What is Behavioral Economics and why does it matter?

You have bought the “Thinking Fast and Slow” book and it has been staring at you from your bookshelf. You have seen Dan Ariely’s TED talks and got curious. Or you have heard about nudging, and read that it recently won the Nobel Prize in economics*. Someone may have even mentioned to you that this might be useful for your business / cause / idea. But you have no idea where to start.

This is where we come in. In this post we’ll tell you everything you needed to know about behavioral economics and had no one to ask. Most importantly, we’ll explain why this concept is important to our day to day lives and why it should matter to you (yes, YOU).

Let’s dig in.

So what IS behavioral economics, actually?

We’re getting there.

But first, let’s back out a bit further, to a world as envisioned by traditional economists.

In this world, all people are utility maximizing, which is a fancy way of saying that they always choose the alternative that is in their best interest. They carefully weigh benefits and costs, and they are fully informed of the implications of their choices. They aren’t swayed by emotions or other distractions, and therefore always make rational decisions that are optimal for them. How splendid!

Unfortunately for these “rational people”, they live in a place called nowhere ever, because they don’t exist. In reality, people aren’t rational, they don’t always choose what is best for them, and their decisions are often swayed by anything from what their neighbors are doing, whether or not they have had lunch, or what music is playing in the background.

The idea that our ability to make decisions is limited by factors such as available information and time – bounded rationality – was already brought forward in the 50s by the Nobel Prize winning economist Herbert Simon (timewise, this is the first Nobel Prize of this post. Spoiler alert – it’s not the last). But it would take another 20 years before behavioral economics would get the breakthrough it deserved – brought on, of all people, by two psychologists.

Daniel Kahneman and Amos Tversky are two Israeli psychologists who are considered by many the founding fathers of behavioral economics (along with another key figure, but we’ll get to that later). Their research focused on decision making processes and they identified and classified groups of behavioral heuristics and biases. Heuristics are rule-of-thumb, simple mental shortcuts that we often use to make decisions. When we are faced with decisions that are simply too complex for us to wrap our heads around, we tend to focus on one aspect of them and ignore the others. Heuristics work great for us most of the time, but sometime they result in errors called cognitive biases. This work was the base for the second Nobel Prize of this post, for Daniel Kahneman in 2002, as well as for his bestselling book “Thinking Fast and Slow”.

To give an example – we tend to judge the likelihood of events based on how easily we can think of an example of them (availability heuristic). That’s why more people are afraid of flying than driving, even though the chances of getting hurt in a car accident far exceed the chances of dying in a plane crash. Because plane crashes are an uncommon and therefore noteworthy event, they often get reported with major headlines in all newspapers. Whereas car accidents, which are much more common and therefore mundane, hardly get reported at all. The result is that in our minds, plane crashes are much more salient than car crashes, so more people tend to be worried when getting on a flight than getting in a car.

One of their most prominent works is called Prospect Theory. It revolutionized the way we think about decisions involving gains and losses and risk. Rather than coolly calculating the expected benefits from a gamble, we are far more afraid of losing something than of gaining something of the same value. This makes us more willing to take risks when we losses are involved.

Because of our loss aversion, we are subject to the endowment effect. It is basically the warm and fuzzy feeling we get when we own something, which makes us value it way more than what it’s actually worth. Ever tried sell something you own on e-bay and was surprised to discover that not many people are willing to pay a ridiculous amount for your favorite signed Rolling Stones coffee mug or your grandmother’s porcelain figurines? Endowment effect in action.

The magic of behavioral economics happened when the field of economics started embracing influences from parallel social science disciplines such as psychology, sociology and cognitive science. The other key figure we mentioned before is Richard Thaler, an economist who was inspired by the work of Kahneman and Tversky when he developed his theory of mental accounting. This theory explains why people treat money differently depending on where it came from and its intended use. So, for example, we will go halfway across town to buy a pair of jeans for 50 dollars less, but we won’t think twice about blowing 500 dollars for extras when buying a car. Even though the absolute value of 500 dollars is greater than 50, we judge it relative to the larger cost of buying a car. Since it is a smaller percentage, it “hurts” less. We also practice mental accounting when we take on a bank loan to buy a new TV in order not to use the money we have saved up for our next vacation to pay for it although that would be much cheaper for us. Mental accounting is just one of the many contributions of Richard Thaler to behavioral economics that won him the Nobel Prize for his work in 2017. Along with Kahneman and Tversky, he is the most prominent figure in behavioral economics.

