Abstract: The traditional economic approach to enforcing tax compliance rests on the assumption that taxpayers are reluctant to pay their share, are inclined to maximize their egoistic goals by rationally considering audit probability and fines in case of detected evasion, and comply only if forced to. Behavioral economic and psychological insights draw a more complex picture of determinants of compliance and point to differences between taxpayers and their inclination to be compliant, which calls for differential strategies to ensure compliance rather than a one-size-fits-all strategy. This chapter describes actors in the tax arena and interaction dynamics. Interaction is shaped by the power of the authorities and their trustworthiness, which, combined, are the underlying dimensions of the tax climate. As conceptualized in the slippery slope framework and its extension, it is argued that a distinction between coercive and legitimate power, and between reason-based trust and implicit trust, is necessary to understand the interaction dynamics. Subsequently, emotions elicited by the power of the authorities and their trustworthiness are described, followed by speculations about the impact on compliance of anger, fear or feelings of protection and security. Finally, strategies to shift from control to cooperation are summarized.

Overview

From an economic perspective, the same laws are valid in the labour market as in markets for consumer goods: demand and supply determine the price. Employers have a demand for workers and workers supply their labour. The combination of demand and supply is assumed to determine the wages. These assumptions can be tested in experimental labour markets. The setup of these labour markets can mimic different aspects of real-life labour markets, in particular by allowing reciprocity. Findings indicate that higher wages are reciprocated by higher effort.

Wages are often discussed as a tool to increase motivation. However, the connection is not always straightforward. Several theories of motivation have highlighted the importance of subjective perceptions of values and probabilities as well as social comparisons. An important aspect of wages is whether they are perceived as fair or unfair. Equity theory offers an explanation of these subjective fairness perceptions: importantly, fairness perceptions are influenced not only by own input and output, but also by the comparison with other people.

Entrepreneurs run companies or found new companies and thereby provide job opportunities in labour markets. They seek to make a profit through participation in the market but run the risk of possibly losing their invested capital. On the one hand, established entrepreneurs have been found to show characteristic personality traits and motivations. On the other hand, the process of successfully founding a company is a complex interplay between personal characteristics and situational conditions. Female entrepreneurs face specific challenges due to stereotypes.

Introduction

Labour occupies a major part of life for most of us. In this chapter, the goal is to understand how labour markets work. Do they work on the basis of supply and demand or is this approach alone too simplistic? What motivates people to seek employment and to provide effort? What are the psychological processes through which wages can improve motivation and performance? What is considered a fair wage? Finally, who are the people that create jobs for themselves and others?

Supply and Demand for Labour

In markets, selling and buying takes place. Just as consumer goods and services are supplied and demanded in markets, labour power is supplied by workers on the one hand and demanded by employers on the other.

Overview

Modern societies are characterised by extreme specialisation and division of labour, and production is highly intertwined. In consequence, production is a topic of relevance on the society level. Societies develop specific views on the meaning of work. These views shape opinions about how work should be structured and about people who do not find work.

The meaning of paid work has undergone a number of changes in the course of history.Work was at one time considered a burden, and those who could afford not to work did not. Later, work came to be seen as a service to society. Presently, it is postulated that work must both be a service to society and satisfy workers’ extrinsic and intrinsic needs. In particular, the focus on intrinsic motivation and its connection to job performance and well-being is relevant for questions of how to structure work. Changes have also occurred in working time over the decades, and consequently the focus is on the importance of leisure. The question is how work and leisure influence each other, and how work–life balance can contribute to both performance and well-being.

The labour market structure has changed as well. The trend towards greater flexibility in employment relationships means that people more often need to search for work. Consequences of job loss are not only of an economic nature, but also of a social and psychological nature. Unemployment has severe psychosocial effects and is connected with physical and psychological well-being. However, consequences of unemployment are not the same for everyone – they are moderated by a number of psychological variables, for example the subjective importance of work. Chances for re-employment also differ depending on psychological variables such as self-esteem and job search strategies.

Introduction

In most societies, work has a central role. People invest a lot of time and energy into paid work. Young people seek education and training, be it in the form of an apprenticeship, school or university, to secure a better chance of getting a job they desire.Work is important for identity, for an understanding of who we are. Additionally, many societies see the work of individuals as a way to evaluate their worth in the community. Consequently, the loss of a job is often stigmatised and connected with a decline in social standing, sometimes even accompanied by feelings of resignation and depression.

Overview

This chapter introduces well-being and happiness in general and particularly discusses the relationship between happiness and wealth. People strive for well-being, happiness, contentment and high quality of life. These factors are important socio-political measures at the country level as well. Empirical research on happiness and satisfaction has intensified in recent years and ‘positive psychology’ has become an important research trend. Periodic surveys of life satisfaction and satisfaction with specific areas of life are conducted, and determinants and consequences of satisfaction are investigated.

