Behavioral economics is the study of how individuals’ and institutions’ economic decisions are influenced by emotional, psychological, social and cognitive factors. These economic decisions have a significant impact on the state of the economy, as they affect resource allocation, market prices as well as returns. The primary focus of behavioral economics is the economics agents and their bounds of rationality under different economy situations.
The behavioral models, in behavioral economics, explain how market participants make decisions and the drivers of public choice by use of a range of methods and concepts. These variables integrate microeconomic theory, psychology, and neuroscience in explaining the behavior of the decision makers and their consequences.
Correlation of Behavioral Economics and Behavioral Finance
Behavioral economics is closely related to the sub-field, behavioral finance, in their focus on the factors that influence decision making by the market participants. One major factor of consideration in these two disciplines is risk tolerance. It is defined as the willingness of an individual to pursue a financial activity even though the result is uncertain.
Behavioral economics and behavioral finance seek to explain the rational and irrational decisions made and the effect of these decisions on returns and prices which then determine market efficiency or inefficiency. The economy is characterized by unstable market trends, bubbles and crashes which are caused by market inefficiencies. Market inefficiencies are in turn caused by investors’ behavior, characterized by; noise trading, overconfidence, over and under – reaction to market information and mimicry. This correlation between these two disciplines has been heavily exploited by the technical analysts in the economic, technical analysis.