Basic Principles of Behavioral Economics

The roots of behavioral economics can be traced back to the 18th century, when economist Adam Smith noted that human decision making is often influenced by overconfidence, loss aversion, and a lack of self-control. Since then, these observations have been formalized by the likes of Herbert Simon, Daniel Kahneman, and Richard Thaler.

In behavioral economics, Homo Psychologicus, not Homo Economicus, takes center stage. This is a significant shift in perspective. While Homo Economicus is a rational, self-interested actor, Homo Psychologicus is more complex. Driven by emotions, biases, and social context, Homo Psychologicus does not always make optimal decisions. This more nuanced interpretation of human behavior forms the basis of behavioral economics.

With Homo Psychologicus as its model, behavioral economics acknowledges the complexity and variability of human decision making. It recognizes that humans are not always rational but are influenced by a range of factors, many of which are emotional or psychological in nature.

Introduced by Herbert Simon, the concept of Bounded Rationality proposes that human decision making can never be fully rational the way traditional economics suggests. Some decision problems are too complex, opening up a universe of considerations. Other times, situations require snap decisions, denying us the time needed to carefully consider all options. Additionally, our cognitive facilities are limited. Sometimes our minds simply do not have the computing power to optimize choices.

On some level, humans understand these limitations, which is why we ‘satisfice.’ In complex and uncertain situations, we do not necessarily aim for the best possible outcome but settle for 'good enough' – contrary to what traditional economics espouses.

Another ​​point of difference from conventional economics is the acknowledgement that we are complicated beings in a complex ​world. Where Econ 101 has a penchant for ‘holding all other things equal,' bounded rationality recognizes that the real world hardly bends to such theoretical shortcuts.

Far from being ‘irrational,’ the habit of satisficing can be considered a practical adaptation in light of the decision-making limitations we face.

For example, consider an HR manager looking to fill an important position within his organization. It would be impractical for him to study all possible candidates one by one. Instead, he must find ways to narrow down his options efficiently. This might involve setting certain minimum qualifications or other criteria to screen applicants. He might unintentionally miss out on the perfect candidate, but he will still end up finding a fairly good hire with this method.

Similarly, a young adult choosing what to major in college does not have the capacity to sift through the costs and benefits of all possible options. They might consider factors such as their interests, job prospects, and the advice of others, but ultimately, they must make a decision based on limited information and using their own ‘imperfect’ methods.

Another key principle in behavioral economics is loss aversion, which suggests that people feel the pain of losing more intensely than the pleasure of gaining. This asymmetry in our emotional responses to gains and losses can significantly influence our decision-making processes.

Loss aversion often leads individuals to avoid risks where potential losses are perceived, even if potential gains are relatively higher. This can result in conservative decision-making, as individuals seek to avoid the pain of loss.

For instance, some people choose to park their savings in low-interest-bearing savings accounts when they could be earning much higher rates playing the stock market. This is because they are loss-averse. The potential for higher gains in the stock market is outweighed by the fear of potential losses.

Loss aversion can be traced back to our neurological makeup. Research has shown that our brains react more strongly to experiences of loss than to equivalent gains. This means that the pain of losing something is literally felt more intensely than the pleasure of gaining something of equal value.

Cultural factors can also influence the degree to which an individual is loss-averse, as different cultures may have different attitudes towards risk and loss. As a behavioral principle, it appears that even loss aversion is shaped by broader social and cultural factors.

Interestingly, a study conducted by London Business School professor Ena Inesi found that people in positions of power are less likely to be loss-averse. This is because they are more capable of dealing with potential loss, perhaps due to their greater resources or their ability to influence outcomes. This finding suggests that loss aversion is not a universal trait, but can vary depending on one's circumstances.

Mental accounting is a concept that helps explain the subjective value we assign to our money. It suggests that people often categorize their money into different mental accounts, such as "savings" or "disposable income," and assign different values to these categories. This stands in contrast to traditional economics, which assumes that all money is interchangeable.

If a person receives a bonus at work, they may view this money as "extra" and spend it on non-essentials, even if they have outstanding debts or other better uses for this cash. In this way, mental accounting can lead to seemingly irrational financial behavior when one encounters windfalls or bonuses.

Mental accounting also helps explain why people often maintain separate accounts for different purposes – one for vacations, another for monthly bills. This can lead to missed investment opportunities or higher transaction costs, but at the same time, it allows for easier tracking of progress towards one’s financial goals or for more controlled spending.

Shrewd marketers use mental accounting to sneak their products or services into our budget plans. For example, we might find it absurd to set aside $200 for a fancy steak dinner. By positioning that very same steak dinner not as any other meal but as a special experience to enjoy with loved ones, marketing experts make the idea of spending $200 on a meal palatable. Neither the price nor the product has changed. What has changed is the way we perceive the product – not as a regular meal but as a celebration.

Payment decoupling is another powerful technique related to mental accounti​​ng. Parting with our hard-earned money hurts much more when we pay with cash as opposed to our credit cards. When we make an installment purchase and defer payments, the immediate pain of parting with money is further lessened. When companies successfully implement payment decoupling strategies, we are prone to increase our spending. ​

The framing effect explores how the presentation of information can significantly impact decision making.

The framing effect was famously demonstrated by Amos Tversky and Daniel Kahneman in a 1981 study.

Participants in the study were presented with a choice between two different treatments for 600 people suffering from a disease.

Treatment A would save 200 lives but would result in 400 deaths. Treatment B would have a 33% chance of saving all of the lives, but a 66% chance that everyone would die.Tverysky and Kahneman were not interested in the ethics of this question. Instead they wanted to see how the wording of the question affected people’s choices.

First, they asked the question in a way that emphasized the number of deaths in Treatment A – saying ‘Treatment A will result in 400 deaths’. This same phrasing also downplayed the number of deaths potentially caused in Treatment B.

Next, they asked the question again (to a different group). This time, they emphasized the number of lives saved by Treatment A (200), and drew attention to how many lives could potentially be lost under Treatment B.

The difference in results is astonishing – when the negatives of Treatment A were emphasized, only 22% of people chose it. When the positives were emphasized, that number rose to 72%.

The influence of framing can be seen in various aspects of daily life. In politics and journalism, the way issues are framed can sway public opinion. In the legal profession, how arguments are presented can influence court decisions.

When we know little about something or someone, we rely on framing to form an initial impression. We might judge a person based on how they dress or how they carry themselves. A reliance on framing can lead to biases and stereotypes. This highlights the importance not just of being aware of how framing impacts our opinions but also of how others perceive us.

High-end brands use framing techniques expertly. By creating a certain image around their products, they can persuade consumers to pay a premium compared to their generic counterparts. Designer fashion brands offer a veneer of luxury; branded medicine, a sense of security; and branded baby products, peace of mind. This is because we tend to prefer prettily packaged products that make us feel good about ourselves.

The anchoring effect refers to a cognitive bias in which we rely too heavily on an initial piece of information, or 'anchor,' to make subsequent judgments. Because the initial information may not be relevant or accurate, this tendency can lead to biased decisions.

Amos Tversky and Daniel Kahneman demonstrated how random, arbitrary numbers can act as anchors in their 1974 study. When subjects spun a wheel to receive a random number, they unknowingly used that number as a reference point for making an unrelated future estimation. This experiment shows that humans are susceptible to the anchoring effect without us even realizing it.

Anchoring is a concept frequently used in negotiations. For example, in used car sales, the initial asking price sets the tone for the rest of the negotiation. This initial price serves as an anchor, influencing the buyer's perception of the car's value and their willingness to negotiate.