The terms well-being, happiness, satisfaction and quality of life are often used synonymously. What is meant is a good, pleasant, either short-lived or long-lasting and more or less intensely perceived emotional state. However, sometimes these terms are defined and operationalised differently, making it difficult to compare the results of empirical studies. Sometimes one term encompasses the other, sometimes it does not. Sometimes the terms refer to processes, sometimes to outcomes. Attempts have been made to make a clear definitional distinction between various aspects of life satisfaction by differentiating between life chances versus life outcomes on the one hand, and between inner versus outer qualities on the other. Numerous proposals for measuring one or more dimensions of quality of life, satisfaction and well-being can be found in the social scientific literature. In addition to uni- and multidimensional instruments that collect data on respondents’ subjective views, external assessment instruments are often applied in health research. However, external assessments are controversial, given that well-being, satisfaction and quality of life represent subjective experiences. Therefore, surveys and time-sample diaries are frequently used to assess subjective evaluations of well-being and satisfaction. Nevertheless, none of the applied methods is free of biases and critique.

National happiness indices vary considerably across countries. Since the highest values are measured in the Western industrialised world and the lowest in the third and fourth worlds, it can be assumed that satisfaction is correlated with economic prosperity. People in rich countries do tend to be more satisfied than people in poor countries, and rich people in industrialised countries are happier than poor people.

Overview

Decision situations can be described by options involving consequences and probabilities, and information about these elements may be more or less available. The classical economic model of human behaviour assumes that decisions are driven by rationality and that utility maximisation is the goal. Rationality is first and foremost a formal principle of decisionmaking logic with a predominantly normative character. It presumes that decision-makers have preferences and that the alternative they ultimately choose is the one with the highest subjective utility. Classical decision models rely on the assumption that decision-makers have a high information processing capacity as well as the time and motivation to process such complex information.

Empirical studies have demonstrated, however, that actual behaviour diverges from the predictions of classical decision models and shows systematic ‘anomalies’. Information processing capacity is limited and complex decision situations contain various sources of error. To name just a few examples, information is subjectively perceived and can be processed through different paths. The value decision-makers assign to an option changes with time, and with the associated emotions. When there is no opportunity to gather enough information, or insufficient time or motivation to do so, judgments are made on the basis of heuristics. Heuristics are decision rules that allow decision-makers to save time and energy. They can lead to suboptimal judgments in some cases because they are vulnerable to irrelevant factors. However, they can also lead to good judgments when they are used in a valid environment.

Introduction

Every day, people make a large number of decisions, important and less important ones. Some decisions are easy because their consequences are quite clear. Other decisions are hard, especially if consequences are uncertain. In some cases, people do not have the time, motivation or ability to process all information in order to analyse the entire situation. In other cases, their preferences seem to change with emotions or to change over time. People often use shortcuts, so-called heuristics, to simplify the logical and rational step-by-step process. The focus of this chapter is to show the classical, normative approach to decision-making and a number of so-called anomalies that stand in contrast to predictions from that approach.

Decisions under Uncertainty

Private households, companies and administrators all have to consider how to use their limited financial capital, energy, time and other resources sensibly.

Overview

Financial markets worldwide conduct transactions running into billions, making them particularly important for individuals as well as national economies. Since financial markets, particularly stock exchanges, represent ideal markets, it can be assumed that decision-making there follows the laws of homo economicus, at least at the aggregate level. However, behavioural economics and financial psychology – particularly the psychology of the stock exchange – have substantiated that financial markets are also subject to psychological influences. Decision-making anomalies lead to outcomes diverging from those postulated by the homo economicus model, even at the aggregate level. For example, actors’ current moods are relevant in determining their expectations with regard to market trends; conversely, stock prices are also a reflection of current moods of actors on the market. Actors’ convictions with regard to their ability to control events are also often massively overblown. People frequently do not behave as the available factual information would suggest, but rather follow the crowd in a form of herding behaviour.

This chapter provides an overview of psychological and behavioural-economical approaches to describe financial markets. It starts out with reactions to news, and information use by investors. It then moves to a systematic pattern of how investors treat stocks that have lost or gained in value, the disposition effect. Heuristics used by investors and financial managers will be discussed, using examples from both real-life financial markets and experiments. A particularly important part is heuristic risk diversification in investors’ portfolios. Emotions and mood also influence decisionmaking on financial markets. Of particular relevance are social influences, such as the herd behaviour that can frequently be observed in financial markets and that can lead to speculative bubbles. Finally, the role of trust in financial institutions will be discussed.

Introduction

The homo economicus is a rational thinking and self-interested human intent on maximising utility or profit. But is this idea applicable to humans in the context of financial markets? The goal is to understand how the seemingly irrational movements and fluctuations in the financial markets come to be – for example, the creation of speculative bubbles. These observations are hard to explain by rationality alone. For this reason, we expand our view to behavioural economics and psychology. Making the right decision is a difficult task, yet some traders are more successful than others. What are the mistakes traders make?

Overview

In the official economy, economic success is achieved within the framework of regulatory laws. Labour and capital income, consumption, etc. are taxed to provide public goods, to balance income differences in the society, and to regulate the behaviour of individuals and firms.However,money is also made in the shadows of the official economy, and some citizens do not pay taxes as prescribed by law.

