What Is Behavioral Economics? Theories, Goals, Applications

What Is Behavioral Economics?

Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. Behavioral economics is often related with normative economics. It draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models.

Understanding Behavioral Economics

In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction.

This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. Alas behavioral economics explains that humans are not rational and are incapable of making good decisions.

Because humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if Charles wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories.

Behavioral economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall off of the weight loss bandwagon, showing his lack of self-control.

History of Behavioral Economics

Notable individuals in the study of behavioral economics are Nobel laureates Gary Becker (motives, consumer mistakes; 1992), Herbert Simon (bounded rationality; 1978), Daniel Kahneman (illusion of validity, anchoring bias; 2002), George Akerlof (procrastination; 2001), and Richard H. Thaler (nudging, 2017).

In the 18th century, Adam Smith noted that people are often overconfident with their own abilities, noting « the chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.” In this sense, Smith believed individuals are not rational with their own limitations.

More recently, behavioral economics took shape as early as the 1960’s when several economists identified key biases when recalling information. This idea called availability heuristic was explained by Amos Tversky and Daniel Kahneman, and it leads individuals to irrationally interpret data. For example, shark attacks tend to happen less than people think, but headlines may make people feel otherwise. Tversky and Kahneman are also credited with developing prospect theory, how people are potentially more adverse to losses as opposed to receiving an equal win.

Even more recently, Richard Thaler received the Sveriges Riksbank Price in Economics Science in 2017 for his work in identifying factors that guide individual’ economic decision-making. Thaler’s work included limited rationality, social preferences, lack of self-control, and individual decision-making.

Factors That Influence Behavior

There are often five factors that are cited when analyzing how individual behavior is influenced.

Bounded Rationality

Bounded rationality is the concept in which individuals make decisions based on the knowledge they have. Unfortunately, this information is often limited, whether by the individual’s lack of expertise of lack of available information. In regards to finance and investing, the same public information is available to everyone, though investors may not know true circumstances of what is happening with a company internally.

Choice Architecture

People can be easily manipulated, and this is often on display in the way promoters craft incentives or deals to make consumers buy certain products. Consider how a cracker display may be presented right next to the cheese aisle within a supermarket. This type of design is meant to steer a consumer into making a decision based on a choreographed demonstration often between complimentary goods.

Cognitive Bias

Whether people realize it or not, everybody makes decisions that are influenced by cognitive bias. Consider the choice of choosing between two companies to invest in. Behavioral economics holds the theory that the color of the logo, the name of the CEO, or the city in which each company is headquartered in may stir up an unknown bias that yields us to choose the other company.

Discrimination

In a similar light, behavioral economics are often associated with discrimination. People perceive things, events, or other people through their own lenses, potentially discriminating towards others because they simply favor a different alternative. This does not necessarily mean the alternative is a better option, though.

Herd Mentality

Many consumer decisions are influenced by what other people are doing. Whether it is the fear of missing out or whether others want to be part of a larger collective, herd mentality is the believe that individual decisions are swayed based on what other people do, not necessarily on what is the best outcome. After all, it is much easier rooting for your favorite team even if they haven’t won a championship in a while as long as other fans share your pain.

Principals of Behavioral Economics

The field of economics is vast. Although behavioral economics is just a subset of the field, it itself has a number of guiding principles that dictate the themes within behavioral economics. Some of the primary principles and themes are listed below.

Framing

Framing is the principle of how something is presented to an individual. This behavioral economics concept presents a cognitive bias in that an outcome may be determined based on the structure of how something has been presented. Consider how someone may feel about the two following statements about Babe Ruth, both of which are describing the same thing:

1. Babe Ruth failed to get a hit in nearly two-thirds of his at-bats.
2. Babe Ruth, one of the greatest baseball players of all time, hit .342 in his lifetime.

