"Wouldn't economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?"
Neoclassical economists believe that people are “rational”, and we would make decisions that can maximize our utility through carefully weighing costs and benefits. This “rational man” assumption advocated by neoclassical economics is widely applied in other disciplines like sociology and psychology. This assumption, however, has been challenged by behavioral economists since the 1970s. Grounded in empirical observations of human behavior, behavioral economics have demonstrated that people do not always make what neoclassical economists consider the “rational” or “optimal” decision, even if they have the information and the tools available to do so. Decisions of individuals and institutions often vary from those implied by traditional economic theories, as they are affected by psychological, cognitive, emotional, cultural and social factors.
An example would be the prospect theory developed by Daniel Kahneman and Amos Tversky in 1979, which states that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses. For example, if presented with an opportunity to win $250 guaranteed or gamble on a 25% chance of winning $1,000 and a 75% chance of winning nothing, most people will choose the sure win. But if presented with the chance to lose $750 guaranteed or a 75% chance to lose $1,000 and a 25% chance to lose nothing, most people will risk losing $1,000, hoping for the slim chance that they will lose nothing at all. This classic example demonstrates that people are more willing to take a greater statistical risk if it means avoiding a $1,000 loss versus obtaining a $1,000 win, which contradicts the expected utility theory.
Behavioral economics uses psychological experimentation to develop new theories about human decision making and has identified a range of biases as a result of the way people think and feel. This provides economists with new ways of thinking about people’s perceptions of value and expressed preferences - people are not always self-interested, benefits maximizing, and costs minimizing individuals with stable preferences; instead, out thinking is subject to insufficient knowledge, feedback and processing capability, which often involves uncertainty and is affected by the context in which we make decisions. The development of behavioral economics in the past few decades is a good example of how knowledge from other disciplines can shed new light on the development of economics.