Behavioral Economics

The Basic Idea

Economics is concerned with production, consumption, and wealth, all of which involve human behavior. However, not all economic ideologies base their predictions on the same ideologies. Two popular and opposing branches are traditional economics and behavioral economics. Traditional economics makes calculations on human behavior based on the idea that humans are rational beings that are reasonably successful at deciding what they value and acting to maximize it. Behavioral economics, on the other hand, combines psychology with economics in order to try and better understand how humans actually act instead of how they should act. This means taking into account factors like emotions, beliefs, cultural influences and cognitive biases, all of which cause humans to deviate from straightforward rationality.2

Imagine that you are deciding what kind of laptop to purchase. According to traditional economics, the only thing that would be considered in this purchasing decision would be utility. Which laptop is the best in order to maximize utility? What laptop is the best value for its money?

However, behavioral economics would allow room for other influences, such as emotions, or bounded rationality. What laptop is considered cool? How much time did you have to make the decision?

The second set of questions represents the kind of factors that behavioral economics takes into account, which might not be rational influences, but impact decision-making all the same. Once behavioral economics has been able to understand the different kinds of influences that really impact human behavior, it also can demonstrate how human behavior can be shaped through the use of heuristics and biases. Instead of expecting humans to behave rationally, we can understand how biases influence their decisions. Policy makers, governments and businesses can use behavioral economics to their advantage to try and push people towards making the best decisions possible.

 

 
Wouldn’t economics make a lot more sense if it were based on how people actually behave, instead of how they should behave?

– Dan Ariely, an Israeli-American author, in his book Predictably Irrational: The Hidden Forces That Shape Our Decisions

Key Terms

Rationality: decisions based on logic or reason.3

Utility: a measure of to what extent something satisfies wants, needs or desires.4

Bounded rationality: a decision-making process where we attempt to satisfice instead of optimize. Due to constraints in time, knowledge and brain capacity, we make ‘good enough’ decisions instead of the ‘best’ decisions.

Prospect theory: a theory that suggests our decisions are not always optimal because our decisions are influenced by the way that choices are framed. Our choices are therefore context-dependent.5

Nudges: techniques used by behavioral economics to influence how we make decisions.

Heuristics: shortcuts that humans take when making decisions, often necessary for making quick decisions, but can lead to irrational choices.

History

Traditional economics is based on the principle of homo economicus, a hypothetical model that assumes that humans behave in accordance with simple rules that indicate that they make optimal decisions to maximize utility.6

However, contemporary economists started to see the limitations of traditional economics: humans did not behave according to pure logic. Daniel Kahneman and Amos Tversky, two Israeli psychologists, were some of the first people to dispel the notion of homo economicus. In particular, their work showed that humans do not always behave according to base rate information (objective, statistical, rational information), that they are instead influenced by all sorts of biases. A few examples include the bias to maintain the status quo and trying to recoup losses that should have no impact on present utility (known as the sunk cost fallacy).7 These early insights began to shape a new field of economic theory, behavioral economics, that examines all the different heuristics and biases that influence our behavior. Kahneman continued to study behavioral economics throughout his career, and he eventually earned the Nobel Prize in Economics in 2002.8

Richard Thaler, who is often called the founding father of behavioral economics, was inspired by Kahneman and Tversky’s theories. He conducted his own research into the ways in which psychology and economics intersect. An early study by Thaler in 1985 showed that individuals prioritize novel information over prior information, which sometimes defies expectations for a rational agent.7

Thaler is also responsible for the concept of mental accounting. Mental accounting explains how we treat money subjectively, where we think of value in a relative manner instead of in absolute terms.5 Thaler showed that people derive pleasure not just from an object’s value, but the quality of the deal. For example, people are more likely to buy something if they think it’s a good deal regardless of the fact that its utility does not change.5 Thaler continued to work in behavioral economics and co-authored a book, Nudge, that examines the psychological biases that cause people to deviate from rational decision-making.9 Nudge is considered one of the foundational texts of the field and has had a great influence on decision-makers in nearly every field. Thaler won the Nobel prize in economics in 2017 for his contribution to behavioral science.9

Today, behavioral economics seems to be everywhere. Governments are using behavioral economics to inform public policy, businesses are using nudges to influence consumer behavior, and behavioral economics are informing intrapersonal relationships between employees and employers.8 It has begun to intersect with other fields as well, such as philosophy and positive psychology.

