Intro
Behavioral economics is a branch of economics that deals with understanding why people and businesses make decisions that might not follow what traditional microeconomics says they should. Mainstream economic theory explains how people, firms, and societies make decisions about the allocation of scarce resources. It is based on the assumption that people and firms make rational decisions that are based on their own self-interest and that they try to maximize their own well-being or profit. Behavioral economic theory, in constrast, looks at how our thoughts, feelings, culture, and society affect our choices about money and other things.
This study combines ideas from psychology, brain science, and how prices and markets work. It can be used to “nudge” us to decide what we should buy, how we should form our opinions about things, and ultimately change our behaviors for better or worse.
Foundations of Behavioral Economics
As I mentioned above, traditional economics is based on the idea that people make rational decisions to maximize their self-interest. It assumes that individuals have complete information, make logical choices, and act consistently to achieve their goals. This theory forms the basis of many Western economic models and policies. For instance, it suggests that if the price of a product goes up, people will buy less of it because it becomes more expensive. #demandCurves
On the other hand, behavioral economics recognizes that people often don’t act rationally or predictably regarding economic choices. It considers psychological, cognitive, and emotional factors that influence our decision-making. For example, some people make choices that go against their best interests, such as buying things they don’t need or making financial decisions that aren’t optimal. #debtCrisis
Behavioral economics introduces concepts like biases, heuristics (mental shortcuts), and social influences that affect decision-making. It explores how emotions, cognitive limitations, and societal norms impact economic behavior. One famous example is the concept of “loss aversion,” which suggests that people fear losses more than they value equivalent gains.
In essence, while traditional economics assumes rational behavior, behavioral economics considers the complexities of human behavior and how it deviates from purely rational decision-making. Both perspectives offer valuable insights into understanding economic choices. Still, they approach the subject from different angles, with behavioral economics expanding the traditional view by integrating psychological and social elements into financial analysis.
Two key contributors to the field are Daniel Kahneman and Richard Thaler.
Daniel Kahneman
Daniel Kahneman is like a detective of the mind. He explored how our brains make decisions and discovered that sometimes, we don’t make choices in rational ways.
He showed that our minds have two systems: one that’s fast and kind of automatic (System 1) and another that’s slower and more careful (System 2). Kahneman discovered that our fast-thinking system often takes shortcuts, called biases, which can make us predictably irrational.
His work explained why we fear losing things more than we enjoy gaining them and how our first impression of something can affect all our later thoughts, a concept known as Prospect Theory. Kahneman’s ideas helped us understand how we think and make choices, changing how we see decision-making in both daily life and big stuff like economics.
Richard Thaler
Richard Thaler explored how our minds work when making money decisions. He found that people often fail to make smart choices regarding spending or saving.
He discovered that our brains often take shortcuts that can lead us to make not-so-great decisions. For example, we spend more money on something because it’s on sale, even if we don’t need it, because we don’t want to miss out on the “deal”. Or that people are likely to continue losing money on something they have already invested a large amount in, for fear of losing that initial amount, a concept called the sunk cost fallacy.
Thaler also showed that sometimes we value things more when we own them vs when they are not yet ours, a concept known as the Endowment Effect.
His ideas helped us understand that people are sometimes more rational than traditional economics thought. Thaler’s work changed how we see economics, showing that our feelings and behaviors significantly affect how we handle money, and that all it takes sometimes is a little nudge.
Future Trends and Developments
New research by the National Academies is attempting to discover if any of this is scalable and replicable. Due to the nature of idiosyncratic behaviors of consumers, there is also concern that the “personas” around this would be so small as to limit the generalizability of the findings. And lastly, there remains concerns that the studies themselves exhibit a selection bias based on which studies end up being published.
To make things better, researchers need to share their data more and be careful about how they do their studies. They also need to try their ideas in different places to be sure they’re really useful. It’s important to fix these problems so that the research can help more people in the real world, especially as concepts like nudging and behavioral finance make their way to public policies.
Next Steps
Throughout this blog, I hope to incorporate my learnings about behavioral science into thoughts on marketing, public policy, and other topics. I am truly fascinated with this science and find it a useful pedagogical tool for many business applications including general management, human resources, marketing, strategy, and sales.
Additional Resources/References
Some recommended books and articles for you below! (I get commissions for purchases made through links in this list.)
- Thinking, Fast and Slow, Kahneman (Amazon)
- Nudge, Thaler and Sunstein (Amazon)
- Behavioral Economics, Sendhil Mullainathan and Richard H. Thaler (Econlib)
- Articles on Behavioral Economics (Harvard Business Review)
- Behavioral Economics: Policy Impact and Future Directions (National Academies)
- and of course, the wikipedia article on Behavioral economics!
1 commentSkip to comment section