Behavioral Economics and How It Can Impact Your Life
Everything you need to know about behavioral economics and how you can use principles of behavioral economics to benefit your own life.
What is Behavioral Economics?
Traditionally, classical economics was taught as if human behavior was black and white. Predictions about consumer decisions were cemented in concrete binaries that attempted to describe consumer behavior. In reality however, these predictions gravely missed the mark. They underestimated the complexities of human behavior and thus made for unrealistic modeling.
The Banana Stand Paradigm
The theory of competition is the perfect example of this. If there is a person on a street corner selling bananas for $2 each, he can continue selling at this exorbitant price because his consumers don’t have options. However, let’s say another fruit seller sets up their stand on the next corner and sells bananas for $1 each. According to traditional economic theory, the first seller would presumably no longer be able to price his bananas at such at $2 because people now have the agency to buy from a lower priced distributor.
This concept of competition and how it drives down prices for consumers is generally accurate. We see it at work everyday in our marketplace and it is the very foundation of our capitalist system. However, the theory doesn’t always explain all of economic practices. This is because at the end of the day, people’s behaviors are inherently unpredictable.
Going back to the banana example, people might be deterred from buying at the lower price stand because they believe that higher prices indicate higher quality goods. Thus, many people might continue to buy from the higher priced vendor simply because they believe, whether grounded in fact or not, that the quality of the bananas are better.
Alternatively, but equally as possible, people might have gotten into a routine and identify the banana stand as their stand and, though prices somewhere else might be cheaper, they do not want to interfere with habitual routine that has proven successful for them. This relates to the inherent opposition to change that many people experience. They might have a relationship with the higher priced vendor, perhaps he is the son of a family friend or a neighbor, and thus feel an obligation to remain a loyal customer regardless of price.
All of these reasons and more only begin to introduce the complexities that are ignored when relying solely on a classical economics theories. The inherent flaw in relying on classical economic models is that they expect consumers to be completely rational and always make decisions based on logic. However, in reality, people have many other factors that cloud their judgement and complicate the decision-making process, for better or for worse. Classical economics theories don’t take into account the emotions, ability, time, or access to information that contribute to a consumer’s decision.
To be clear, this is not to say that classical economics models should not be used. These models provide the crucial broad-scoped picture of how humans behave and make decisions to a certain extent. However, incorporating behavioral economics principles provides a more holistic picture and introduces vital nuances that provide insight into making the mysteries of consumer decisions less unpredictable.
De-Mystifying the Unpredictable Consumer
Economists have used predictable models that describe human behavior with relation to consumption based on rationality. However, this method is highly unsuccessful due to the fact that people make irrational decisions a lot of the time. To address these inconsistencies, economists developed the theory of “Bounded Rationality,” which is the idea that people can only make rational decisions to a certain extent due to limited information, time, and abilities that might prevent a person from obtaining the best possible outcome. Here I will break down each of the three most influential limitations consumers face and how they affect our understanding of economics.
Outside Factors That Affect Decision-Making
Classical economic theories assume that consumers can quickly access information about competing prices and quality for a certain product. However, this is not the case. Prices often change perception. The result of this is two-fold. In some cases, consumers simply do not know that another cheaper option exists and thus, they continue to buy the more expensive product due to their lack of awareness that they indeed have other options.
The second scenario is that often times consumers cannot obtain reliable, credible information about the quality of the goods they are purchasing. Consequently, they rely on prices to accurately describe the quality of a product. If a consumer sees a bag of chips at the supermarket for a suspiciously low price, they might believe that they won’t taste good.
The Wine Test
A study in California experimented with just this concept. The researchers served people different wines, telling them only the name of the wine and its price. They had the people taste the wine and afterwards, did brain scans to determine the level of experienced pleasure from drinking the wine. They found that people experienced significantly higher perceived pleasure after drinking the more expensive wines, even if they actually weren’t.
The researchers decided to take the experiment one step further and serve the same wine to each participant twice, at non consecutive times, telling them that it was a low price one time and a high price for the second time.
They found that the perceived increase of the price actually increased the level of enjoyment for consumers, even when it was the exact same wine being served. The economists concluded, “Contrary to the basic assumptions of economics, marketing actions can successfully affect experienced pleasantness manipulating non-intrinsic attributes of goods.”
This experiment doesn’t completely undermine fundamental laws of classical economics, it just explains certain reasonings for why people would do things differently than expected. Certain marketing tactics can use these aspects of what we now call behavioral economics to their advantage by addressing and anticipating the nuances that are present in the consumers’ decision making processes to effectively have their product reach the intended consumer. Two such tactics include psychological pricing and nudge theory.