People

  

Herbert Simon

Herbert Simon’s early work in the 1950s focused on the micro: everyday decisions that humans make.10 It was during this time that Simon began to use the term ‘heuristics’ that inspired much of the work that Daniel Kahneman and Amos Tversky later conducted. Simon is credited to have first come up with the ideas behind bounded rationality but is less often discussed in relation to behavioral economics than Kahneman and Tversky because although he showed that people did not adhere to pure rationality when making decisions, he still claimed that the rational model was best for economics.11 He did, however, also win a Nobel Prize in Economics in 1987 for his interdisciplinary contributions.11

Ernst Fehr

Ernst Fehr has been a professor of microeconomics and experimental economics since 1994. He has conducted work that spans across different disciplines, including psychology, neuroscience and evolution, by examining how each relates to human economic behavior. In particular, he has attempted to show the ways in which human sociality comes into play in economic decision-making by examining phenomena like reciprocity, altruism and fairness.12

George Loewenstein

George Loewenstein is also considered one of the founding fathers of behavioral economics. He worked alongside Thaler to demonstrate anomalies in human’s intertemporal choices, where for various reasons, they deviated from the rational model. In particular, Loewenstein focused on affective forecasting, examining how humans predict future behavior and he is said to have coined the projection bias and the hot-cold empathy gap.

Vernon L. Smith

Another important figure in behavioral economics, Vernon Smith pioneered the use of experimental economics; replicating microeconomic principles in a small setting, often a classroom. Such a methodology allowed researchers to more easily examine anomalies from the rational economic model.12 Since then, he has continued to conduct experiments in behavioral economics, often alongside Daniel Kahneman. The two won the Nobel Prize in Economics together in 2002.13

Dan Ariely

Ariely is the author of one of the fundamental books on behavioral economics, Predictably Irrational, that shows that not only are there anomalies to the homo economicus rational model, but that there are patterns within these anomalies. He suggests that humans deviate from the rational model in predictable and systemic ways.14

Nava Ashraf

Economics is usually a male-dominated field, and behavioral economics is no different. However, Ashraf has certainly made her mark within the field, applying insights from behavioral economics to international development. Ashraf pushes the principles of the field in order to show that different people also deviate from rationality in different ways, depending on their culture and nationality. She also examines gender-specific behavior in order to develop gender-specific nudges and solutions.12

Controversies

Although there is now a general consensus that humans sometimes deviate from perfect rationality, many people still find the rational model useful. While behavioral economics is descriptive, attempting to demonstrate how people actually act, it might not be as helpful in a prescriptive sense, as it does not tell us how people should act. This also means that behavioral economics lacks predicting power.15 Critics suggest that focus should be placed on overcoming our irrational biases and heuristics rather than just demonstrating them, which might be achieved by perpetuating the homo economicus figure.

Alternatively, another strand of criticism suggests that while humans do operate based on heuristics and biases, that this behavior is not irrational. The biggest proponent of this ideology is Gerd Gigerenzer, who suggests that the homo economicus model is just one model of rationality and that behavioral economics represents another one.11

Other critics suggest that behavioral economics lacks scientific validity. Behavioral economics encompasses a lot of observations, but often, the evidence is contradictory. Different biases can seem to contradict each other on a first glance.

As behavioral economics starts to be taken on by companies and businesses, many people also fear the ethical value of the field. Nudges suggest that humans can easily be manipulated, an idea that receives a lot of resistance. As Thaler has made nudges a policy tool, others have become worried about the fate of democracy when we are being manipulated by governments or businesses to act in a particular way and make particular decisions. Nudging assumes that the people creating the nudges are able to know what is best for the wider population, which is not always an accurate statement.9

Case Studies

  

Nudging and COVID-19

Behavioral economics stipulates that humans can be guided to making certain decisions through the use of nudges. During a pandemic, the decisions that we make and the actions we take are of utmost importance to global health, perhaps making nudging more important than ever. As we shift into this new kind of lifestyle, behavioral economics can be used to change our habits to better align with health practices. By being aware of cognitive biases, such as bounded rationality, that stipulate we have limited resources to make decisions, health professionals can adjust their messages to be simple, clear and straightforward, which reduces choice overload.16

