Behavioural Economics – A Complete Beginner’s Guide – Ever heard about Robert Shiller, Dan Ariely, and Daniel Kahneman? These are probably the three most popular names in the field of Behavioural Economics and Finance. Life is about decisions and both finance and economics make us think deeper. Ultimately the subject of Behavioural Economics helps us understand why so called “rational people” like us make decisions the way we do. At first you might think this is a theoretical subject which is boring as theory subjects in general – remember your schooldays? In fact its underpinnings come from mathematical constructs which are rooted in advanced subjects like probability theory. This article is sure to have quite some calculations and numbers not just because I don’t want to make it theoretical, but make you understand your decisions with examples. Personally, this is one of my favourite subjects and is rooted in philosophy and math – what better combination can you think of!
We discuss the following in this article –
- Simple example of Behavioral Economics
- Utilitarianism in Behavioral Economics
- Risk taking and Prospective Outcomes
- Bounded Rationality in Behavioral Economics
- Money and Time
- The Gut Feel
- Salient Goods and Salience
- Status Quo in Behavioral Economics
- The Ego Factor and being consistent
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Simple example of Behavioral Economics
Ever bargained at a shop? Well, Indians are considered to have a fascination for bargaining in general atleast – sort of stereotyping it. If you don’t like the word, go with ‘negotiation’. You may or may not be good at it but it doesn’t change the fact about bargaining. Worse, some even bargain against the Maximum Retail Price (MRP) on the sticker and get the better of everything due to their superior skills. Why do people do so? Simply because you feel that the item is worth lesser than is actually being quoted by the seller for whatever purpose it is! This is not even because the seller wants to make a bigger profit from it.
This is probably a simple yet deep concept in behavioural economics just as an example. So let’s look at some areas we might touch upon in daily life and how it is related to behavioural economics.
Utilitarianism in Behavioral Economics
In simple words, people purchase and make use of things that add the maximum utility to them or the maximum benefit. You would choose 2 apples and 1 orange over 1 apple and 1 orange if it gives you the maximum benefit. But of course at some point you stop looking just at benefits added – 100 apples and 100 oranges are not likely to give you the greatest benefit unless you are sure to sell many of them at a higher price. In a way, the underlying theory is that money is a great equalizer and money can buy happiness.
At the same time, when costs are involved to doing an activity, one compares the benefit to the cost and chooses the point where the difference is the highest. It is also true that what we perceive to be of maximum utility is what any rational person would do – assumed to be rational decision making.
Risk taking and Prospective Outcomes
This deals with how a situation is put up for us to deal with. It depends on the way the subject is conveyed. You can look at a situation in terms of gains or in terms of losses:
You have $100 to shell out. There are stocks of companies which I recommend to you both of them worth $100. I present you with two alternatives and you are forced to choose one of them:
- Company A’s stock will surely pay you back $20 as dividend
- You have a 20% chance of making $100 on the stock increasing and an 80% chance of making nothing ($0 since the stock won’t move) if you want to go with Company B’s stock
Assuming I give you the above information with certainty and that the choices are mutually exclusive, which would you choose? Seems pretty easy you’d choose Company A’s stock because it guarantees $20 right! Company B looks suicidal in nature. But statistically and mathematically, the expected return you would get is the same $20 ([20% x 100] + [80% x 0]).
Thus B looks equally good as A isn’t it! You may still not be convinced and can argue by saying that A gives the same outcome with certainty while B doesn’t. So, you would go with a least risky alternative provided.
How about the same question with the following alternatives (not the two presented earlier).
- Company A’s stock will surely lose $80
- You have a 80% chance of losing $100 on the stock dropping and an 20% chance of losing nothing ($0 since the stock won’t move) if you want to go with Company B’s stock
You’d choose B right? It gives you an effect of losing less although it is quite risky by nature. Though you aren’t gaining anything you would not like to lose money – you dislike losses.
The situation involving gains (former example) gave you a sense of risk aversion and the latter, that of loss aversion. The outcomes of both mathematically give the same results! You could conclude that robots without human intelligence would’ve tossed a coin and chosen whatever the outcome would’ve been – indifferent between both. Humans make “smarter” choices!!
Bounded Rationality in Behavioral Economics
This is a seriously interesting topic! As the words say, we assume humans make rational decisions. But these decisions are made given certain constraints. This is why some make decisions that differ from others. Why would you choose a Starbucks coffee versus one from Barista or an Ariel versus a Tide detergent? The first one may depend on the taste – argument accepted. The second? Both might clean equally well. You may choose one over the other just at random since you’re indifferent or because one of them may not be available in the shop. These reasons aside, you might have more information, a different experience, a feel of after sales support, quick and perfect feedback etc. about one brand versus another. Thus decisions made like these are relative to the environment in which we are put and in which these products came.
