Introduction to Behavioral Economics--What is it?
How does our psychology influence the decisions we make every day and, ultimately, economic outcomes? Behavioral economics is a field that combines insights from psychology, judgement, decision making, and economics to generate a more accurate understanding of human behavior. This field analyzes the decision-making processes of individuals, exploring why people make the decisions they make, whether irrational or rational. Behavioral economics uses psychological experimentation to show how people are not always acting in their self-interest due to insufficient knowledge, indecision, and emotion; this study provides a framework to understand when and how people make errors and what lessons can be used to create environments that nudge people toward making wiser decisions. Behavioral economics show that people don’t actually know what’s best for them: People have limited cognitive abilities, no self-control, make choices that ultimately don’t make them happy, and choose the option that has the greatest immediate appeal at the cost of long-term happiness. This irrational behavior can be shown through humans’ decisions to succumb to various types of sales strategies and purchase goods out of their price range. Basically, behavioral economics attempts to integrate psychologists’ understanding of human behavior into economic analysis, and in this article I plan to go deeper as to what prompts humans to make the decisions they do and what tactics can influence humans’ decision making.
Behavioral Economics Concepts--Nudge Theory
Behavioral economics principles have major consequences on the actions of our daily lives. For example, an important concept in this field is nudge theory. Nudges encourage people to act a certain way without actually changing the choices that are available to them. Richarde Thaler and Cass Sunstein define a nudge in their book Nudge: Improving Decisions About Health, Wealth, and Happiness:
“A nudge, as we will use the term, is any aspect of the choice architecture that alters people's behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.”
A nudge makes it more likely that an individual will make a particular choice or behave in a particular way by altering the environment so that automatic cognitive processes are triggered to favour the desired outcome. Nudges are small changes in the environment that are easy and inexpensive to implement. Several different techniques exist for nudging, including a default option, social proof heuristics, and increasing the salience of the desired option. A default bias aims to alleviate the discomfort of complex choices from individuals for them to opt for the default supplied to them, even when choosing the alternative does not require much effort; people are more likely to choose a particular option if it is the default option. A social proof heuristic refers to the tendency for individuals to look at the behavior of other people to help guide their own behavior; therefore, heuristics are commonly defined as cognitive shortcuts or rules of thumb that simplify decisions, especially under conditions of uncertainty. Certain nudges implement the framing effect, which is cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations. If people were entirely rational, they would consistently make the same decision given identical options, but sometimes people’s preferences are dependent on how the options are presented.
How Humans Evaluate Risk--Prospect Theory
Prospect theory, also called loss-aversion theory, is the psychological theory of decision-making under conditions of risk. Prospect theory is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty. Prospect theory was developed by framing risky choices and indicates that people are loss-averse; since individuals dislike losses more than equivalent gains, they are more willing to take risks to avoid a loss. The term risk-averse describes the investor who chooses the preservation of capital over the potential for a higher-than-average return. Individuals who are loss averse are much more likely to take risks in order to recoup previous losses or to recover from a loss in order to revert to a previous position. For example, the disposition effect explains the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value. People have to be offered about two and a half times as much as a loss in order to prove willing to take a risk for the chance of a gain. In order to understand how loss aversion and prospect theory works, consider the following example. Someone had $1,000 and had to select one of two choices. Under Choice A, they would have a 50% chance of gaining $1,000 and a 50% chance of gaining $0; under Choice B, they would have a 100% chance of gaining $500. In the second situation, they had $2,000 and had to select either Choice A (a 50% chance of losing $1,000, and 50% of losing $0) or Choice B (a 100% chance of losing $500). In this experiment, the majority of participants chose “B” in the first scenario and "A" in the second. This suggested that people are willing to settle for an acceptable amount of earnings (despite the fact that they have a reasonable opportunity of gaining more). However, people are willing to participate in risk-seeking activities where they can reduce their losses. In a sense, people value losses more than the same amount of gains.
Examples of Behavioral Economics in Businesses
Behavioural economics studies how a customer’s purchasing choices are influenced by factors that are seemingly unrelated to the product itself. These factors can be psychological, cognitive, emotional, cultural or social. The core principle of marketing is to ensure that the consumer chooses your business over a competitor. Behavioural economics aids marketing strategies by understanding how consumer decisions can be influenced. As a result, making small changes to the product offered can massively influence consumer behaviour. For example, producers use the decoy effect, whereby consumers change their preference between two options when presented with a third option (the decoy), which is priced oddly to make one of the other options much more attractive. Similarly, framing effects demonstrate the way in which the substance of a person’s choice can be affected by the order, method, or wording in which it is presented. For example, psychological pricing gives the impression that you are getting a good deal by pricing things with 99; this could make something look cheaper than it actually is. Conversely, many sellers implement the concept of bounded rationality to limit information, time, and abilities that might prevent people from seeking out the best possible outcome. These examples of nudges show the vast tactics sellers can use on consumers and how consumers can react to these tactics.
An individual's behaviour is not always in alignment with their intentions. It is common knowledge that humans are not fully rational beings; that is, people will often do something that is not in their own self-interest, even when they are aware that their actions are not in their best interest.