Behavioral Economics

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Behavioral Economics?

Behavioral Economics aims to understand economic decisions made by humans by combining elements of psychology with classic economics. This branch of economics looks into how and why people arrive at their economic choices, how they differ from rational choices, and find the implications they have on various aspects of life.

What Is Behavioral Economics

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The behavioral economics theory bridges the gap between neo-economics and reality. Behavioral economics assumes that humans are rational and study because they make deviated choices from logical decisions. The goal is to understand how different types of information influence individuals’ decision-making skills and how their cognitive limits and psychological biases affect socioeconomic and political outcomes.

Key Takeaways

  • Behavioral economics differs from traditional economic theory. It helps understand why people make their choices, deviating from rational decisions. This concept studies the factors influencing them and makes small changes to persuade people to make conscious choices.
  • Human decisions are influenced by factors such as Bounded rationality, choice architecture, cognitive bias, discrimination, and herd mentality.
  • The objective is to study how different types of information influence people’s decision-making and how people’s cognitive limitations and psychological biases influence socio-economic and political outcomes.
  • Governments, organizations, and businesses use behavioral economic studies to motivate people to make certain kinds of decisions.

Behavioral Economics Explained

Behavioral economics is the domain that refutes the area of economics that talks about rationality, preferences, and self-interest as the significant determinants leading to human decision-making. Instead, this is the part of the subject that states how human beings make decisions based on various other determinants that have nothing to do with their preferences, rationality, obviousness, or self-interest.

Behavioral economics principles attempt to look beyond the traditional economic theory, which is based on “rational choice.” This concept presents humans as logical beings. When presented with multiple alternatives, they assess the pros and cons of each option and choose one that serves them best. However, in reality, buying trends of consumers suggest otherwise. They do not always choose the obvious logical option, and hence behavioral economic studies yearn to understand why people act, defying rational choices.

It was Richard Thaler, a Chicago scholar, who first examined the idea of the emotional side of human beings and its effect on decision-making rather than people following optimal routes, which looks like an obvious action. But the original attempts at understanding these ideas go back to studies of 18th-century economists like Adam Smith. 

The behavioral models have helped governments and businesses alike create policies and game plans that can influence people’s financial behavior.

Behavioral Economics

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Video Explanation of Behavioral Economics

 

Principles

Behavioral economics theory revolves around a few principles, which advocate how people might have different choices, opinions, or decisions from what is perceived to be rationally correct. It emphasizes how what people should do differs from what they choose to do. This domain of economics helps people derive policies based on the unpredictable responses of individuals, especially customers.

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Based on the determinants that drive human decision-making, here are a few principles derived to explain behavioral economics better:

Principle #1 – Search for Feasibility

Humans tend to choose the most feasible option, from a food item to order to a suitable location to construct their house. However, the most feasible option doesn’t always need to be the right option.

For example, a good location can be good from a conveyance perspective but might not be good in terms of the type of crowd around. In that case, people might face difficulties and realize their chosen option was wrong. In short, though feasible options tend to drive the decision, humans might opt for the wrong option, which seems right at that moment.

Thus, businesses aiming to target a customer base must try to exhibit features of the products that look like the most feasible choice for people at that moment. This trait or principle helps boost sales figures significantly.

Principle #2 – Comparison of Circumstances

The following principle influencing individuals’ and entities’ behavior and decisions is how they relate their circumstances and reference points.

For example, the willingness to invest in a plan depends on the returns in the long run. Here, the expected returns are the reference point, which requires a thorough study to understand how individuals would relate their circumstances with it and decide on their investment plans. 

Usually, the losses incurred are higher than the gains reaped out of an opportunity of equal magnitude. Still, people take this chance. This avoidance of loss is loss aversion. It happens as the few early chances indicate the trials of humans. As they gain experience, they become better. However, by then, the loss is already heavier than the gain.

Principle #3 – Self-Control Issues

Human beings have significant self-control issues. They decide to quit their addiction at one moment and fail to follow the same the next moment. They impose self-restrictions but forget to stick to them for a long time. Behavioral economics attempts to specify this trait of the subject, which is yet another determinant that influences an individual’s decision-making. The present bias of decision-makers can lead to opposite decisions if they lose self-control. 

Principle #4 – Emphasize Others’ Opinions

This is one of the principles of behavioral economics that advocates how, sometimes, material payoffs take a backseat, with others’ opinions, intentions, offerings, and actions becoming more critical to consider before making a decision. For example, suppose parents offer two candies to their three children. While the youngest one agrees and accepts the candies happily, the oldest refuses to take them as he feels he is older than the other two and deserves more than two candies. 

The middle one observes the situation and accepts the offer without worrying about what she deserves. It is because the child does not want to remain empty-handed. While the first child knows what he wants, he chooses to have nothing over having less, the second child knows she wants at least something, if not more.

