What is Behavioral Economics?

You’re not perfect.

You’re not alone. Ever feel torn between immediate gratification and making a sensible decision? We like to believe we’re rational and intelligent, making decisions in our best interest. Reality shows otherwise.

You might have noticed the term, “Behavioral Economics” in conversation. Maybe you heard Richard Thaler won the 2017 Nobel Memorial Prize in Economic Sciences this past October.

What is behavioral economics?

Behavioral economics can help people make better decisions and habits; ones that lead to happier, healthier lives. By blending psychology and economics, it provides insights to why we don’t act in our own best interests. It exposes the flaws and biases that influence our actions.

Thaler’s research helped pioneer the field of behavioral economics. Thaler and Cass Sutton published Nudge: Improving Decisions about Health, Wealth and Happiness in 2008. They explained that subtle nudges can encourage better decisions, especially when planning long-term. They also outlined others ways we unconsciously betray ourselves.

These are some of the main ways we sabotage ourselves when making decisions:

 
 Illustration of the concept of loss aversion (pain from loss outweighing pleasure from gain.  Image credit, New York Times

Illustration of the concept of loss aversion (pain from loss outweighing pleasure from gain. Image credit, New York Times

 

Endowment Effect and Loss Aversion

We tend to value things more when they own them. Thaler described this as the Endowment Effect. This bias occurs when we overvalue a good that we own, regardless of its market value. Symbolic, experiential, or emotional values come into play here. You’re more likely to sell something you own at a higher price than what you would be willing to pay to buy the same thing.

The Endowment Effect links to another important concept of behavioral economics: Loss Aversion.

Would you rather get a $5 discount, or avoid a $5 surcharge? The pain of losing is can be psychologically twice as powerful as the pleasure of gaining. People are more willing to take risks to avoid a loss than to take one for a similar gain. Trial offers are another embodiment of this. Once accustomed to having something, you’re more likely to pay to keep it than to pay for it from the beginning.

 
 

Status Quo Bias

People are more likely to stick with the status quo, even if big potential gains involve little cost. Many prefer things to stay the same by doing nothing or by sticking with a previous decision
 Loss aversion comes into play, but changing defaults can have a huge effect.

You’re less likely to enroll in a retirement plan if you need to chose to do it. If you are automatically enrolled in a retirement savings plan, you’re less likely to opt out. Status Quo Bias means once you’re in, you’re less likely to leave.

 
 Illustration of the Availability Heuristic.  Image Credit, James Clear

Illustration of the Availability Heuristic. Image Credit, James Clear

 

Availability heuristic

The easier it is to remember something, the greater it’s importance is perceived to be. People tend to weigh their judgments toward more recent information. It leads towards making opinions biased on the latest news heard.

The Availability heuristic is a notion that often comes into play with marketing. Put something in front of people often enough, it stays readily in their mind. Need car insurance? Who are you going to check first?

 
 Netflix’s next episode auto-play is an example of a nudge to have you continue watching.  Screenshot (featuring Stranger Things), Netflix

Netflix’s next episode auto-play is an example of a nudge to have you continue watching. Screenshot (featuring Stranger Things), Netflix

Nudges

Let’s go back to feeling torn between immediate gratification and making sensible decisions. It’s an internal struggle between your “planning” and “doing” selves. You might plan to save more for retirement or go to the gym every day, but there’s this other thing right here, now, that would be fun. This is where nudges come in.

Thaler and Sunstein pioneered the idea of using nudges to promote good long-term decision making while maintaining freedom of choice. One method of doing this is changing your default option. Switching a retirement plan from opt-in to opt-out is an example of this. Since their study and publication, this has become a growing factor in public policy. Over 50 countries now have centralized “nudge units” influenced by behavioral sciences. They’ve made strives in areas like retirement savings and organ donation.

Be mindful that if misused nudges can be manipulative and a detriment to individuals. They should benefit both parties involved. That is the use Thaler and Sunstein argue for in Nudge. They should be transparent and never misleading. It should be easy to opt out. Nudges should be driven by the belief that the behavior encouraged will improve the welfare of those being nudged.

With the rise of human-centered design and design thinking into the general consciousness, it’s not surprising to see interest in behavioral economics grow. Like those concepts, behavioral economics brings focus back to people. It attempts to integrate psychologists’ understanding of human behavior into economic analysis. It can guide toward more healthy behaviors by correcting cognitive and emotional barriers.

It acknowledges that we often make errors and need a nudge to guide us towards making decisions in our own best interest. By understanding where we go wrong, we can better help ourselves go right.

Nick Di Stefano