What is behavioral economics?
The field of Behavioral Economics blends insights from psychology and economics to help us understand how people make decisions and act in real-life situations. Behavioral Economics studies how people and decisions can be influenced by internal, external, environmental, psychological, and contextual factors, through information-framing and choice architecture (the ways in which information or choices are presented).
Economic theory assumes people will make rational, intelligent, logical decisions, always acting in their own best interests.
Many economic theorists argue that people make choices based on cold hard economic rationality, always keeping in mind their own best, self-interest. However, these arguments are mistaken: Choices are often irrational, and many decisions are strange, illogical, and emotionally-driven. Behavioral Economics shows us that people have inherent, unconscious biases that can influence their decision-making. Using experimentation, Behavioral Economics develops theories that explain both the psychology and economics of decision making and helps identify the biases involved.
Behavioral Economics attempts to assess the underlying reasoning behind irrational decisions.
In other words, Behavioral Economics studies irrational decisions and actions in order to understand them and make them predictable. In today’s widely-accepted terminology, the phrase Behavioral Economics is used as a catch-all term for any study of human psychology crossed with economics that is aimed at observing behavior and influencing people in real-world scenarios.
Behavioral Economics can provide a framework to help us understand the where, when, and why of decision-making, and how people can be influenced throughout the decision-making process.
Every day, in any given situation, the ability to make rational decisions is constrained by multiple factors including cognitive overload, the amount of direct and indirect information presented, the amount of environmental stimuli, information processing and comprehension, attention deficiencies, time constraints, implicit biases, and both internal and external resource limitations. Additionally, choices can be influenced by previous experiences, social influences, psychological perspectives, emotional states, personal motivations, or intimate preferences.
Need-to-Know Behavioral Economics Terms and Ideas
Before diving into some of the concepts, theories, practices, and cognitive biases that Behavioral Economics has uncovered, we’ll quickly cover some of the need-to-know terms and ideas:
In a purely economic world, decision-making would be the result of careful analysis, a weighing of costs and benefits unaffected by external forces. In other words, if we all followed Rational Choice, we would always make optimal, intelligent, logical, decisions, regardless of internal or external influences or how information and solutions were framed.
Bounded Rationality is the theory that cognitive capacity will never be fully rational because of the numerous limitations experienced. These limitations include informational constraints, mental processing (or computational) limitations, external and environmental stimuli, and limitations on time to consider and assess optimizations.
Utility refers to the benefits (value, use, or satisfaction) that are received from a good, product, service, or experience. Utility can be assessed and measured in numerous ways; it is not based only on the direct value a product provides (for example: the perceived, received or intrinsic utility of a pair of designer jeans may be higher than the utilitarian value of a pair of jeans as covering for the lower half of the body).
We tend to make decisions by Satisficing – accepting something that does more than merely suffice, but which does not quite satisfy – rather than maximally optimizing for utility. In short, most decisions end up simply being “good enough” given the situation and all constraints involved.
A Heuristic is a method, a technique, a mental shortcut, or a “rule of thumb” used to help decrease cognitive processing, to simplify decisions, and to solve problems more quickly. Heuristics represent a process of substituting a difficult question with an easier, more familiar one. Heuristic practices may not lead to a perfect (or maximally optimized outcome) but they usually lead to a “good enough” (or satisficing) decision.
Dual-System Theory, developed by Daniel Kahneman and Amos Tversky, states that our minds use two different systems of decision-making: System 1 (Fast) and System 2 (Slow). System 1 consists of our intuitive, automatic, experience-based, relatively unconscious decision-making. System 1 decisions are rooted in past impressions, drawn from our previous experiences, and rely on mental information that is easily accessible. Our System 2 decisions are more thoughtful, reflective, controlled, and analytical. System 2 is more effortful, logical, calculating, and requires information analysis; System 2 decision-making is more cognitively taxing.
Nudging (or nudge theory)
The Nudging (or Nudge Theory) concept proposes that the best ways to influence behavior and decision-making are through pointed suggestions and minute reinforcements (or being “nudged” in a certain direction). Nudging is different from other key ways of influencing behavior, such as educating, legislating, or enforcing. In 2008, University of Chicago economist Richard Thaler and Harvard law professor Cass Sunstein brought Nudge Theory into prominence and defined Nudging as:
“Any aspect of choice architecture that alters people's behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates: Putting fruit at eye level counts as a nudge; banning junk food does not.”
