How do you make decisions? What are some of the factors that influence your decisions? How long does it take for you to decide on something important? Are you able to make rational choices that best maximize your outcome based on the constraints that you have?
Behavioral economics is all about how people make decisions and what influences their decisions. Behavioral economics’ main argument is that human beings are not always rational, and there are certain factors that influence their decisions. In this explanation, you will learn everything you need to know about behavioral economics. Ready? Then keep on scrolling!
Behavioral economics definition
What is the definition of behavioral economics? Behavioral economics uses psychology and economic theory to draw new explanations for how human beings choose to interact in an economy. It aims to provide an alternative to conventional economic theory, which assumes that all humans are rational and that their decisions are always optimal.
Behavioral economics is a discipline that applies insights from psychology to explain how individuals make their choices.
Traditional vs behavioral economics
What is the difference between traditional vs. behavioral economics? Traditional economics supports the concept of individual rationality, while behavioral economics argues against full rationality.
Rational choice theory suggests that when individuals are faced with many choices and constraints, each individual is reasonable enough to make the choice that best maximizes their gains.
Behavioral economists challenge this rational choice theory and argue that, in reality, humans are not always rational decision markers due to many constraints, which we will discuss later.
Behavioral economics takes into account other aspects of an individual, such as their social norms, habits, personality, etc. It does so by taking into account psychological factors that might play a role in encouraging an individual to choose one option over another.
Think about it. To what extent do your social norms dictate your consumption? An individual’s psychology influences all their choices to a certain extent.
Julie goes to a university in London. She is an aspiring engineer, and she aims to graduate top of her class. Julie has to allocate most of her time studying to achieve this.
To stay at the top of her class, Julie needs to study about 10 hours a day. The rational choice theory would suggest that Julie would study for 10 hours and dedicate the rest of her time to other activities.
However, her friends tell her to cancel her study plans and join them in exploring the city instead. At some point, Julie will be influenced by her and her friends’ desires to go out.
Behavioral economics principles
Let's dive straight into some principles of behavioral economics!
Behavioral economics principles: Rational decision-making
Behavioral economics principles challenge the idea that humans can make rational decisions that would allow them to maximize their gains based on a number of constraints.
There are two perspectives behavioral economics provides that challenge rationality of human beings:
- Bounded rationality.
- Bounded self-control.
Behavioral economics principles: Bounded rationality
Behavioral economists argue that there are many restrictions on people’s ability to make rational decisions, and this causes them to act in an irrational way.
Bounded rationality is the idea that individuals have limits on decision making and these limits hinder their ability to make sound rational decisions all the time.
Think about it. You are different to your friends. You may perceive things in a different way, and that is true of everyone else in the world. We all have varying degrees of perception, intelligence, skills etc., that influence the way we think and make decisions.
Bounded rationality theory suggests that there are three limitations to individual choices:
- Limited information. We all face limited information or inaccurate information about something, and this could cause us to make irrational decisions.
- Mental capacity. Not all of us are able to process vast amounts of information to make a decision, and this limits our ability to make rational choices.
- Time constraints. There may not be enough time to weigh in all the alternatives and explore all the possible choices to make a fully rational decision.
Behavioral economics principles: Bounded self-control
Another aspect behavioral economists challenge is that all individuals have total self-control.
Bounded self-control is the idea that individuals have limits on their self-control and these limits hinder their ability to maximize their utility.
Bounded self-control suggests that there are limits to the extent individuals can commit to a choice that would be in their best interest. Therefore, this affects whether or not they can make rational decisions.
Thinking, Fast and Slow
Another interesting point behavioral economists make is that different decisions require different amounts of time. 'Thinking, Fast and Slow' was published by a famous psychologist - Daniel Kahneman in 2011.1
Thinking fast and thinking slow refers to the time it takes for an individual to decide based on the type of decision they have to make.
When you crave a milkshake, you go buy it. But the same thing doesn’t apply to enrolling in a university. You take the time to think and process what you want to do in life, what career you choose, etc.
Behavioral economics examples
Let's take a look at some behavioral economics examples of decision-making biases.
Many factors influence the decision-making of an individual. It could be their past experiences and the weight they attribute to the past. It could be their tastes. All these contribute to individuals making biased decisions. Some of the biases in decision-making are:
- Availability bias
- Anchoring
- Bias based on social norms
- Habitual behavior
- Rule of thumb
Before we look at each of these, let’s define bias.