At the same time, it is not the smartest assumption that humans decide rationally. Dan Ariely wrote a book titled “Predictably Irrational.” He gives a simple example which goes somewhat like this. A chocolate which is given free is more attractive relative to a chocolate that costs $0.20 than a chocolate given for $0.01 which costs $0.21 – disproportionate attraction. The price difference in both cases is the same at $0.20. Guess what, some of us may go ahead with the free chocolate even if the difference in the second case was higher. Price is generally considered an indicator of quality but we still make such choices.
Money and Time
Money has some value associated to it. This leads to the concept of present values, future values and discounting. A dollar today is worth more than the same dollar tomorrow since interest is added to the value of the dollar. Tomorrow also depends on how far tomorrow is from today. If interest rates are at 10% p.a. and doesn’t change, $100 today will be preferred over the same amount one day from now and given choices between receiving $100 one day from now versus one year from now, you know for sure what you would want.
The Gut Feel
This one would test you! If a bat and ball cost $1.10 and the bat costs $1 greater than the ball, how much would the ball cost? $0.10 is sadly not the right answer. If the ball did cost $0.10, then the bat should cost $1.10 to be $1 more than the ball whereas it is currently only $0.9 more than the ball. The bat doesn’t cost $1 but $1 more than the ball.
Let the cost of the ball and the bat be ‘x’ and ‘x+1’
So, x + x + 1 = 1.10
- 2x = 0.10
- x = 0.05
The ball would cost $0.05 and the bat would cost $1.05.
Don’t worry if you got it wrong. Around 50% of the students at Harvard got the answer wrong if you would like to keep Harvard as your benchmark to keep you sane for longer. We might even tend to make such decisions in real life!
The outcome of the above test was meant to study how people respond to situations. Those who gave the answer as $0.10 tended to be more intuitive by nature while those who answered it as $0.05 were more analytical by nature. This could even reflect in our purchasing behaviour and daily life, be it a cornflakes vs muesli debate or anything else.
Salient Goods and Salience
What is salience? It’s a form of behaviour where the most recent information or knowledge got stays longer in our memory due to which we remember them more often than older information and influence our decisions and actions. Here is an example.
Just as in many other countries, the major indicator of inflation in India is the Consumer Price Index (CPI). CPI inflation is determined by taking surveys from individuals and households. It is believed that people mention during the survey that their measure of inflation is very high. When asked why, they say that it is the price of ‘Pulses’ that they buy which makes them feel so since the price of pulses have been going up continually. They do not factor in how overall inflation reduction has led them to have greater personal disposable income. Here, pulses are salient goods since it was probably the last thing they bought and is a commodity they keep buying where they can clearly gauge the rise in price. There are different degrees of salience that are observed and several studies have gone deep into this.
Status Quo in Behavioral Economics
There are times we aren’t willing to change our mind-set. This may be due to past experiences or just due to the way we actually are. Even without trying a sizzler or a taco we think that pizzas are the best food item. We might not even listen to a connoisseur and fail to adapt to change. Only if the incentive to change our behaviour is so strong will we be willing to change – status quo bias.
The Ego Factor and being consistent
Whether you like it or not, you just have to accept this. Yeah it is quite spiritual in subject but just cannot be ignored. We as humans tend to think positively of ourselves as people. This carries further into an adamant nature to change or listen merging into ego problems. Your junior might make a better suggestion than a superior, but the fact that he’s a junior doesn’t allow the superior to admit that he made a better suggestion. When this is pushed a bit further, the superior ensures that he consistently behaves in such a way. The big risk of course is that the decision made by the superior due to his consistency of living up to his ego/image may blow up and cause a deep negative impact overall.
There’s quite some material covered and a lot of examples to support each kind of behaviour and is not an exhaustive list, but a mere introduction into what you may encounter. The essence is that humans think they are rational while making choices. We think that a decision made by us was the smartest that could be. We have a predisposition to think that we are smart and make smart choices but do not realize that there could’ve been smarter and better decisions that we could make. Well it is not so much due to our ego that we behave in such ways, but based on our behavioural tendencies rooted from past experiences, pool of choices, limited thinking etc.
The more difficult part is that even if we think and try to alter our decisions from now on, there is no guarantee that we will make the best decision. What is good enough is to be aware of this constantly when we make decisions because it will not only make us appreciate behavioural economics better, but may also be a better reflection about ourselves in the future. This can even help reduce the number of arguments we have outside and at home on a deeper angle. Think about it!