In the early years of neoclassical economics, agents were pleasure-seekers and their marginal utility for a good diminished continuously as consumption increased. This psychology ensured that agents could optimize and identify smooth trade-offs. Later generations abandoned this utilitarian inheritance in favor of a theory of rationality, but they had no replacement explanation for why agents can always order their options from best to worst. The same pattern has recurred in the theory of choice under uncertainty. In early theories, agents have preferences over lotteries where outcomes have known or objective probabilities. But once economists recognized the primacy of idiosyncratic risks, they turned to theories where agents form preferences based on their judgments of the likelihood of outcomes. These theories of subjective probability cannot explain why agents are capable of making these judgments. And if agents cannot pin down subjective probabilities they will not able to order their options. More broadly, agents face different classes of decisions, some where they are guided by an ordering principle that shows how to weigh their options and others where agents cannot judge trade-offs and form preferences.

This chapter first describes the generic situations of risk, subjective uncertainty, ambiguity, and true uncertainty. It then outlines the main decision theory under risk in neoclassical economics, expected utility theory (EU). We outline EU’s axiomatic structure and highlight the independence axiom that has often been rejected by the evidence, as exemplified by the Allais paradox. The two main drawbacks of EU are that it does not allow for individuals who (i) derive utility from changes in outcomes relative to a reference point (although this is consistent with it's underlying axioms) and (i) weight probabilities in a nonlinear manner. Other violations of EU are also considered; these include description invariance and preference reversals.

Production rather than preferences should play the leading role in the theory of markets, as in the book’s analysis of volatility and policymaking. Production is not only the fount of social wealth, it is organized by firms whose decisions are guided by a clear ordering principle, their profitability. There is moreover an institution, the market, that can weed out the firms that fail to pursue profits effectively. But the purging of inefficiency by the market confronts policymakers with the dilemmas of Schumpeterian creative destruction. Policies that compensate firms and their owners for any declines in profitability will also dampen the threat of bankruptcy; the enforcement of productive efficiency can require unfettered competition. An application to international trade illustrates some of the challenges: For foreign competition to lead to productive efficiency, domestic prices must be aligned with world prices, which will push some firms into liquidation.

The introductory chapter sets the stage for the rest of the book. It begins by tracing the historical development of behavioral economics, then giving a working definition of the subject, followed by a discussion of the scope of behavioral economics. In particular, the various kinds of data that form the basis of inferences in behavioral economics are discussed. These include observational data, experimental lab data, field data, survey data, and neuroeconomic data. It is argued that no particular source of data holds hierarchical sway over any of the other sources of data. All sources of data have their pros and cons, and we need all of them to build a more rounded understanding of human behavior. We lay great emphasis on the scientific method and describe best practice in the natural sciences, following the Popperian tradition. It is vital that students get themselves well versed in these ideas to put them in the right frame of mind for taking a course in behavioral economics.

Chapter 2 relaxes two features of EU: linear probability weighting and utility defined over final wealth levels. Our main focus is on prospect theory (PT). The salient features of PT are reference dependence (utilities are derived from changes in wealth relative to a reference point), loss aversion (losses bite more than equivalent gains), and inverse S-shaped probability weighting functions that replace the “linearity of probabilities” in EU. Under PT, attitudes to risk are determined “jointly” by the shapes of the utility function and the probability weighting function, giving rise to a four-fold pattern of risk attitudes. We also give an exposition of rank dependent utility. We consider several applications of prospect theory. These include, exchange disparities; optimal contracts; tax evasion puzzles; backward bending labor supply curves; attitudes towards low probability events, and loss aversion among professional golf players. Close primate relatives also exhibit loss aversion; thus, loss aversion precedes the evolutionary separation of humans from close primate relatives. We also apply PT to the Ellsberg paradox.