Medical-Decision Making and Technology

If we were purely rational beings, we would always make decisions that would be beneficial for our health. But as behavioral economics shows, we do not always make those choices. Luckily, behavioral economics also tells us that we can be nudged to make optimal choices, and therefore, behavioral economics becomes very important in the medical field. Although the medical field has widely adopted various technology platforms, alone, these are insufficient for changing human behavior. When nudges are combined with scalable technology, however, we may be able to positively impact patient behaviors. For example, by being aware of the bias that humans are more likely to try and avoid losses than orient themselves towards goals, physical activity applications can focus on informing patients what the risks are of not getting enough exercise instead of the benefits.17

Related TDL resources

How (Not) to Use Behavioral Economics to Influence Consumer Decision

As behavioral economics takes into account irrational influences on consumer’s decision-making, companies that employ behavioral economics tactics will often try to manipulate consumers into purchasing their product by attempting to make them veer from logic. In this article, our writer James Rowbotham examines one particular company, Viagogo, that used behavioral economics to cause irrational consumer behavior.

The Tale of Positive Psychology and Behavioral Economics

In this article, our writer Fahima Mohideen examines the ways in which positive psychology and behavioral economics intersect. Positive psychology, which examines positive human functioning and behaving, gained traction around the same time as behavioral economics. This article examines the way in which nudges that are informed by positive psychology can make for positive behavioral change in consumer and producer decision-making.

Sources

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  3. Merriam-Webster. (n.d.). Definition of rational. Retrieved November 5, 2020, from https://www.merriam-webster.com/dictionary/rational
  4. Shaikh, S. (2015, November 17). Utility: Meaning, characteristics and types. Economics Discussion. https://www.economicsdiscussion.net/utility/utility-meaning-characteristics-and-types-economics/13594
  5. Behavioral Economics. (2020, April 22). An Introduction to Behavioral Economics. https://www.behavioraleconomics.com/resources/introduction-behavioral-economics/
  6. Behavioral Economics. (2019, March 29). Homo economicus. https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/homo-economicus/
  7. The TSEconomist. (2018, July 5). A Short History of Behavioural Economics. The TSEconomist. https://thetseconomist.wordpress.com/2017/09/20/a-short-history-of-behavioural-economics/
  8. Baddeley, M. (2019, October 10). Behavioral economics: Past, present, and future. MIT Technology Review. https://www.technologyreview.com/2019/10/10/65182/behavioral-economics-past-present-and-future/
  9. Farrell, H. (2017, October 16). This year’s economics Nobel winner invented a tool that’s both brilliant and undemocratic. Vox. https://www.vox.com/the-big-idea/2017/10/16/16481836/nudges-thaler-nobel-economics-prize-undemocratic-tool
  10. Schwartz, H. (2002). Herbert Simon and behavioral economics. The Journal of Socio-Economics, 31(3), 181-189. https://doi.org/10.1016/s1053-5357(02)00161-0
  11. Fox, J. (2015, May 1). From “Economic man” to behavioral economics. Harvard Business Review. https://hbr.org/2015/05/from-economic-man-to-behavioral-economics
  12. Barham, J. A. (2018, October 15). 25 Top Behavioral Economists. TheBestSchools.org. https://thebestschools.org/features/top-behavioral-economists/
  13. The Library of Economics and Liberty. (n.d.). Vernon L. Smith. Retrieved November 5, 2020, from https://www.econlib.org/library/Enc/bios/SmithV.html
  14. Staff, T. (2020, March 23). Dan Ariely interview — A primer on behavioral economics. TheBestSchools.org. https://thebestschools.org/features/dan-ariely-interview-behavioral-economics/
  15. Pūce, L. (2019). Criticism of behavioural economics: Attacks towards ideology, evidence and practical application. Journal of WEI Business and Economics, 8, 32-46. https://doi.org/10.36739/jweibe.2019.v8.i1.3
  16. Villarreal, D. B., R Mendez, A. M., & Scartascini, C. (2020, April 24). Behavioral economics can help fight coronavirus. Publications. https://publications.iadb.org/en/behavioral-economics-can-help-fight-coronavirus
  17. Waddell, K. J., Shah, P. D., Adusumalli, S., & Patel, M. S. (2020). Using behavioral economics and technology to improve outcomes in cardio-oncology. JACC: CardioOncology, 2(1), 84-96. https://doi.org/10.1016/j.jaccao.2020.02.006

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