Behavioral Economics: Study of irrational human in Economics
When law breaks
Newton made physics so well that you can use his theories to solve H.C.Verma’s free body diagram questions and complete your deep space/sea exploration as well.
But in many places, it fails because of one assumption, Single Gravitational Force.
In space, you have more than one gravitational force. So, the result would be based on Eistince’s relative theory. At the microscopic level, where atoms are not affected by gravitational force but electronic force, we have Quantum physics.
A similar case can be seen in economics as well.
Concepts of economics might be true at the institution or organization level but when you try to apply those concepts to individual consumers, it might fail.
The assumption is that consumers are rational.
But that’s not the case always. Humans are not rational and maximum benefit-seeking robots. There are a lot of things that affect our behaviors and decisions and the logic behind those behaviors is studied in Behavioural Economics.
Behavioral economics
For years traditional economics has had a blind spot in consumer decision making and behavioral economics tries to fix that.
It is a sub-field of economics that focuses on psychological, social and emotional factors that influence decision making. It is applied in various fields like marketing, finance, political science and public policy. It does not go against classical economics, just adds a layer of complexity.
Traditional economics says that consumers follow a few steps when they are buying anything. First, they gather all relevant information, then evaluate that information, then think about the pros and cons of that information and then consider making rational, utility-maximizing decisions.
Behavioral economics doesn’t deny this. It just says that this is not always the case.
Consumers are not always rational and look for maximum profit. But consumers are what you can say, bounded rational.
They are bounded by time, choice and information. They might not have enough time to make decisions, how traditional economics suggests. Maybe there are too many choices that evaluating the pros and cost of those choices just feel too much work. Maybe the information available is not clear, maybe they are not accurate or maybe not even present to take a decision.
Behavioral economics doesn’t break traditional economics but it tries to understand when and why people behave differently than an economic modal suggests.
Framing
If people were entirely rational they would constantly make the same decision given identical options. But sometimes people’s preferences are dependent on how the options are presented. Psychology call this The Framing effect and it’s a bias.
Classic economics generally assumes people are rational and predictable, but in most cases, they are not.
“Lack of information” Send Signals to our brain and it can change perception. Contrary to basic assumptions of economics, marketing actions can successfully affect pleasantness by manipulating some values of goods.
For example, given a decent wine, increasing the price of the wine may actually create a demand, because people perceive wines with higher tags to be good wines. So, by increasing the price they can increase the demand also, which is opposite of what classical economics suggests. The idea that perception and passions influence our decisions also applies in finance, which explains the 2008 Financial Crisis in the US.
Let’s take another example, you are filing a form in a hospital and at the end of it, you have one question about organ donation.
Among these 2 options, which one do you think will lead to more organ donation?
1. Check the box, if you don’t want to donate your organs when you die.
2. Check the box, if you want to donate your organs when you die.
Hospitals/Governments that want more participation from the public in organ donation, will go for option 1. Removing friction from Your desired and User’s expected default action gives you a +ve response.
Discounts or price ends with 9 is also part of the framing strategy. This is mostly done by giving discounts or little alteration in price, so that you feel you feel like you are getting more value at less price, except in high-end stores. They raise prices to increase value.
The latest and most trendy example is ‘No-cost EMI’. If there was a cost on the EMI of the product, would you have purchased iPhone12 Pro or settled with older models where you have to pay full price while buying it?
Companies are getting better value by not collecting interest on EMI.
Decision making
As I’ve said we are not fully rational but bounded rational. Maybe we are bounded by self-control. Everyone knows consuming too much sugar, fast food, nicotine and social media(look at your screen time) is not good for us, unless you are working for such companies. But still, we do not take decisions that are in the best of self-interest. Why? We have all accurate information at our thumb but we still don’t take profit-maximizing decisions. Because we are bounded by self-control.
The utility might be sacrificed but that’s still a satisfactory outcome will be at the end of a decision. A Decision that is easy for consumers to make will always be more acceptable.
That is why websites/products try to keep minimum fields in their sign-up forms because it leads to more conversion.
Suppose you have a choice of two sealed envelopes.
One has 10,000Rs, and one is empty. You can choose an envelope, or you can take 5000Rs cash right now. So do you take the 5000Rs?
Or what about 4900Rs? Now, this is unlikely to happen to you in real life, but the exercise is about your attitude towards risk. Since there’s a 50/50 chance of getting 10000Rs or nothing, the expected return, or the average of the possible outcomes is 5000Rs. If you’re willing to accept 5000Rs cash to abandon the envelopes, then you are risk-neutral. But If you accept less than 5000Rs, just to avoid walking away with nothing, then you’re risk-averse.
Studies by Behavioral Economists about risk and loss aversion suggest that people strongly want to avoid losing.
The study suggests that people feel losses are more painful than gains are pleasurable.
So people might choose the safe course of action even if it’s not the most logical choice.
For example, loss aversion can help incentivize employees. Researchers subdivided a group of workers into 3 groups. The first group was a control group and was not given any bonus. The second group was promised a bonus at the end of the year based on performance. The third group was given the bonus at the start of the year and they were told they have to pay it back if they didn’t meet specific goals. The workers in the first and second groups performed about the same. But the ones in the third group performed significantly better. So people hate losing and account for emotion gives us a realistic view of how people actually behave.
Final Note
Humans are emotional. That’s makes us more alive and different from machines. Our body and brain are one of the biggest mysteries world’s best geniuses are interested in.
As it’s been said, the world’s biggest geniuses are either sending people in space, saving lives or making us click more on the screen.
Those clickbait people are experts of human emotions.
Corporations are masters of behavioral economics. They know what will make consumers behave irrationally and against their own interests and they capitalize on that. They know that they have an information advantage over essentially everyone, and they capitalize on that.
Why does a plain white Gucci T-shirt cost $630?