This chapter starts out with a discussion of the shadow economy. In the narrowest sense, the shadow economy comprises work on the black market and the exchange of goods there. In a broader sense, housework and helping one's neighbours also count – as do illegal activities like drug dealing, smuggling and dealing in stolen goods. In general, those activities are discussed that would otherwise be included in official calculations of the gross national product, but are concealed through the circumvention of regulations and the evasion of social contributions in general, and of taxes in particular.

One particular problemanalysed by economic psychology concerns the willingness to pay taxes and fees. This can be partly described through attitudes towards taxes and tax morale. However, taxpayer behaviour can range from deliberate tax evasion to voluntary cooperation and needs to be examined more closely. Different actors can be distinguished in the field of taxation (government, tax authorities, tax accountants, taxpayers) and they interact in complex ways.Various research methods are applied in studying taxpayer behaviour and these sometimes produce inconsistent findings.

Taxpaying can be researched within different paradigms. There has been a shift from investigations of the effect of tax authorities’ enforcement on taxpayer compliance towards investigations of trust-building measures that encourage cooperation for the welfare of the community. Perspectives range from the effectiveness of audits and fines, social norms and fairness considerations in social contribution dilemmas and the ‘psychological contract’ to the interactional climate where actors mutually influence each other. Over the past few decades, the predominant view of taxpayers has shifted from an authoritarian perspective, where authorities compel citizens to pay their taxes, to a view where authorities are encouraged to provide the necessary services to promote compliance, and, more recently, to a view where authorities and citizens cooperate with one another. The slippery slope framework is presented as a theoretical concept, integrating economic and psychological approaches to compliance and cooperation.

Overview

Economic decisions in private households are made by individuals, usually in collaboration with others. For instance, couples make economic decisions when they plan their next holiday, gather information about different ways to save money, or compare different credit opportunities.

Economic decisions therefore are relevant tasks that can create problems for couples. It is not only because private households control the bulk of every country's total economic budget that these problems are of interest to the social and economic sciences. Economic decisions are simultaneously the cause of conflicts between partners, which can pose a threat to the quality of the relationship. Additionally, economic decisions are reflecting the quality of the relationship between partners.

When ‘private households’, ‘romantic partners’, ‘married couples’ or ‘the family’ are mentioned, a decision-making unit consisting of two or more people is generally meant. These terms, of course, are not perfectly interchangeable. In its narrow sense, ‘the family’ is generally understood to mean a unit consisting of parents and their children. In its wider meaning, grandparents and other relatives can be added to this group. Decisions between partners relate to how two people think about deploying their financial resources. These partners are living together (whether with or without a marriage certificate) and have an intimate relationship with one another. Finally, a ‘private household’ refers to a group of people running a joint household who do not necessarily need to have an intimate relationship with one other. However, in this book these four terms are used rather indiscriminately: what is essential is that they refer to a decision-making unit consisting of two or more people who have a close relationship to one another and make joint decisions on the use of financial resources.

After introducing a taxonomy of economic decision-making in private households, this chapter will turn to a discussion of models of individual decision-making before moving to a process model of purchasing decisions in those households. When partners have differing opinions, decisional conflicts can arise which need to be resolved. The conflict resolution process depends not only on the type of conflict but also on the harmony of the relationship and existing power relations between the partners. In a complex process model, the progression from the beginning of a purchasing decision up to its conclusion is outlined.

The purpose of this book is to give an introduction to economic psychology.We are confident that the book will stimulate further interest in an emerging interdisciplinary field of research and application.

Economic psychology builds bridges between the disciplines of economics and psychology. Based on their common research focus on human behaviour, both economists and psychologists early on showed an interest in each other's fields. However, both disciplines developed their own ‘languages’, their specific research paradigms and methodological toolboxes, hence conducting separate research on similar topics. In the past decades, economic psychology has gained significant momentum, especially with the recognition of the research by Daniel Kahneman and Amos Tversky by the Nobel Prize Committee in 2002. At the latest since then, research in economic psychology and behavioural economics has significantly increased. It has gained visibility and relevance both in scientific discussions and in the applied fields. Specifically, economic psychology has been recognised in institutions regulating human behaviour, in applied economics, law and politics.We present an introduction to the theoretical topics of economic psychology and their relevance in applied fields.

We cover questions about how people decide over the use of scarce resources, in particular money, from a psychological perspective. After giving an overview of the field, we start out with three chapters discussing the basic building blocks of economic behaviour: decision-making from a normative and a descriptive perspective as well as lay theories.We then move on to three chapters addressing the major markets on which economic behaviour occurs as an interaction between individuals and companies or institutions: consumer markets, labour markets and financial markets. We close with three chapters focusing on society-level topics: collective cooperation, collective production and collective prosperity.

In Chapter 1, we present economic and psychological approaches towards the study of human behaviour. We also give an overview of the history and the current fields of economic psychology that we use as the guiding structure of this book.

In Chapter 2, we present normative decision-making theories, starting out with classical decision theory and empirical studies on its predictions.We give an overview on decision anomalies that arise from information processing, emotions, time and heuristics.

In Chapter 3, we present descriptive decision-making theories. First, prospect theory as a highly influential approach that can explain several systematic deviations from rationality in people's decisions is addressed.