Behavioral Economics and Cognitive Biases
Below is an overview of some of the concepts, theories, practices, and cognitive biases that Behavioral Economics has uncovered. By no means is this list comprehensive and by no means are my explanations or examples exhaustive: There are many other beliefs and theories of behavioral economics not covered below, and some of the concepts summarized in one paragraph are the subject of lengthy articles in thick scientific journals and/or books.
Framing is the way information is conveyed, described, and presented to influence decision-making
Information, choices, and options can be presented in ways that highlight particular aspects of a decision, leading to changes in its perceived attractiveness. Framing a question, proposition, or decision in a certain way can directly influence the expected response. Framing can provide positive or negative significance and can be categorized as falling typically into a Positive Frame or a Negative Frame. The simplest, most-common example of Framing is “the glass is half full” vs. “the glass is half empty.”
Decoy effect (or asymmetrical framing)
Our preferences and behaviors change when presented with a third, similar, but less desirable option
The number of options available when making a choice can influence value assessment and decision-making is known as The Decoy Effect. As an example, the magazine The Economist offered a promotion for access to all its web content for $59, a subscription to the print edition for $125, or a combined print + web subscription, also for $125. When surveyed about this pricing structure; 84 percent of respondents opted for the combination deal and 16 percent for the web subscription. However, when the poll was repeated without the unpopular print-only option, 32 percent chose the print + web option and 68 percent chose the web-only option. In practice, says behavioral economist Dan Ariely, “You can actually introduce products into the market that nobody chooses but nevertheless have effect on what people end up getting.”
Thinking of money, value, and utility in relative terms rather than absolute terms
The core idea of Mental Accounting is that numerous factors affect the way money is viewed and treated: It is not viewed in a strict accounting sense. In other words, twenty dollars is not always twenty dollars. Some factors that influence Mental Accounting include the origin, intended use, and transaction style (cash, credit, gift card, digital currency, etc.) of the money, and its location or availability. For example, we have a greater propensity to spend money more readily if we feel disconnected from it. This disconnect occurs when money comes without effort – finding twenty dollars on the ground, winning twenty dollars at the casino, receiving money on a gift card, or storing money in a digital wallet) – in contrast to the connection felt to money we have earned through work, saved over time, or even have as cash in hand.
Information that is received first creates an imprint in our mind, significantly influencing relative, future decision-making
When we are provided a starting reference point, our subsequent perceptions of value can be influenced and will rely heavily on the first reference point offered. That first reference point is then used as a benchmark for later decisions. For example, a stores may perform Anchoring mechanisms by pricing clothing at $399 then marking it down to $99. This creates the idea that the piece of clothing is expensive, increasing its perceived value and making it more attractive; at the discounted price it is viewed as a great purchase.
People prefer options they are more familiar with
Due to System 1 (Fast) thinking, when we are provided with both familiar information and experiences and those that are less familiar, we are more likely to select those we recognize. When we receive information or are in situations that appear similar to information received or situations experienced in the past – especially when we are experiencing a high cognitive load – we may attempt to decrease cognitive processing by leveraging our Familiarity Heuristic, or accepting the familiar information as a default foundation for decision-making. When information and options are conveyed through familiar framing techniques, we are more likely to default to option types that are more familiar.
Tasks appear easier to handle in smaller pieces
The idea of completing a large-scale task or tackling a complex situation can be overwhelming and cognitively draining; we can be easily deterred from starting (let alone completing) such tasks. By Chunking larger processes into smaller, more convenient, “bite-sized” parts, the ability to process or work on the individual elements of a task increases significantly (and, subsequently, the likelihood of completing the task entirely increases as well).
Information that comes easily to mind has a disproportionate influence
The Availability Heuristic is a mental shortcut relied on to immediately assess information when evaluating a specific topic, concept, method or decision. Judgments tend to be based heavily on more readily available material, making new information more powerful and creating a bias in favor of the most recent information received.
