PSYCHOLOGY AND ECONOMICS
Matthew Rabin
Department of Economics
University of California Berkeley
September 28, 1996
Abstract: Because psychology systematically explores human judgment, behavior, and well-being,
it can teach us important facts about how humans differ from traditional economic assumptions. In
this essay I discuss a selection of psychological findings relevant to economics. Standard
economics assumes that each person has stable, well-defined preferences, and that she rationally
maximizes those preferences. Section 2 considers what psychological research teaches us about
the true form of preferences, allowing us to make economics more realistic within the rational-
choice framework. Section 3 reviews research on biases in judgment under uncertainty; because
those biases lead people to make systematic errors in their attempts to maximize their preferences,
this research poses a more radical challenge to the economics model. The array of psychological
findings reviewed in Section 4 points to an even more radical critique of the economics model:
Even if we are willing to modify our familiar assumptions about preferences, or allow that people
make systematic errors in their attempts to maximize those preferences, it is sometimes misleading
to conceptualize people as attempting to maximize well-defined, coherent, or stable preferences.
Acknowledgments: This is a longer version of an essay under preparation for possible publication in the Journal of
Economic Literature. I thank John Pencavel and anonymous referees for earlier comments on its structure and
content. For comments on this draft, I thank Steven Blatt, Colin Camerer, Peter Diamond, Erik Eyster, Ernst Fehr,
Danny Kahneman, George Loewenstein, Ted O Donoghue, and John Pencavel. For helpful conversations over the
past several years on topics covered in this essay, I thank George Akerlof, Gary Charness, Eddie Dekel, Peter
Diamond, David Laibson, David I. Levine, George Loewenstein, Rob MacCoun, James Montgomery, Vai-Lam Mui,
Drazen Prelec, and especially Colin Camerer, Danny Kahneman, and Richard Thaler. Co-authors on research related
to the topics of this essay include David Bowman, Deborah Minehart, Ted O Donoghue, and Joel Schrag. Helpful
research assistance was provided by Gadi Barlevy, Nikki Blasberg, Gail Brennan, Paul Ellickson, April Franco,
Marcus Heng, Bruce Hsu, Jin Woo Jung, and especially Steven Blatt, Jimmy Chan, Erik Eyster, and Clara Wang. I
am extremely grateful for financial support from the Russell Sage and Alfred P. Sloan Foundations.
Comments are appreciated. Contact: Department of Economics / 549 Evans Hall #3880 / University of California,
Berkeley / Berkeley, CA 94720-3880. E-mail: rabin@econ.berkeley.edu. CB handle: Game Boy .

11. Introduction
Because psychology systematically explores human judgment, behavior, and well-being, it can teach us
important facts about how humans differ from traditional economic assumptions. In this essay I discuss a selection
of psychological findings relevant to economics.
There are two basic components of the standard economics model of the individual: That she has stable, well-
defined preferences, and that she rationally maximizes those preferences. Given some choice set X, a person is
assumed to Max
x∈X
U(x). Psychological research can be roughly categorized by how radically it challenges this
model, and by the nature of the modifications implied.
Section 2 considers what psychological research can teach us about the true form of the function U(x). By
searching for ways to make U(x) more realistic within the rational-choice framework, Section 2 reviews evidence
that requires relatively small modifications of the familiar economic framework. I begin by discussing research
suggesting that a person s preferences are often determined by changes in outcomes relative to reference levels, not
merely by absolute levels of outcomes. In particular, relative to the status quo (or other reference points), people
dislike losses significantly more than they like gains. I discuss the implications of this loss aversion for choice
under uncertainty, and then briefly discuss attitudes towards risk and uncertainty more generally. I then discuss how
people depart from pure self interest (as narrowly defined), pursuing other-regarding tastes such as fairness,
reciprocal altruism, and revenge.
Section 3 presents psychological evidence on systematic errors people make in their attempts to Max U(x),
and thus poses a more radical challenge to the economics model. Specifically, Section 3 reviews research on biases
in judgment under uncertainty. I will discuss in detail a few of these biases (how we under-use base rates, infer too
much from too little evidence, and misread evidence as confirming previously held hypotheses), and explain a few
more in broad outline. I also discuss some of the psychological evidence on how learning and reasoning do and
don t lead people to overcome these biases.
The array of psychological findings reviewed in Section 4 points to an even more radical critique of the
economics model. Even if we are willing to modify our standard assumptions about U(x), or allow that people make
systematic errors in their attempts to maximize U(x), it is sometimes misleading to conceptualize people as
attempting to maximize well-defined, coherent, or stable U(x) s. I begin by reviewing evidence that people are not
fully adept at evaluating their own preferences we don t always accurately predict our own future preferences, nor
even accurately assess our experienced well-being from past choices. I then discuss research on framing effects,
preference reversals, and related phenomena in which people prefer some option x to y when the choice is elicited
one way, but prefer y to x when the choice is elicited another way. I then turn to evidence that we sometimes make
choices because we seek to have justifiable reasons for making those choices, rather than because of underlying
preferences. I then discuss self-serving biases and motivated cognition how our wishes influence our beliefs. I
conclude Section 4 with a discussion of self control and other phenomena that arise because a person s motivations
and propensities at different times are inconsistent.