5 Behavioral Economics Concepts, in the Order Judgments Are Formed

Prospect theory, mental accounting, and nudges. The names are familiar, but when your own judgment goes awry, it’s hard to know which one to reach for.

Behavioral economics concepts become clear when you organize them by the order in which judgments are formed. The five stages are: Reference Point → Labeling → Choice Set → Design → Memory Editing.

I only noticed this sequence after writing several pieces on behavioral economics.

As I introduced these concepts one by one, the connections between them were missing. I’ve linked to more in-depth articles for each stage.

Prospect Theory: Judgment Starts at the Reference Point

People perceive gains and losses based on their movement from a reference point rather than the absolute amount of money.

Even with the same 1 million won, losing 1 million won from a 5 million won base feels entirely different from gaining 1 million won on top of 500,000 won. Furthermore, the loss hurts more. Tversky and Kahneman estimated in 1992 that the loss aversion coefficient is approximately 2.25, meaning that for the same magnitude, the pain of a loss is roughly twice as intense as the joy of a gain.

The real problem is who sets that reference point.

Reference points don’t just appear; they are usually set by someone else. Sales tactics that display a regular price before showing a discounted price rely entirely on this principle.

Comparison with others follows the same structure. The moment you measure your own standing against someone else’s achievement, that person becomes the reference point, and your own share is perceived only through that difference.

Mental Accounting: Every Dollar Gets a Label

Once a reference point is established, the next step is categorization.

In textbooks, money is fungible, so a 1 million won bonus and a 1 million won salary are the same. In reality, the bonus disappears much faster. This is because it enters a “found money” account in our minds—a phenomenon Richard Thaler termed “mental accounting” in his 1985 paper.

The usage and speed of spending the same amount of money depend on the label attached to it. However, these mental partitions aren’t always detrimental.

Dividing funds into living expenses and emergency savings is a useful self-control mechanism. The only thing to consider is whether you set those boundaries yourself or if you simply accepted a label someone else attached.

The Paradox of Choice: Too Many Options Lead to Inaction

Third comes the choice set.

In Sheena Iyengar and Mark Lepper’s 2000 jam experiment, when 24 varieties of jam were displayed at a tasting booth, 60% of passersby stopped; when only 6 were displayed, 40% stopped. However, the purchase conversion rate was 3% for the 24-variety group and 30% for the 6-variety group.

Why does this happen?

Rational choice theory suggests that “more options lead to better choices.” However, once choices exceed a certain number, the comparative cost outweighs the utility gained. While weighing 24 options, the fear that a better one might have been missed follows you, and the easiest exit becomes postponing or abandoning the decision altogether.

However, this effect isn’t always this strong. A 2010 meta-analysis by Scheibehenne’s team, which combined 50 choice-overload experiments, found the average effect to be close to zero. It is more accurate to say this effect is prominent when there is no clear preference between options.

Nudge: Someone Is Designing All of This

Whose hands are setting the reference points, attaching the labels, and adjusting the number of options?

As Thaler and Sunstein described in their 2008 book Nudge, the original concept was a design that nudges people toward better outcomes while preserving freedom of choice. A prime example is the 2003 study by Johnson and Goldstein, which showed that countries with opt-out organ donation systems have significantly higher consent rates.

The power of defaults is most evident in savings.

As analyzed by Madrian and Shea in 2001, when a large U.S. company switched to automatic 401(k) enrollment, the participation rate for employees with 3–15 months of tenure jumped from 37% to 86%. It shows that changing a single default setting is far more powerful than relying on willpower alone.

When this technique is inverted, it becomes a dark pattern. Hiding the subscription cancellation button three menus deep is technically no different from a nudge. The turning point isn’t whether there is a design, but whose interests it is tilted toward.

Hindsight Bias: Memory Rewrites Finished Judgments

Even after a judgment is made, the bias doesn’t end.

Once we know the result, everything seems inevitable, and “I knew it all along” is the first thing that comes to mind. This is the hindsight bias demonstrated by Baruch Fischhoff in his 1975 experiment.

This is dangerous because it overwrites what I actually knew at the time.

Since the material for reflection disappears, there is no way to pinpoint where you went wrong in the previous four stages. This is why the same mistakes are repeated.

When Individual Bias Becomes Market Structure: Passive Investing

So far, we have looked at individual judgment.

When the same default is applied to tens of millions of people simultaneously, the scale of the story changes.

The advice to [“stop trying to beat the market and just buy the market”] is rational for an individual. According to Morningstar, U.S. passive fund assets surpassed active fund assets for the first time by the end of 2023. As everyone chooses the same default, a paradox has emerged where the agents discovering prices are diminishing. An individual’s optimal solution produces a different result for the collective.