The tendency to over- or underestimate the possibility that unlikely events will occur
Broadly speaking, the Possibility Effect addresses how we tend to either completely ignore or highly overestimate the likelihood of events with only a low probability. If we believe there’s a possibility of a large gain or a large loss, we may behave irrationally, depending upon how risk-seeking or risk-averse we are. A prime example of the Possibility Effect is playing the lottery; the probability of winning is negligible and uncertain, but some of us still play for the possibility of hitting the jackpot. Another example of the Possibility Effect is shown when we choose not to buy travel insurance; the probability of something going awry while traveling is much higher than the probability of winning the lottery, yet a full 50 percent of the U.S. population plays the lottery, but only 21 percent of travelers buy travel insurance.
When items are scare, their perceived value increases
The creation of Scarcity is a well-worn marketing tactic. Limited editions, exclusive deals and short-term availability of products and deals can increase the allure and perceived intrinsic value by triggering the psychological instinct to secure scarce goods or products.
irrational value assessment
Perceived or high-cognitive values can influence decision-making
Irrational Value Assessments occur when perceived value (the psychological element that defines the amount of worth or value a customer ascribes to a product, service, or good) outweighs the actual value. The psychology behind perceived value works like this: The higher something costs, the stronger is the belief in the value of that product, good, or service. Combined with branding and scarcity tactics, Perceived Value helps explain why designer clothes are sold at such a high premium. Irrational Value Assessment operates in conjunction with Perceived Value, in that a higher-priced good, service, or product is perceived as delivering more value than a cheaper, lower-priced good, service, or product.
the paradox of choice
An excessive number of options in a consideration set can lead to cognitive overload, decision paralysis, and worse outcomes
More choices are not always a good thing: Research on The Paradox of Choice shows that an excess of options often leads us to be less – not more – satisfied when making decisions. With more options available the likelihood that we feel we could have made a better decision afterwards increases. Having fewer choices can decrease cognitive overload, decrease decision paralysis, and decrease cognitive dissonance. In a famous study about the Paradox of Choice, a supermarket set up two tests using jam. In the first, shoppers were given a choice between six jams. After trying the different samples, they made purchases 30 percent of the time. In the second test, shoppers were presented with twenty-four different jams. After trying the samples, they ended up making purchases only 3 percent of the time. Afterwards, the shoppers who purchased from the selection of six jams reported lower levels of cognitive dissonance and greater satisfaction.
Planted ideas can influence recall, subconsciously
Priming is a technique used to engage us in a task or expose them to stimuli with the goal of influencing their subsequent preferences. For example, one study primed people with words representing either ‘prestige’ brands (Tiffany, Neiman Marcus, and Nordstrom) or ‘thrift’ brands (Walmart, Kmart, and Dollar Store). Later, in an unrelated task, those who had been primed by initial exposure to the name of prestige brands showed a higher preference for products from the ‘prestige’ brands.
salience (or perceptual salience)
Items that are more prominent receive greater focus (and those that are less so are ignored)
Salience refers to ideas, items, or information that are particularly noticeable or prominent. Information that stands out, is novel, or seems relevant is more likely to affect thinking and actions. Salience also underlies practical judgments that rely on external cues, such as branding and visualization: Brand owners rely on the psychology of salience to simplify consumer decision-making by leveraging branding to extend feelings of quality and consistency across their product line. An option can be made to appear more salient by manipulating or rearranging its environment. For instance, a change as simple as moving products to end caps or near checkout lanes in grocery stores has been shown to increase sales of those products.
status quo bias
The continued preference for the current state
By nature, we don’t like to disrupt the Status Quo (or our existing state of affairs); it’s easier and more comfortable to stick to what is already known. We tend to prefer consistency and hope things will remain the same. Unless there is a compelling incentive to change, it is commonplace to cling to established behaviors. Evidence of this can be found in the formation of habits (which pleases the psychological cravings for reliability, predictability, and consistency).
inertia (or cognitive inertia)
The natural tendency to maintain the status quo
There are four main reasons for our inherent resistance to change: Fear of the Unknown, Mistrust, Loss of Control, and the worry over Timing. In addition, some of us are naturally inclined to resist change more than others. Inertia, the inclination to rely on familiarity and exhibit a reluctance (or inability) to revise assumptions over time, is identified as the main reason why it’s hard to change thoughts, behaviors, and actions: In most cases, Inertia is disrupted on an as-needed basis or during major life events (such as getting married, changing careers, having children, buying a house, etc.)
