In neoclassical economics, choices reflect considered judgment, so one can use revealed preference arguments for welfare judgments. The evidence from behavioral economics calls this view into question. This chapter considers the proposed modifications to neoclassical welfare economics when people might not be the best judges of their actions. The generic form of paternalism in behavioral economics is soft paternalism that nudges the choices of boundedly rational individuals in a beneficial direction, but the choices of rational individuals are minimally affected. We consider several forms of soft paternalism: libertarian paternalism, asymmetric paternalism, and light paternalism. Our main focus is on libertarian paternalism, and we consider the evidence from several forms of nudges as well as the importance of distinguishing between partial and general equilibrium effects of any policy intervention. We consider the inevitability of the choice architect and the concept of informed consent. We critically evaluate the criticisms of this approach, for example, those by the contractarian approach. We consider applications to sin goods and to the foundations of behavioral public economics.

An agent unable to decide how to trade-off rival goods can turn to a family of welfare functions and choose the option that guarantees the greatest welfare level. The agent will then display a bias in favor of the ‘safe’ options to which all of the welfare functions impute the same level of welfare. When the rival goods are ordinary items of consumption, the safety-biased preferences that result will exhibit complementarities. When the rival goods are commodities delivered at different states of nature, safety-biased preferences will generate the maxmin model of choice under uncertainty. In any setting, the agent’s sets of preferred options will display kinks at the safe options but not at other options. Such agents will therefore tend to consume at just the points where slight changes in consumption have a large effect on agents’ marginal valuations of goods and hence on prices.

Agents are classically considered rational in economics if their preferences satisfy the completeness and transitivity axioms. But no matter how preferences are defined, an agent can always violate these axioms without making decisions that leave the agent worse off. If preferences are defined by an agent’s welfare judgments, those judgments can be incomplete, while if preferences are defined by an agent’s choices then sequences of those choices can be intransitive. In both cases, agents can shield themselves from harm simply by maintaining the status quo unless offered an unambiguously superior option. Agents will then display several of the anomalies discovered by behavioral economists, including the endowment effect, loss aversion, and the willingness-to-accept/willingness-to-pay disparity. These behaviors are therefore consequences rather than violations of rationality. Moreover, a single set of preference judgments can explain all of the choices an agent makes through time; the theory therefore wields predictive power. Behavioral economics in contrast courts unfalsifiability by positing a separate preference for an agent at every decision-making juncture.

This chapter covers selected topics in behavioral game theory. We begin with the winner’s curse in common value auctions where players overbid in auctions and make losses. We then consider standard bargaining models such as the Nash bargaining outcome and alternating offers bargaining; the evidence does not support the latter. We introduce evolutionary game theory and the main equilibrium concept, evolutionary stable strategies (ESS). This is followed by a description of replicator dynamics that gives rise to ESS, and a study of its properties. A range of examples illustrate the underlying concepts. We then consider stochastic dynamics generated by an underlying source of persistent randomness and introduce a stochastically stable steady state. Finally, we consider psychological game theory in which beliefs directly enter the utility function allowing for a rigorous modelling of emotions such as guilt and shame.

This chapter critically discusses the exponential discounted utility model (EDU). In the class of discounted utility models, the EDU model uniquely gives time consistent choices. The psychological foundations of EDU are quite limited, and captured by a single parameter, the constant per-period discount rate. The EDU model is rejected on several grounds. Unlike the assumption of constant discounting, as an outcome is brought towards the present, the discount rate increases, making individuals more impatient, and giving rise to present-focussed preferences. This leads to preference reversals and the common difference effect. Furthermore, animal and human evidence shows that the pattern of temporally declining discount rates is hyperbolic, giving rise to hyperbolic discounting. Other anomalies of EDU that are considered include: Sign effect, magnitude effect, sub-additive discounting, intransitivity of preferences or cyclical preferences, and dependence of utility on shapes of consumption profiles with identical EDU.

Preferences are incomplete when agents cannot rank some of their options. Incompleteness can arise when individuals believe that multiple utility functions or preference relations are reasonable ways to make decisions. When these potential preferences conflict, an agent will fail to come to a bottom-line judgment. Faced with such conflicts, agents can still specify the options preferred to some reference point but that set will be kinked at that point. Agents will therefore fail to have well-defined marginal valuations for goods: they will sacrifice a unit of a good only when offered a large amount of another good in exchange. The chapter also presents a more abstract model of incomplete preferences that begins with kinks in preferred sets of options rather than deriving them from a multiplicity of potential preferences. Indecisiveness and kinks also appear in decision theory when agents are unable to identify unique subjective probabilities.

