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Behavioral economics represents a fundamental challenge to the traditional economic assumption that people are perfectly rational, self-interested decision-makers. On the AP exam, you're being tested on your ability to explain why real-world markets and individual choices deviate from the predictions of standard models—and these concepts give you the vocabulary to do exactly that. Understanding behavioral economics helps you analyze everything from consumer demand to market failures to policy design.
These concepts cluster around a few key ideas: cognitive limitations that prevent optimal decision-making, psychological biases that systematically skew our choices, and social motivations that go beyond pure self-interest. When you encounter an FRQ asking why consumers don't always maximize utility or why markets produce unexpected outcomes, behavioral economics provides your explanation. Don't just memorize definitions—know which bias explains which real-world phenomenon, and be ready to apply them to novel scenarios.
Traditional economics assumes people process all available information and make optimal choices. In reality, our brains take shortcuts because full optimization is cognitively expensive. These concepts explain how we simplify complex decisions—and why those simplifications sometimes backfire.
Compare: Bounded rationality vs. heuristics and biases—bounded rationality explains why we need shortcuts (cognitive limits), while heuristics and biases describe what shortcuts we use and how they fail. On an FRQ about consumer behavior, bounded rationality is your "big picture" explanation; specific biases are your supporting evidence.
One of behavioral economics' most powerful insights is that people don't evaluate outcomes in absolute terms—they measure gains and losses relative to a reference point, and losses hurt roughly twice as much as equivalent gains feel good.
Compare: Loss aversion vs. endowment effect—loss aversion is the underlying psychological principle (losses hurt more), while the endowment effect is a specific application (ownership creates a reference point, so selling feels like a loss). If asked to explain why markets for used goods are thin, the endowment effect is your answer.
Standard theory assumes preferences are stable and consistent. Behavioral economics shows that how choices are presented dramatically affects what people choose—even when the underlying options are identical.
Compare: Framing effects vs. anchoring—both show context dependence, but framing changes how we perceive options (gain vs. loss), while anchoring provides a numerical reference point that biases estimates. For FRQs on advertising or pricing strategy, anchoring is typically more relevant.
Standard models assume people discount the future consistently. Behavioral economics reveals that our preferences change depending on when we're making the decision—we're impatient about immediate tradeoffs but patient about distant ones.
Compare: Present bias vs. bounded rationality—both explain suboptimal choices, but present bias is specifically about time preferences (we know what's best but can't resist immediate gratification), while bounded rationality is about information processing (we can't figure out what's best). Retirement undersaving involves both: present bias makes us prefer spending now, and bounded rationality makes retirement planning feel overwhelming.
Traditional models assume pure self-interest. Behavioral economics documents that people genuinely care about fairness, reciprocity, and others' welfare—and will sacrifice personal gain to uphold these values.
Compare: Social preferences vs. loss aversion—both lead to "irrational" behavior, but for different reasons. Rejecting an unfair offer (out of ) reflects social preferences (punishing unfairness), not loss aversion. If the question involves fairness or cooperation, social preferences are your concept; if it involves risk or ownership, look to loss aversion.
| Concept | Best Examples |
|---|---|
| Cognitive limitations | Bounded rationality, heuristics and biases |
| Reference-dependent preferences | Loss aversion, prospect theory, endowment effect |
| Context and framing | Framing effects, anchoring, mental accounting |
| Time inconsistency | Present bias |
| Non-selfish motivation | Social preferences and fairness |
| Why people hold losing investments | Loss aversion, endowment effect |
| Why policy "nudges" work | Present bias, framing effects, anchoring |
| Why markets deviate from efficiency | All of the above—pick based on context |
A consumer refuses to sell concert tickets for even though she wouldn't pay more than to buy them. Which two concepts best explain this behavior, and how do they work together?
Compare and contrast how framing effects and anchoring would each influence a consumer's response to a "Was , Now !" sale sign.
An FRQ describes a worker who spends her entire tax refund on a vacation but carefully budgets her regular paycheck. Which behavioral concept explains this inconsistency, and why does it violate the standard economic assumption of fungibility?
Which behavioral concepts would you use to explain why automatic enrollment in retirement plans increases savings rates more than simply offering the same plan as an opt-in choice?
A firm offers employees a choice: bonus now or bonus in one month. Most choose the immediate payment. Does this reflect bounded rationality, present bias, or loss aversion? Explain your reasoning and identify what additional information would help you distinguish between these explanations.