Psychological pricing is a marketing strategy that takes into account the way in which price affects consumers’ perceived value of a product. The main tenet of this strategy is that it makes people feel like they are always getting a high quality product at a reasonable price. The actual execution of this strategy can play out in a number of different ways. For example, convenient stores might advertise certain products for just $19.99 because even though it is just one cent away from being $20, it makes the item seem cheaper. On the flip side, designer stores always price their products at whole numbers rather than cents to show their customers that the goods are for those belonging to an elite class that does not care for cheap deals and rather prioritizes quality.
A third example is seen in payment plans where a company chooses to have an option to have 4 payments of $25, for example, rather than paying $100 upfront. This makes the consumer feel more secure because even if they are paying the same price at the end of the day, they are only obligated to due it in small sums at a time.
This tactic is seen more and more in retail shopping, as now more than ever before there are options by companies like afterpay that allow interest-free payments that reduce the immediate cost of purchasing an item online.
Another important marketing strategy utilized by companies to turn a profit and target a consumer population relies on what is known as the “Nudge Theory.” The goal of the strategy is to make people act a certain way without changing the options that are available to them. This strategy will use very specific diction in their advertising so that their product appears as desirable as possible. Nudge theory can be seen at work when companies intentionally market a product as “25% less fat in Caesar’s salad dressing” rather than “75% fat in Caesar’s salad dressing.” Effectively, the two advertisements are saying the same thing, that there is less fat in the lite salad dressing option, but it is doing so in a way that nudges the consumer to buy the product. In this way, the nudge theory is helping companies actively apply behavioral economics principles to better market their product.
Classical economics models describe people in terms of binary systems, there are many limitations to this method. In reality, people have many different factors that complicate their lives and thus complicate their decisions as well. They often cannot be described in such simple terms. Instead, the utilization of behavioral economics strategies give further insight into the decisions we make on a daily basis. By identifying necessary factors that affect a person’s psyche, one can better predict the way that they will behave in any setting. From lack of information to opposition to change, there are a number of factors that render many of the principles of classical economics unreliable in application.
Applications of Behavioral Economics
The power of behavioral economics is truly remarkable. The insight that one gains from utilizing behavioral economics models can lead to huge improvements in efficiency and quality of outcomes.
One example of behavioral economics at work is using small data rather than big data to study certain population behavior. Traditionally, companies would gather huge quantities of data in order to obtain feedback about their consumers and business practices to improve their product. However, many have found that gathering small quantities of precise data based on behavioral economics strategies that actually prove most effective. For example, this might involve including consumers’ face-to-face interactions with sellers as well as post-purchase outcomes in the data collection. Through this method, the company gains insight into the psyche of their consumers and how to best service them.
Another way one can apply behavioral economics is by understanding the theory of loss aversion to predict the behavior of people. When it comes down to it, people hate losing. This has huge implications in instituting policies. For example, in California, a policy was instituted in an effort to have people use less plastic by giving five cent bonuses to people who shopped with reusable bags. The policy had almost no effect whatsoever.
On the other hand, when the state imposed a 5 cent tax when people used plastic bags, the use of bags decreased dramatically. This can be explained by loss aversion, the idea that people hate losing. What got people to change their habits was imposing a risk of losing rather than an opportunity for a bonus. With understanding of how powerful loss aversion is and what a large role it plays, especially in the execution of policy, powerful changes can be made.
Using Behavioral Economics To Your Benefit
So now you may be wondering, how can I use this insight about how people make decisions to improve my own life? Well, the answer is clear and simple. At its core, behavioral economics breaks down the psyche of a person. It strives to explain the unpredictable, straying from the classical use of binaries in economic theories to dive deeper into the nuances integral to the way people make decisions, carry out tasks, and perform overall. At the end of the day, where behavioral economics really holds its power is providing insight to managing bodies about the intricacies of their often times unpredictable business tasks. In this way, behavioral economics holds the power to change the way that systems work and secure employers to reduce unpredictability and ensure that every operation is executed successfully and effectively.
One example of this is SafeMode, a startup company that is using its expertise in data collection, analysis, and innovative AI algorithms to decrease the unpredictability integral to something we do everyday and at great risk; driving. SafeMode strives to document and improve driving behavior by using this understanding of human psyche illuminated by behavioral economics techniques. Using SafeMode, drivers can receive feedback regarding their driving behavior and use this information to stay more alert, reduce texting while driving, and improve overall safety. By applying a behaviorally predictive AI layer, SafeMode seeks to predict human drivers' next actions for better autonomous decision making. Learn more at their website.