History of Behavioral Economics

Notable individuals in the study of behavioral economics are Nobel laureates Gary Becker (motives, consumer mistakes; 1992), Herbert Simon (bounded rationality; 1978), Daniel Kahneman (illusion of validity, anchoring bias; 2002), George Akerlof (procrastination; 2001), and Richard H. Thaler (nudging, 2017).

In the 18th century, Adam Smith noted that people are often overconfident in their abilities, noting “the chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.” ” 1 In this sense, Smith believed individuals were not rational with their limitations.

More recently, behavioral economics took shape as early as the 1960s, when several economists identified fundamental biases when recalling information. Amos Tversky and Daniel Kahneman explained this idea, called the availability heuristic, and how it leads individuals to interpret data irrationally.2 For example, shark attacks tend to happen less than people think, but headlines may make people feel otherwise. Tversky and Kahneman are also credited with developing prospect theory, which explains how people are potentially more averse to losses than receiving an equal win.

Even more recently, Richard Thaler received the Sveriges Riksbank Prize in Economics Science in 2017 for identifying factors that guide individuals’ economic decision-making.3 Thaler’s work included limited rationality, social preferences, a lack of self-control, and individual decision-making.

Factors That Influence Behavior

Often, five factors are cited when analyzing how individual behavior is influenced.

Bounded Rationality

Bounded rationality is the concept in which individuals make decisions based on their knowledge. Unfortunately, this information is often limited by the individual’s lack of expertise or available information. Regarding finance and investing, the same public information is available to everyone, though investors may not know the actual circumstances of what is happening with a company internally.

Choice Architecture

People can be easily manipulated, often displayed in how promoters craft incentives or deals to make consumers buy certain products. Consider how a cracker display may be next to a supermarket’s cheese aisle. This type of design is meant to steer a consumer into making a decision based on a choreographed demonstration, often between complementary goods.

Cognitive Bias

Whether people realize it or not, people make decisions influenced by cognitive bias. Consider the choice between two companies to invest in. Behavioral economics holds the theory that the logo’s color, the CEO’s name, or the city in which each company is headquartered may stir up an unknown bias that causes us to choose the other company.

Discrimination

In a similar light, behavioral economics is often associated with discrimination. People perceive things, events, or other people through their lenses, potentially discriminating against others because they favor a different alternative. This does not necessarily mean the alternative is a better option, though.

Herd Mentality

Many consumer decisions are influenced by what other people are doing. Whether it is the fear of missing out or whether others want to be part of a larger collective, herd mentality is the belief that individual decisions are based on what other people do, not necessarily on the best outcome. After all, it is much easier to root for your favorite team, even if they haven’t won a championship in a while, as long as other fans share your pain.

Principals of Behavioral Economics

The field of economics is vast. Although behavioral economics is just a subset of the field, it has several guiding principles that dictate the themes within behavioral economics. Some of the primary principles and themes are listed below.

Framing

Framing is the principle of how something is presented to an individual. This behavioral economics concept presents a cognitive bias in that an outcome may be determined based on the structure of how something has been presented. Consider how someone may feel about the two following statements about Babe Ruth, both of which describe the same thing:

1. Babe Ruth failed to get a hit in nearly two-thirds of his at-bats.
2. Babe Ruth, one of the greatest baseball players of all time, hit .342 in his lifetime.4

Heuristics

Heuristics is a complicated field, but it simply means that humans tend to make decisions using mental shortcuts instead of long, rational, optimal reasoning. People often latch onto something true that may no longer be the case. In this situation, it’s easier for the consumer to continue what they’ve been doing than to realize a more beneficial situation exists.

Loss Aversion

Behavioral economics is rooted in the notion that people do not like losses. People are loss-averse to the point that the economic outcome of one negative financial value outweighs the emotional toll of the same positive financial value. For example, some people feel much stronger negative emotions associated with losing a $20 bill than finding a $20 bill on the ground.

Market Inefficiencies

For lack of a better phrase, the market can take advantage of behavior economics. For this reason, market inefficiencies play a crucial role in behavior economics. Consider how overpriced stocks may still lure investors in due to drops in P/E ratios. Though the trading multiple may still be abnormally high, investors may think something in the market is more reasonable simply because it is lower. For example, a stock worth $20 may be trading at $50. Should the price be $40, investors may feel this is a great opportunity.

Mental Accounting

Consumers and investors may change their spending and trading tendencies based on circumstances. Though this is fair, often it is illogical and shapes many aspects of behavioral economics. For example, after receiving one’s annual bonus, an investor may choose to invest in riskier stocks. This mental accounting exercise led investors to decide based on their circumstances, not their long-term strategy.

Sunk-Cost Fallacy

The sunk-cost fallacy is the emotional attachment to costs incurred in the past. Consumers and investors have difficulty “letting go” of failed investments or committed capital. Consider a failed stock purchased at $100/share worth $15/share. An investor may not feel compelled to buy in at $15 per share because they think the company is not worth that. However, they are unwilling to sell their shares bought at $100 per share due to an emotional attachment to that committed capital.

Applications of Behavioral Economics

Financial Markets

One field in which behavioral economics can be applied is behavioral finance, which seeks to explain why investors make rash decisions when trading in the capital markets. Much like how poker professionals not only study the mathematics and odds of poker, they also attempt to capitalize on the irrational nature of other players. The same can be said of financial markets.

Game Theory

When a decision is made, it leads to error; heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game theory, can also be applied to behavioral economics, as game theory runs experiments and analyzes people’s decisions to make irrational choices. This concept attempts to override illogical behavior to predict consumption outcomes.

Pricing Strategies

Companies are increasingly incorporating behavioral economics to increase sales of their products. In 2007, the price of the 8GB iPhone was introduced at $600 and quickly reduced to $400. By introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal, even if the product’s actual value was only $400.

Product Packaging and Distribution

Consider a soap manufacturer that produces the same soap but markets it in two packages to appeal to multiple target groups. One package advertises the soap for all users, and the other is for consumers with sensitive skin. The latter target would not have purchased the product if the package did not specify that the soap was for sensitive skin. They opt for the soap with the sensitive skin label even though it’s’ the same product in the general package.

Examples of Behavioral Economics

Payless shoes may be known for their “buy one, get one” deals. The second pair is often discounted if a consumer purchases one pair of shoes. Though a consumer may not need two pairs of shoes, they may be unwilling to part ways with a discount.

One form of loss aversion and scarcity is Amazon’s Lightning Deals. A consumer may not be willing to part ways with a product they don’t even know about. Because these Amazon deals are for a limited time only, a consumer faces the behavioral economic dilemma of buying the product or “losing” it. The seasonality of Starbucks’ drinks is another example of a product consumers must buy now or miss out on.

Last, turn on your television, and almost every commercial contains framing. Note how car advertisements or splash pages like Tesla’s website for its Model Y only point out the vehicle’s strengths.7

Behavioral economics is the field of understanding why people do things financially that may be irrational. Blended between cognitive bias, heuristics, bounded rationalities, and herd mentality, people tend to do things that may not always be in their best interest. This information can be used to price goods, package products, craft commercials, and generate promotional deals.