This chapter presents an operational test of indifference versus incompleteness. Indifference obtains when two alternatives have the same sets of more preferred and the same sets of less preferred options. This definition turns out to be equivalent to declaring indifference when a trade of alternatives cannot convert a harmless sequence of trades into a sequence that takes an agent from a better to a worse option. Incompleteness obtains when a trade of unranked alternatives makes a harmful sequence of trades possible. The distinction resolves the puzzle that agents frequently cannot strictly rank alternatives even though classical economic theory claims that indifference is rare. When an agent’s preferences are allowed to be incomplete, pairs of alternatives where no preference obtains will abound. Indifference on the other hand nearly disappears.

The problems that afflict Pareto efficiency can be overcome if the criterion is rebuilt on preference-free foundations. A policy change passes the ‘availability test’ if it allows agents to afford whatever they purchased originally: Agents might not then be better off but no one can legitimately object to the change. One way to pass the availability test is to give agents the right to repeat their original transactions; a reform of rent control serves as an example. A second strategy stabilizes prices for consumers while letting the prices that firms face promote efficiency in production. A deregulation of a public utility, for example, can preserve consumer prices while giving firms an incentive to innovate. These policy alternatives show how to resolve the Schumpeterian dilemma of creative destruction: They harness the progressive feature of capitalism, that it fosters technological change, while protecting the individuals who can be harmed by the same forces. Conventional laissez-faire policies are in contrast difficult to justify even from within the orbit of traditional economic theory and can generate bitter social conflict. An application to opening an economy to free trade shows how to combine the advantages of technological change while satisfying the availability test.

We consider theoretical models of social preferences such as the Fehr–Schmidt model of inequity aversion; the ERC model; type-based reciprocity models; and hybrid models such as the Charness–Rabin model. Empirical evidence is used to evaluate the relative success of the models. Applications are given from behavioral political economy and from social identity in ultimatum games. We also consider issues of moral hazard and asymmetric information in the presence of other-regarding preferences. A range of complete and incomplete contracts, both short- and long-term, are studied. The evidence on alternative contractual forms, and on extrinsic and intrinsic motivation is outlined. Behavioral factors, such as reciprocity, often lead to low-powered incentive schemes that have greater empirical support relative to the high-powered incentive schemes predicted in neoclassical theory. Some of the main findings are: Bonus contracts may often dominate incentive contracts; even flat wage schedules may elicit high effort levels; incentives may crowd-out intrinsic motivation; moral suasion may dominate direct punishments; and incentives that are too high may lead to choking under pressure.

We begin with the theoretical and empirical foundations of happiness economics, in which the aim of economic policy is to maximize self-reported happiness of people in society. We also discuss the economic correlates of self-reported happiness. We outline some of the key insights from the literature on behavioral industrial organization, such as phishing for phools and the effects of limited attention on the pricing decisions of firms. When products have several attributes, we explain how some might be more salient than others. We also explain the effects of limited attention on economic outcomes. We introduce the basics of complexity economics. Here, people use simple rules of thumb and simple adaptive learning models in the presence of true uncertainty. We show that the aggregate systemwide outcomes are complex, characterized by chaotic dynamics, and the formation of emergent phenomena. The observed fluctuations in the system arise endogenously, rather than from stochastic exogenous shocks. We introduce two kinds of learning models – reinforcement learning and beliefs-based learning. Finally, we critically evaluate the literature on competitive double auction experiments.

This chapter makes progress towards theoretical explanations of the anomalies of the EDU model, and we show how to estimate discount rates. The focus is on applications of present-focussed preferences, which typically lead to self-control problems. The framework of multiple selves is employed, where it is critical to specify the current-self’s degree of awareness about the self-control problems of future-selves. We give a concrete application of hyperbolic discounting to the lifecycle model in macroeconomics, and we show how people optimally make consumption and saving choices over time. The effect of present-focus on the retirement decision and the role of legislation, such as a mandatory retirement age, are considered. We also use present-focussed preferences to explain procrastination and preproperation using activities that have current costs and future benefits, as well as activities that have current benefits but future costs. We also present an alternative revealed preference approach to modelling temptation preferences. Finally, we present a more general psychological approach to decision making over time that does not fit into existing models in economics.