Principle #5 – Behavioral Biases

Though behavioral biases tend to be ineffective if it comes from a small portion of the population, the same throws a significant impact when coming from a majority of the population. For example, the biases of a small portion of traders will not affect the total stock market as their beliefs won’t influence the decisions of the major players in the trading sector. As a result, the effects would reflect the rational outcome. 

Principle #6 – Paternalism

The last on the list of principles of behavioral economics is paternalism, which helps control behavioral biases. Here, the authorities in the country take charge and introduce policies to improve the lives of the citizens. However, they do not give the population any freedom to choose. 

In behavioral economics, paternalism is said to cause other problems. This includes the overconfidence of the government or the authorities in introducing plans that might not positively affect people’s lives. 

One can condense behavioral economics principles into the following points:

  • People try to choose the best option available, but they don’t always succeed.
  • They are concerned about how their situations compare to benchmarks (such as money).
  • People have issues with self-control.
  • In markets, too, psychological variables play a role. 
  • People can be partially protected from behavioral biases by restricting their options. (However, in reality, it is not found to be true in most cases.)

Factors Influencing Human Decisions

According to behavioral economics principles, human decisions are influenced by various factors such as:

#1 – Bounded Rationality

Individuals tend to make informed decisions based on their limited knowledge. They conclude that having the required amount of information is sufficient and create a “good enough” decision rather than the best possible one.

#2 – Choice Architecture

Presentation of goods has an impact on people’s decisions. Pens, and ink, for example, are complementary commodities, and presenting them together can help enhance ink sales more effectively than if sold separately.

#3 – Cognitive Bias

Individuals make choices based on their beliefs and values and how they interpret the world. For example, suppose a person likes a particular color. Then, they are likely to buy products that are particularly not useful because it is their favorite color and pleases their eyes.

#4 – Discrimination 

Here, individuals tend to reject choices based on their dislike. Preconceived biases unrelated to the actual situation can play a huge role in discriminating against an idea. They can favor other decisions because of their aversion to the alternatives.

#5 – Herd Mentality 

People like a sense of belonging, whether to faith, a country, a language, or even their favorite sports team! So people spend money they would not otherwise spend to fit in and be recognized as a group member.

The subject attempts to study these factors and behavioral economics principles mentioned above that influence an individual’s decision-making ability and prompt them to make better decisions.

Examples

Now that we have a clear understanding of the basics of behavioral economics theory and its related factors, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

As a customer in a mall, Sam came across signs for a product that said $999 instead of $1000, and she chose to purchase it because the price was below $1000. There is no big difference in value between $999 and $1000. There was not much gain in saving that $1, but what made her choose to buy that product was the satisfaction of purchasing a product under $1000. It was rather an emotional decision rather than a rational one.

There are countless behavioral economics examples, such as these, that we come across in our daily lives where industries take advantage of human behavior.

Example #2

Myra wants a couch cover like the one she saw at her friend’s house. She takes the address from her friend, visits the shop, and chooses the same cover design for her couch. The shopkeeper says it’s worth $150, which surprises her. This is because her friend paid $130 for the same product. So, she bargained and tried to get it at the same price. 

If Myra had come across the product at her friend’s house before noticing it, she would have readily agreed to pay the price. However, in the current instance, she looks at the product and its price from her friend’s perspective. It is a simple example of how people’s behavior or situations affect their economic activities.

Example #3

The US housing bubble that led to the 2008 financial crisis indicates the effect of behavioral biases on the market if that involves a large population. During that phase, the lenient interest rates drove most people to take home loans, which led to significant defaults when the interest rate rose suddenly. This led to the entire stock market crash, affecting the global economy.

Example #4

Google promoted the consumption of widely disliked vegetables (beets, Brussels sprouts, cauliflower, etc.) through an experiment.

Instead of mailing the employees the benefits of Brussels sprouts, they advertised it as “vegetable of the day” and displayed colorful pictures and intriguing facts. Placing them right next to the dish made people choose it. As a result, the number of employees who tried the highlighted dish jumped by 74%, and the average amount each individual served themselves increased by 64%.

Experiments such as these are part of behavioral economics research. They demonstrate how little nudges can influence people’s behaviors. Positive changes such as these reduce consumption of junk food and keep them healthy. It decreases their chances of health issues and increases productivity. Many companies can also benefit economically from such changes.

Applications

The application of behavioral economics principles is spread across industries and facets of life and business. From market to government policies, it is very much prevalent across these places. Let us understand its applications through the explanation below.

#1 – In a market

Companies make use of the predictable behavioral tendencies of people.

Behavioral economics helps understand consumer behavior, which might be unpredictable. However, if studied thoroughly, the bent of mind of customers could be assessed.

In addition, the principles, when properly taken into consideration, let businesses analyze the latest trend in the market. The trends tend to influence the decision-making of the people around them. This intervention or influence is called a nudge in behavioral economics.

