economics, especially neoclassical economics, neglected anomalies in normative economic theory and the relevance of psychological variables for the explanation and prediction of economic behavior. Although emotion has long played a key role in many behavioral theories, it has not generally been recognized as an important component of human judgment and decision making.
Behavioral economics, which was pioneered by Kahneman and Tversky, improved the relevance and realism of the psychological assumptions underlying economic theory. They developed a descriptive model of decision making under uncertainty, which they call prospect theory, as an alternative model of expected utility theory.
Prospect theory proposes two functions; the value function and the decision weight function. Three principles (reference dependence, diminishing sensitivity and loss aversion) are invoked to explain the characteristic curvature of the value function. That is, the value function is defined on deviations from a reference point, is concave for gains and convex for losses, and is generally steeper for losses than for gains. The decision weight is a nonlinear transformation of the probability scale that overweights low probabilities and underweights moderate and high probabilities.
The descriptive study in behavioral economics challenged the theory of rational choice in decision making and suggested that anomalies should not be considered as errors or biases, but they should be accepted as valid elements of human experience. Moreover, to elaborate theories of behavioral economics, it is necessary to incorporate the perspective of evolutionary adaptive significance of behaviors into the models of decision making.