Heuristics

Heuristics is a complicated field, but it simply means that humans tend to make decisions using mental shortcuts as opposed to using long, rational, optimal reasoning. Most often, people latch onto something is true that may no longer be the case. In this situation, it’s easier for the consumer to continue what they’ve been doing as opposed to realize a more beneficial situation exists.

Loss Aversion

Behavioral economics is rooted in the notion that people do not like losses. In fact, people are loss averse to the point that an economic outcome of one financial value that is negative outweighs the emotional toll of the same financial value but positive. For example, some people feel there is much stronger negative emotions associated with losing a $20 bill compared to finding a $20 bill on the ground.

Market Inefficiencies

For lack of a better phrase, the market can take advantage of behavior economics. For this reason, market inefficiencies play a crucial part in behavior economics. Consider how overpriced stocks may still lure in investors due to drops in P/E ratios. Though the trading multiple may still be abnormally high, investors may think something in the market is more reasonable simply because it is lower. For example, a stock worth $20 may be trading at $50. Should the price to $40, investors may feel this is a great opportunity.

Mental Accounting

Consumers and investors may change their spending and trading tendencies based on circumstances. Though this is fair, often times it is illogical and shapes many aspects of behavioral economics. For example, after receiving one’s annual bonus, an investor may choose to invest in riskier stocks. This mental accounting exercise led an investor to make a decision based on their circumstances, not their long-term strategy.

Sunk-Cost Fallacy

The sunk-cost fallacy is the emotional attachment to costs that have been incurred in the past. Consumers and investors tend to have a harder time « letting go » of failed investments or committed capital. Consider a failed stock that was purchased at $100/share that is now worth $15/share. An investor may not feel compelled to buy in at $15/share because they think the company is not worth that. However, they are unwilling to sell their shares bought at $100/share due to an emotional attachment to that committed capital.

Applications of Behavioral Economics

Financial Markets

One field in which behavioral economics can be applied to is behavioral finance, which seeks to explain why investors make rash decisions when trading in the capital markets. Much like how poker professionals not only study the mathematics and odds of poker, they also attempt to capitalize on the irrational nature of other players. The same can be said of financial markets.

Game Theory

When a decision made leads to error, heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game theory, can also be applied to behavioral economics as game theory runs experiments and analyzes people’s decisions to make irrational choices. This concept attempts to override illogical behavior to predict consumption outcomes.

Pricing Strategies

Companies are increasingly incorporating behavioral economics to increase sales of their products. In 2007, the price of the 8GB iPhone was introduced for $600 and quickly reduced to $400. By introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal, even if the true value of the product was only $400.

Product Packaging and Distribution

Consider a soap manufacturer who produces the same soap but markets them in two different packages to appeal to multiple target groups. One package advertises the soap for all soap users, the other for consumers with sensitive skin. The latter target would not have purchased the product if the package did not specify that the soap was for sensitive skin. They opt for the soap with the sensitive skin label even though it’s the exact same product in the general package.

Examples of Behavioral Economics

Payless shoes may be most known for their « buy one, get one » deals. If a consumer purchases one pair of shoes, the second pair is often discounted. Though a consumer may not need two pairs of shoes, the consumer may be unwilling to part ways with a discount.

One form of loss aversion and scarcity is Amazon’s Lightning Deals. A consumer may not be willing to part ways with a product they don’t even known. Because these Amazon deals are for a limited time only, a consumer faces the behavioral economics dilemma of buying the product or « losing » it. The seasonality of Starbucks’ drinks is another example of a product consumers must buy now or miss out.

Last, turn on your television and almost every commercial contains framing. Note how car advertisements or splash pages like Tesla’s website for its Model Y only point out the strengths of the vehicle.

The Bottom Line

Behavioral economics is the field of understanding why people do things financially that may be irrational. Blended between cognitive bias, heuristics, bounded rationalities and herd mentality, people tend to do things that may not always be in their best interest. This information can be used to price goods, package products, craft commercials, and generate promotional deals.