Extensive empirical evidence demonstrates that humans possess other-regarding preferences, that is, they care about the well-being of others, in addition to their own. Humans are predisposed to cooperate with each other, but they are conditional cooperators; they respond to kindness with kindness and unkindness with unkindness. The intentionality of actions by others is important in judging the unkindness of their actions. This chapter explores the evidence on human sociality, using several experimental games such as: the ultimatum and dictator games, the trust and the gift exchange games, and the public goods game with and without punishments. The external validity of lab experiments is also considered. Other topics include the evolutionary origins of preferences and the behavioral differences between WEIRD and non-WEIRD societies. We consider the role of human morality and the aversion to lying and breaking promises. Even when lies cannot be discovered, a significant fraction of people chooses to remain honest, while others tell partial lies and only a few lie maximally. We also outline social identity theory, whereby humans treat ingroup members more favorably relative to outgroup members.

Individuals can rationally pursue their interests without the preferences and marginal utilities that have long taken center stage in economics. Economics without preferences lays out the microeconomics of individual behavior, markets, and welfare when agents cannot always come to judgment. Although economic theory has claimed that self-interest requires agents to form preferences, individuals can protect themselves from harm by refusing to trade options they cannot rank. Many of the anomalies uncovered by behavioral economics – from status quo bias to loss aversion – thus have a rationality design. The absence of preferences also resolves the puzzle that classical economic agents are almost never indifferent between options whereas real-world agents often are. When individuals cannot judge trade-offs, gaps appear between the marginal valuations of gains and losses. These gaps explain why market prices can be volatile and render orthodox efficiency criteria indecisive. Policymakers will no longer be able to pin down an optimal provision of public goods. Traditional schemes that try to harness preference information to compensate agents harmed by economic change will allow virtually any decision to qualify as efficient. Governments should instead spur productivity growth, the main benefit capitalism can deliver, while shielding agents from the price upheavals that result.

When agents, due to incomplete preferences, fail to have well-defined marginal valuations for goods, a great many government policies will maximize social welfare or achieve efficiency. Welfare economics then becomes useless as a practical guide to decision-making. For example, the values agents assign to increases in a public good will be discretely smaller than the values they assign to decreases. For society as a whole, a large valuation gap will form and a wide range of quantities of the public good will therefore qualify as optimal. Applied welfare economics and cost–benefit analysis bypass this obstacle by paying attention only to agents’ smallest valuations, thus slanting policymaking against public goods. The multiplicity of preferences that agents view as reasonable also neuters Pareto efficiency as a policy guide: virtually any policy change is likely to harm some of the preferences agents deem reasonable.

The social welfare function furnishes the primary tool of normative economics: It aggregates the utilities of different agents, by summing them for example. That technique is no longer available when preferences are incomplete since agents then cannot be modeled by utility functions. Agents can however have well-defined utility functions for groups of goods, though they will not know how to weigh the functions for different groups against one another. A policymaker can aggregate these utilities across agents and thus pin down a unique normatively optimal allocation for each group of goods. Government policies are usually debated in this fashion. Rather than solve a global welfare optimization problem, governments and advocates attack each domain of policymaking separately, whether it be education or health. The chapter’s approach illustrates Sen’s criticisms of welfarism.

When preferences are incomplete, an agent or policymaker cannot order options from best to worst. Decisions and policymaking are then slanted in favor of the status quo. Individuals and institutions are governed by customary decisions, until a new option appears that allows for an unambiguous improvement. The reshaping of preferences provides a rarely explored escape hatch to this conservatism and is illustrated by how the flexibility of preferences can cure Baumol’s cost disease (low productivity growth in services).

In this chapter we consider a variety of non-optimizing mental shortcuts that people use to make sense of the complex world around them. We consider mental models; narrow bracketing and broad bracketing; the diversification heuristic; and the difference between transaction utility and acquisition utility. We then consider mental accounting, whereby people form different mental categories for different sources of incomes/expenditures and money is not fungible across them. This explains diverse phenomena, for example, why people prepay for vacations and post-pay for consumer durables. We consider projection-bias, the tendency to project our current preferences in inferring our future tastes and actions. This is followed by a discussion of Herbert Simon’s aspiration adaptation theory, which gives a boundedly rational approach to decision making. It highlights the procedural aspects of decisions. The final topic in this chapter is behavioral finance. We give a statement of efficient markets hypothesis (EMH), which is the cornerstone of modern finance. We show that EMH is rejected by the evidence. We also give a brief note on corporate finance.