Clearly, we don’t behave as rational, as traditional economists have assumed, but it doesn’t end there. Not only are we affected by our cognitive biases, we are also extremely influenced by other people, and our perceptions about their attitudes and behaviors. This has been known to social psychologists, such as Robert Cialdini, a leading name in the context of social norms, for a long time. Integrating this knowledge into economics, however, gave it a structure and a predictability that made it easier to use deliberately. Among other things, Ciladini talked about how we use our expectations of what others do to determine our chosen course of actions in uncertain situations. To put it simply – when in Rome, do as the Romans do. If you’ve ever been in a formal dinner party and looked around you to get cues on when to sit, how to eat, etc., you know all about this. We also look to other people’s approval of what we should do. For example, if we are having dinner with a person we value who we know is a vegetarian, we are less likely to order the bloodiest steak on the menu.

Why does this matter to me?

Glad you asked! First of all, behavioral economists can identify situations in which we make irrational decisions that might not be in our best interest. That means, if we had lots of time to think of every decision and nothing to distract us, we would often make better decisions. But in our hectic everyday lives we make so many quick decisions and thus we are vulnerable to making some we might regret. Being easily biased also leaves us at risk of being manipulated by, for example, marketing and media. So it’s probably a good idea to just be aware. Dan Ariely has explored the many ways in which the limits in our thinking processes drive a distorted price and value perception. For example, he talked about the zero price effect. In essence, we LOVE free stuff. We love them so much that they sometimes make us buy things we never intended to buy, eventually paying more than we ever intended to spend. Ever walked into a sports store wanting to buy a pair of high quality training socks, just to leave the store with two pairs of low quality training socks because they were on a “buy 1 get 1 free” promotion? We’ve been there too.

Understanding basic concepts from behavioral economics can be very useful. For one, it can help us be better negotiators. We know that people tend to rely way too heavily on the first piece of information they receive about a topic. This is called anchoring bias, and it is the reason that the person who makes the first offer in a salary negotiation often sets the range of what is reasonable. If that person said, for example 6,000 Euros, the negotiation will likely involve salaries in the range of 5,000-7,000 Euros, rather than 9,000 or 4,000 Euros. Think about that the next time your teenage kid wants to renegotiate their allowance.

It’s also good to know that we have an optimism bias – basically a bias towards thinking everything is going to be just fine for us. Which is not always a bad thing, but it might lead to something called a planning fallacy: our tendency to make overly optimistic predictions about the time, cost and likelihood of success when planning a future task or project. Are you chronically late? Do you always overspend your budgets at work? Now you know who (or what) to blame.

And it really doesn’t stop there. In fact, there are so many ways behavioral insights can be applied to our day to day lives, we figured we’d make a separate post just about that. Follow us there.

Nurit Nobel

Nurit.nobel@impactually.se

+46 76 191 71 34

 

I want to learn more!

We hear you. If you’ve already read our post about how Behavioral Economics can be used in practice, then here’s a list of booksTED Talks and other online resources. Other interviews, articles and videos we have published elsewhere can be found here. You are also welcome to sign up to our newsletter, where we give you relevant news and links on behavioral economics.

 

I’m convinced that behavioral economics can do wonders for me. Now what?

Contact us and let’s talk about how we can help you get going.

 

* The official name is The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. The prize is often referred to as The Nobel Prize in Economics, and that is the name we chose to use throughout this article, for cognitive-load-reducing purposes.

 

 

Resources

Ariely, D. (2008). Predictably Irrational. New York: Harper Collins.

Cialdini, R.B. (2008). Influence: Science and Practice, 5th ed. Boston: Pearson.

Danziger, Shai & Levav, Jonathan & Avnaim-Pesso, Liora. (2011). Extraneous Factors in Judicial Decisions. Proceedings of the National Academy of Sciences of the United States of America.

Kahneman, D. (2011). Thinking, fast and slow. London: Allen Lane.

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.

Kahneman, D. (2003). Maps of bounded rationality: Psychology for behavioral economics. The American Economic Review, 93, 1449-1475.

Kahneman, D., Knetsch, J., & Thaler, R. (1991). Anomalies: The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5(1), 193-206.

Kahneman, D., & Tversky, A. (1982). The psychology of preference. Scientific American, 246, 160-173.

Kahneman, D., & Tversky, A. (1972). Subjective probability: A judgment of representativeness. Cognitive Psychology, 3, 430-454.

Nolan, Jessica & Schultz, Paul & Cialdini, Robert & J Goldstein, Noah & Griskevicius, Vladas. (2008). Normative Social Influence Is Underdetected. Personality & social psychology bulletin.

North, A & Hargreaves, David & McKendrick, Jennifer. (1999). The Influence of In-Store Music on Wine Selections. Journal of Applied Psychology.

Thaler, R. H. (2015). Misbehaving: The making of behavioral economics. Allen Lane.

Thaler, R. H. (2008). Mental accounting and consumer choice. Marketing Science, 27, 15-25.

Tversky, A., & Kahneman, D. (1981). The Framing of Decisions and the Psychology of Choice. Science, 211 (4481), 453-458.

Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and biases. Science (New Series), 185, 1124-1131.

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