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.
KEY TAKEAWAYS
Behavioral economics is the study of psychology that
analyzes the decisions people make and why irrational
choses are chosen.
Behavior economics is influenced by bounded
rationality, an architecture of choices, cognitive biases,
and herd mentality.
Behavior economics is crafted around many principles
including framing, heuristics, loss aversion, and the
sunk-cost fallacy.
Companies use information from behavioral economics
to price their goods, craft their commercials, and
package their products.
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.”
1.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.
2.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.
3.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 is 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:
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.
