Sep 28, 2020

The Importance Of Behavioral Economics

In countless studies over the course of hundreds of years, economists have based their economic models on the assumption of perfect rationality - the premise that humans always act logically, and make their decisions with the sole aim of maximizing their utility.

As Professor Richard Thaler (Nobel Prize Winner for Economic Sciences 2017 for his work in Behavioral Economics) says that economic theory has been laid down for ‘Econs’ or Homo Economicus, a fictional species that is always rational and optimizing.

However, based on anyone’s own life experience it is clear that humans are more prone to be emotional and spontaneous than perfectly rational. Incredible revolutionizing research by economists and psychologists such as Herbert Simon, Daniel Kahneman, and Amos Tversky, who have all earned the Nobel Prize for Economics, has proven that the human brain utilizes heuristics to cope with complex tasks leading to systematic biases. Humans aren’t always rational. 

“No ‘Econ’ will buy a particularly large portion of whatever will be served in dinner on Tuesday because he happens to be hungry when shopping on Sunday. Your hunger on Sunday should be irrelevant to choosing the size of your meal for Tuesday. An ‘Econ’ would not finish that huge meal on Tuesday, even though he’s no longer hungry, just because he paid for it and hates waste. To an Econ, the price paid for some food item in the past is not relevant in making a decision about how much to eat now.”

An excerpt from Misbehaving, by Sir Richard Thaler

For example, in the image below which line is longer?

The answer may seem obvious - how could it not be the top one?

But the lines are in fact the same length. This is called the Muller-Lyer illusion.

In reality, companies frequently employ techniques that exploit the mind in an effort to convince the customer to spend more. For example, to take a commonplace example, nearly every price tag ends with 99 cents. This technique plays on the brain’s biases of reading from left to right. The brain naturally places a greater emphasis and importance on the first digit, so when comparing prices between $3.99 and $4, despite a 1 cent difference in pricing, the product at $3.99 sells exponentially better.

Here’s another question for you: would you rather choose to have a 100% chance of earning $100,000 or a 10% chance of earning $10,000,000? Most would say they prefer to take the safe $100,000, however, any statistician would quickly point out that the expected return of option 1 is only $100,000 while option 2 has an expected payout of $1,000,000.

Thus, any rational human would immediately choose option 2 without a second of hesitation. This example demonstrates the economic theory of loss aversion. It is believed that a human’s pain of losing something is twice the magnitude of the pleasure of gaining something, thus the thought of losing $100,000 is greater than the thought of gaining $1,000,000.

Thus, any business policies that are enacted must take into account the behavioral economic aspects. For example, when prompting drivers to give their mileage that affects their insurance premiums by placing the honesty signature at the top of the form rather than the bottom drivers are much more likely to declare their mileage honestly.

Another heuristic is the sunk cost fallacy. For example, why do humans who order too much and insist on finishing their entire meal even when they're completely stuffed making another bite painful to swallow? If humans are completely rational then they would choose to stop eating rather than suffer, however, humans are wired to eat more than they can in order to get their money’s worth. This applies to countless businesses who even when operating a substantial loss, the owners would still push to continue the sinking business due to having already invested time and money into the company, which makes no economic sense.

These quirks have massive impacts on the economy as a whole. Economists can use these heuristics to nudge the populace into making decisions that will benefit society as a whole.

For example, any driver knows that they can choose to either opt-in to be an organ donor or opt-out. Even in this simple case, psychologists can still influence one’s decision. In countries with the highest opt-in donor rate, they employ an opt-out policy, where upon birth they are automatically organ donors but can choose to opt-out leading to a substantially greater number of donors. This in turn allows countless lives to be saved through organ donations. And therein lies the powerful and crucial importance of behavioral economics.

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