Behavioral economics looks at how psychology affects economic decision-making – how our thoughts and emotions may affect how we make decisions about money. It explores why individuals sometimes make irrational decisions, and why and how what they do may not follow forecasts made using economic models.
Behavioral economists try to develop models which account for the fact that we are impatient, procrastinate, and do not always make the best choice when decisions are hard – sometimes we even completely avoid making a decision.
Unlike traditional economics, behavioral economics takes into account that humans rarely make decisions rationally. For example, prospect theory shows how we place more weight on an unpleasant event than its equivalent pleasant event. Rational expectations theory shows that humans analyze all available data before making predictions about the future – which are surprisingly accurate.
What makes people go for special offers? Why do consumers get so much in debt? Why do so many of us continue eating junk food when all around us we’re being told it’s bad for the health?
How we spend our money is influenced by a vast range of factors, such as what other people are doing or have done, past behavior, offers and promotions, what is available, social norms, beliefs, brand perceptions, etc.
A relatively new field
Behavioral economics is a relatively new field and has emerged as an important area of modern economics, as well as the social sciences more generally. Companies have long known the limitations of individual decision-making and regularly use this knowledge in their commercial practices.
Behavioral economics came to the fore when Professor Daniel Kahneman, an Israeli-American psychologist, was awarded the 2002 Nobel Memorial Prize in Economic Sciences (shared with Vernon L. Smith). His empirical findings directly challenged the assumption of human rationality that prevailed in modern economic theory.
Prof. Kahneman’s award led to a huge explosion of interest in behavioral economics.
“The practical implications of behavioral economics are varied and significant, and acknowledged to provide a powerful and cost-effective approach to improving human welfare.”
Marketers have been behavioral economists for a long time
According to Ned Welch, a senior practice expert at the American multinational management consulting firm McKinsey & Company, marketers had been using behavioral economics before there was a name for it.
‘Three for the price of two’ offers and extended-payment layaway plans grew, not because marketers had run scientific studies showing that people prefer a supposedly free incentive to an equivalent price discount, but because they worked.
However, despite marketers inadvertently using elements of behavioral economics, very few companies used them in a systematic way.
According to traditional economic principle, we all experience the same level of pain for every dollar we spend. In reality, however, several factors influence how we value a dollar and how much pain we feel upon spending it.
Businesses know that allowing shoppers to delay payment can significantly increase their willingness to buy. Economic models will tell us that delayed payment works because future payments make the whole process less costly.
There is, however, also a less rational reason people like to pay later. We don’t like paying – it hurts. A delay in payment means we can enjoy the purchase now while not immediately experiencing the sting of having to pay.
Mr. Welch wrote:
“Marketers have long been aware that irrationality helps shape consumer behavior. Behavioral economics can make that irrationality more predictable. Understanding exactly how small changes to the details of an offer can influence the way people react to it is crucial to unlocking significant value—often at very low cost.”
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