Bias is an irrational assumption or belief that affects the ability to make a decision based on facts.
Keep this definition in mind as we look at each bias in decision-making.
Behavioral economics examples: Availability bias
What is availability bias?
Availability bias occurs when an individual uses outcomes of other similar events to make their own decisions.
You visit a restaurant that your friends continually praise. Because you know of people who had a good experience at this restaurant, you expect good food when you go there. You might not have even considered other options or the money or the cost of eating at that restaurant, but you place a large order, knowing that the food is going to be good.
In this example, you have considered similar events and made decisions based on them. Whether intentional or not, you have made a biased decision.
Behavioral economics examples: Anchoring
Anchoring is based on an obsession with a particular piece of information.
Anchoring occurs when individuals give too much weight to the first or one piece of information they have received.
The first piece of information becomes a reference point for the individual to decide.
You see a cool jacket on sale at a shop. You try negotiating with the salesperson on the price of the jacket, and they quote you the first price of £50. You think this is a fair price and buy it.
In this example, the salesperson would’ve accepted lower, but you thought about how much lower £50 was in comparison to the original price that you forgot about negotiating an even lower price and bought it.
Behavioral economics examples: Biases based on social norms
The social setting an individual lives in has a lot to do with how they make decisions. Living in a social setting where social norms encourage certain behaviors will influence an individual to acquire such behaviors.
Some social norms encourage alcohol consumption, which causes alcohol to be widely accepted in many societies.
However, drinking a lot of alcohol might not be the most rational decision due to its health impacts and the impacts on other third parties.
Behavioral economics examples: Habitual behavior
Habitual behavior includes a routine of behaviors of certain individuals.
You drink coffee every morning at your local shop instead of having it at home. Although this might not be the most rational decision if you’re trying to save money, you will still make it because it’s a habit.
Behavioral economics examples: Rule of thumb
Rule of thumb refers to the already established guides on the behaviors that are appropriately relevant to a certain setting. There are unofficial agreements or codes of behavior that individuals should follow.
There are some rules of thumb in finance that give guidance on how much you need to save for a mortgage.
Behavioral economics examples: nudges
Nudges are studied in behavioral economics and used in practice to alter the behavior of individuals by encouraging specific ways of thinking. It is worth noting that a nudge does not prohibit certain behaviors. In contrast, it aims to provide an individual with information or a nudge that could push them towards making a certain decision.
One of the most controversial nudges is the 'opt-out' instead of 'opt-in' options. Some of these you can find when a company prompts you to 'opt-out' of any marketing communications. Another example is when individuals are asked to tick a box to 'opt-out' of organ donations.
Behavioral economics examples: magnitude effect
The magnitude effect in behavioral economics refers to how much a magnitude of a certain decision affects an individual's choices or their approach to making choices.
When you are making a choice about whether to eat an additional cookie or not, you are likely to make that choice pretty easily. However, you are likely to put a lot more thought into thinking about how to invest a large sum of your money to generate a return.
Behavioral economics applications
Behavioral economics has applications in all aspects of life. We don’t necessarily have to engage in an economic transaction for behavioral economics to be applicable in our lives. Let’s consider two examples:
At school or work
When you go to work or school, there are certain behaviors that have already been established that influence the decisions you make. For instance, you wouldn’t drink while at work.
When shopping
Gucci and other expensive brands charge really high prices, but most customers come from the upper-middle-income class rather than significantly wealthy people. People associate Gucci with the rich, and they buy it because they believe it says something about them. The high prices make brands like Gucci look exclusive, which pushes people to buy them.
Behavioral Economics - Key takeaways
- Behavioral economics uses psychology and economic theory to draw new explanations for how humans interact in an economy.
- Behavioral economics aims to provide an alternative to conventional economic theory, which assumes that all humans are rational and that their decisions are always optimal.
- Behavioral economics suggests that individuals have bounded rationality and bounded self-control, which limits their ability to make rational decisions.
- Biases in decision-making include availability bias, anchoring, biases based on social norms, habitual behavior, and the rule of thumb bias.
- Behavioral economics can be applied in our daily lives, not just when making economic transactions.
References
- Daniel Kahneman (2011). Thinking, Fast and Slow. Macmillan.
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