Picture yourself entering a supermarket to purchase a single loaf of bread.
While walking along the
shelves, you find yourself grabbing some snacks, a beverage, and even a magazine you had no intention
of purchasing. By the time you reach the checkout counter, your basket is filled with more items than you
intended. Why did you buy these products you did not plan to? Were they logical choices made out of
necessity, or were you subconsciously affected by forces that you weren't consciously aware of?
This situation exactly captures the spirit of behavioral economics—a discipline that questions the
conventional presumption that individuals always make rational decisions. Contrary to conventional
economic theory, which postulates that people decide in their own best financial interest with complete
knowledge, behavioral economics applies the methods of psychology to more adequately account for why
and how humans systematically act non-rationally. By examining phenomena such as cognitive bias,
decision-making heuristics, and emotional motivators, behavioral economics offers a more realistic
portrayal of human financial and daily decision-making.
Conventional economic approaches rely on the concept of the "rational actor"—an individual who always
behaves rationally and is well-informed to optimize his or her utility. Yet, actual decision-making
frequently fails to live up to this standard. Behavioral economists such as Daniel Kahneman and Richard
Thaler have demonstrated that human beings are predictably irrational, i.e., they will consistently commit
judgment errors in their thinking under specific circumstances. One of the most popular ones is loss
aversion, a notion of Kahneman and Tversky's Prospect Theory. Loss aversion states that individuals feel
the pain of losing something much more strongly than the joy of gaining the same thing. For instance,
individuals are more prone to stay away from a risky investment if it can result in a monetary loss, even if
the potential for return is substantial. This unreasonable fear of loss causes individuals to make
excessively conservative financial decisions that are contrary to their own best interests.
This divergence from reason is also fueled by cognitive biases, which influence our daily decisions in
subtle ways. Anchoring effect, for example, happens when people place too much importance on the
initial information they receive. Retailers will tend to take advantage of this by charging a very high
"original price" and then offering a discount, with consumers thinking that they are being given an
amazing deal when in fact the ultimate cost might not be much cheaper than its real worth. Present bias is
another influential bias that helps to understand why individuals fail in long-term decision-making.
Humans like rewards today more than rewards tomorrow, which is why so many put off saving for
retirement or choose short-term pleasure (like eating junk food) over long-term health benefits. The bias
has enormous economic consequences, influencing everything from consumer choice (spending patterns)
to public policy (taxes and savings incentives).
Other than individual biases, social influences also play a major role in decision-making since they
predispose individuals to conform to group behavior. Herd behavior, a common psychological
phenomenon, explains why individuals have the tendency to imitate the behavior of the larger crowd even
when such behavior is irrational. This is most evident in financial markets where investors have a
tendency to copycat trends without conducting their own analysis. The dot-com bubble and the 2008
financial crisis were in part driven by such actions, as people rushed to invest in exceedingly overpriced
assets simply because everyone else was doing so.
Similarly, default options shape economic activity in ways that few are even aware of. Research has
found that when people are automatically enrolled in retirement savings accounts and may opt-out, they
will participate at much higher levels than if they have to decide to opt in. This is due to the fact that
people will stick with the default option, even when another option would be better for them. This
observation is often used by governments and businesses to design policies that "nudges" people toward
healthier financial and health-related decisions.
Emotions also play an important role in economic behavior, motivating decisions beyond what reason
would dictate. Fear of missing out (FOMO) could lead to risky financial decisions, for instance, investing
in stocks at their peak because of market hype. On the other hand, regret aversion leads individuals to
steer clear of risk in case they end up regretting their decisions down the line. The emotional aspect
comes strongest into play in consumer spending, with marketers creating ads that make one feel happy,
nostalgic, excited, and more willing to spend impulsively. These emotional cues are important to decipher
in order to create improved policy and financial interventions that enable individuals to make decisions in
their long-term interest.
The findings of behavioral economics have wide-ranging applications, not just to individuals, but to
policymakers and firms as well. Governments are utilizing behavioral insights more and more in an
attempt to nudge good economic behavior, for example, raising tax compliance, encouraging organ
donation, and boosting saving rates. Firms apply the principles to design more effective advertising and
easier-to-use financial products.
Yet the ethics of behavioral economics are fraught. As helpful as it is to nudge people toward improved
decisions, it also implicates manipulation and autonomy. Where do we draw a line between influencing
behavior and coercing it? That is a question that will define controversy as behavioral economics emerges
as a more prominent discipline within economics, business, and public policy.
The grocery store example at the start of this conversation might have appeared trivial, but it
demonstrates a far greater reality about human nature: we are less rational than we would like to think.
Our decisions are influenced by a subtle combination of cognitive biases, social pressures, and emotions.
Behavioral economics discerns these inclinations, providing knowledge that can be applied to enhance
both household financial decisions and economic policy overall.
In a global community where economic choices become increasingly convoluted, the science of
behavioral economics rings truer than ever before. By admitting that we're not always rational and doing
what we can to go against ourselves, we're essentially making smarter, better-informed choices. Next time
you're caught making a spontaneous purchase or hemming and thinking about risking it financially,
reassess yourself: it's possible it isn't your fault after all. Your brain just doesn't work like that, and
behavioral economics exists to inform you why.