For example, if there is a product sold for $10, the chances of it gaining more sales are increased when it is advertised along with another product for a small increase in price. Two products for $12 will be a great deal in the customers’ minds.

#2 – Policy implications

Let’s say it is election time, and every vote counts. So the government can send a small text reminder to the people’s phones to come to do their duty as the country’s citizens. This will urge people to come forward to vote who otherwise would have ignored the opportunity. This little push can decide the fate of a country for a few good years and the economic policies to be framed in that period.

Studying people’s reasoning behind their decisions can reveal what they intend to achieve through that decision. It may be psychological satisfaction, economic relief, or other reasons. This knowledge helps various stakeholdersStakeholdersA stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes.read more guide the masses into choosing what they desire through encouragement such as free products and reminders, as mentioned above.

Criticisms

Behavioral economics is a domain that is individual-driven. However, behavioral economics theory suggests a more generalized format for this thought process. Let us understand its criticisms through the points below.

  • The way it affects individual decision-making is the same, but the decisions made or conclusions reached as a result entirely depend on the nature, circumstances, unbounded rationality, self-interest, thought process, and behavior of one individual. Hence, the inferences gathered for one might not be the same as that derived for the other. 
  • Critics argue that behavioral economics often portrays individuals as inherently irrational decision-makers, neglecting the fact that people can also make rational and well-informed choices. This overemphasis on irrationality might lead to a skewed understanding of human behavior.
  • Some even suggest that findings from behavioral economics experiments might not always generalize well to real-world contexts. Controlled laboratory settings might not accurately represent the complexities of actual decision-making situations.
  • Behavioral interventions designed to nudge individuals in certain directions raise ethical questions. Market experts point out the manipulation of people’s choices without their full awareness or consent, which can infringe upon individual autonomy.
  • Critics point out that many behavioral economics experiments are conducted in Western, educated, industrialized, rich, and democratic (WEIRD) societies, which might not be representative of global populations. Cultural and contextual differences can influence the applicability of behavioral economics insights across different societies.
  • It’s important to note that these criticisms don’t negate the value of behavioral economics; rather, they highlight areas where the field can continue to evolve and improve its methodologies and applications.

Behavioral Economics Vs Behavioral Science

Both behavioral economics principles and behavioral science are related fields that place heavy impetus on human behavior. However, there are differences in their fundamentals and implications. Let us understand them through the comparison below.

Behavioral Economics

  • Behavioral economics is a sub-topic in economics that is a collaboration between psychology and economic theories curated to understand how emotions and biases influence human decision-making.
  • It acknowledges the fact that humans often make decisions based on what is best for them at the present moment without focussing on long-term objectives or goals.
  • It shows us that human decisions are not always made with rationality. In fact, they are heavily influenced by emotions, cognitive biases, and social factors.
  • Based on research from prominent researchers like Daniel Kahneman and Richard Thaler, it has come to light that humans make decisions that are not in their best economic interest because of factors such as loss aversion, framing of choices, and present bias.

Behavioral Science

  • Behavioral science is a broader field that encompasses various disciplines, including psychology, sociology, anthropology, and economics, to study human behavior.
  • It examines the interactions between individuals, groups, and their environment. While behavioral economics is a subset of behavioral science, the latter includes a wider range of topics beyond just economic decision-making.
  • Behavioral science aims to understand and predict human behavior in various contexts, such as health, education, marketing, public policy, and more.
  • It seeks to identify patterns, drivers, and influences on behavior and often employs empirical research methods to study human responses to different stimuli and situations.

Frequently Asked Questions (FAQs)

Why is behavioral economics important?

It helps in understanding what traditional economic theory cannot explain. It aims to decode the patterns of people’s behavior in their choices with the help of psychology. This can help in various socio-economic and political aspects.

E.g., when a country needs to develop a particular area, the government can provide job opportunities. Still, if people are not ready to shift, it can give various amenities like tax cut-offs, free medical insurance, etc., to attract people to come to live there. Here, not paying taxes or bills can influence people’s decisions when job offers do not make an impact.

What is Richard Thaler’s theory?

Richard Thaler’s Nudge Theory is a theory that examines the chances of influencing people’s behavior by appealing to their emotions rather than enforcing them through other means. The theory proposes using positive reinforcements and indirect suggestions to make people follow a certain path of action. It is founded based on the influence of the environment (also called choice architecture), which can impact the chances of individuals choosing one alternative over another.

Why study behavioral economics?

Behavioral economics research can help us better comprehend anomalies in consumer choices and better understand human behavior, preferences, and cognitive errors. Behavioral economics is used in various industries to understand consumer behavior better. There is a wide range of applications of behavioral economics in business, law enforcement, politics, and socio-cultural dynamics.

This has been a guide to Behavioral Economics & its Definition. Here we discuss the application of behavioral economics and explanations with examples. You can learn more from the following articles –

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