Seemingly small barriers can easily deter action completion
Friction Costs are speed bumps (or moments of cognitive resistance) that we hit when attempting to complete a specific action, and the cost of that friction can be measured by the fallout of completion. Friction Costs can be measured in terms of resistance; the more resistance we face, the less likely we are to perform a specific task. Reducing friction, removing hurdles, and eliminating roadblocks creates a better experience which we are more inclined to complete. Conversely, small moments of friction can be useful when attempting to deter or hinder undesirable behaviors.
The tendency to choose the default or easiest option, the one that follows the path of least resistance
Defaults provide us with a signal for what we are supposed to do, this helps us infer what the “automatic” or “preferred setting” should be and helps us avoid cognitive overload when making complex decisions. When marketers, advertisers or brand owners set defaults to a preferred outcome, they can guide consumers, especially those who are undecided or uncertain, in a certain direction.
The pain of losing is more powerful than the pleasure of gaining
Estimates vary on its true psychological impact, but the fear of economic losses is thought to be twice as powerful in decision-making as the promise of economic gains. As an example of Loss Aversion, losing $10,000 is twice as psychologically powerful to us as the prospect of gaining $10,000. We are more willing to take risks to avoid economic losses than to pursue economic gains. For this reason, marketers and advertisers often promote products in ways that demonstrate how to avoid losses instead of conveying gains.
Discounted utility model
Sooner not later; the closer in time the reward, the higher the value assigned
When it comes to the Discounted Utility Model, the old proverb says it best: A bird in the hand is worth two in the bush. We favor current rewards over delayed rewards of similar (or greater) magnitude. The value of the reward must increase as the timing of the reward becomes more distant in order to preserve its utility.
Seeking approval, validation, affirmation, or confirmation from others throughout our decision-making
We often look to others for signals of social acceptance, or Social Proof. While traditional word-of-mouth reviews can help increase a customer base, online and social reviews (such as on Facebook, Yelp, or Amazon) are also important as providing Social Proof to customers. According to a BrightLocal survey, positive online reviews are viewed as trustworthy: 72 percent of respondents said that positive online reviews increased their trust in a company (or product), and 88 percent said that online reviews are as trustworthy as personal recommendations, indicating the incredible strength of Social Proof.
Claimed motivations often differ from actual motivations
We use social norms and social proof combined with self-projectionism (how we want to be viewed by others) as external guidelines for decision-making. Because of the Do-Say Principle, many times our perceptions of what motivates us are inaccurate representations of what actually motivates us. Take, for example, studies based around job satisfaction: Although a majority of workers indicate money is a key motivator in decision-making, researchers identified several motivators that are more effective than money at influencing behavior. Some key “‘Do” motivators include status elevation, emotional commitment, pride, and a sense of ownership, but these are rarely what people “Say” is motivating to them.
behavioral economics, in summary
Behavioral Economics is changing how economists, marketers, advertisers, planners, and strategists think about perceptions, preferences, motivations, actions, behaviors, and assessments of value.
According to Behavioral Economics, people are not always interested in maximizing benefits, optimizing value, and minimizing costs. Decision-making is typically not the result of careful economic deliberation (more on the Modern Consumer Decision-Making Journey, here). We are influenced by available information, memories, and external factors. We prefer to live in the moment, are resistant to change, are poor predictors of future behavior, are subject to distorted memory, information overload, and can be affected by physiological and emotional states. Finally, we are social animals with social preferences, such as those expressed in trust, reciprocity and fairness; we are susceptible to social norms and a need for self-consistency.
The next time you think you’re making an entirely rational, un-influenced decision – Chances are that your “rational” decision is the result of cognitive bias.
additional reading for a deeper understanding of behavioral economics:
Nudge: Improving Decisions About Health, Wealth, and Happiness by Richard H. Thaler and Cass R. Sunstein
Thinking, Fast and Slow by Daniel Kahneman
The Power of Habit: Why We Do What We Do in Life and Business by Charles Duhigg
Influence: How and Why People Agree to Things by Robert B. Cialdini
Pre-Suasion: A Revolutionary Way to Influence and Persuade by Robert B. Cialdini
Decisive: How to Make Better Choices in Life and Work by Chip Heath and Dan Heath
Misbehaving: The Making of Behavioral Economics by Richard H. Thaler
The Undoing Project: A Friendship That Changed Our Minds by Michael Lewis
“Economists think about what people ought to do. Psychologists watch what they actually do.”
- Daniel Kahneman