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Ultimate guide to behavioral economics

Last updated

21 June 2023

Author

Dovetail Editorial Team

Reviewed by

Hugh Good

Every business relies on sales. Marketing teams go to great lengths to identify their ideal customers and develop personalized advertising campaigns. Yet, without considering the psychological underpinnings of human decision-making, your marketing efforts could miss the mark.

In the real world, people don't always make rational decisions. Sometimes, individuals make decisions that seem to go against their best interests. However, when you have an understanding of the human psychology that sits behind these seemingly irrational choices, you can adapt your marketing techniques to align with the real-world thought process of your customers. 

Behavioral economics explores the "why" behind arguably irrational consumer choices. It's grounded in principles of human psychology and has a long and varied history. 

This guide digs deep into the study of behavioral economics, including its history, important contributors, real-world examples, and how businesses use it to boost their bottom line.

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What is behavioral economics?

Behavioral economics is the practice of linking human psychology to decision-making and behavior. It explores the reasons why individuals stray from rational action when making decisions. 

In a perfect world, people would have the time to research every decision, rationally come to the best course of action, and significantly minimize risk. In the real world, humans are led by emotion, easily distracted, and often pressed for time. As a result, we're all likely to occasionally make decisions that aren't in our objective or best interests.

Everything from childhood influences to immediate circumstances can make an impact on the decision-making process. Behavioral economics aims to understand the effects of specific factors and principles that guide consumer decisions. 

What is the difference between economic theory and behavioral theory?

Economic theory is based on the idea that people are rational and able to make decisions based on self-interest and adequate information. Under this assumption, people are always armed with ample information and will change their thoughts and beliefs based on the introduction of new facts. 

The concept also suggests that people make decisions based on careful analysis and are unaffected by external factors and emotions. It's as if the decision-making process can be reduced to a mathematical equation resulting in correct or incorrect paths of decision-making. 

Behavioral theory focuses on the psychology behind irrational decisions. This theory assumes that many factors influence a person's ability to make practical decisions beyond just data alone. 

Behavioral theory suggests that decisions are shaped by:

  • Emotions

  • Social influences 

  • Psychological influences

  • Cultural dynamics

  • Cognitive factors 

Why is behavioral economics useful?

Economic theory alone fails to take into consideration many of the factors included in the human decision-making process. By learning more about external factors and other dynamics that influence consumer decisions, businesses can adapt their processes to be more aligned with potential customers. 

Behavioral economics incorporates patterns of human behavior defined by psychology into the process of serving consumers. It allows organizations in various industries to better understand the anomalies in consumer choices and behavior. 

When properly understood, you can use behavioral economics to improve services across many sectors, including business, law enforcement, politics, and more. 

The history of behavioral economics

While the idea seems relatively new, behavioral economics has influenced interactions between consumers and organizations for centuries. Advertising, politics, and government policies have long been centered around external factors like economic fluctuations and emotions to satisfy the needs of the public. 

In the 18th century, Adam Smith introduced some of the earliest literature surrounding ideas of behavioral economics. He proposed that "passions" drive economic decisions, but these behaviors can be overridden by taking an outsider’s perspective to make rational decisions. 

In 1918, John Maurice Clark, a faculty member at the University of Chicago, published "Economics and Modern Psychology I." This work proposed that economists should not ignore human nature and that individual economic decisions are subject to external influences. Through this work, Clark was credited with introducing behavioral economics.

More recently, in the 1970s, psychologists Amos Tversky and Daniel Kahneman contributed to the study of behavioral decisions based on the principle of heuristics. The research suggested that biases influence the way people think and the judgments they make, leading individuals to irrationally interpret data.

Kahneman went on to win the 2002 Nobel Prize alongside Vernon L. Smith, marking a major milestone in the study of behavioral economics. His research suggests that investment decisions are often driven by irrational considerations (like biases and heuristics) despite investors’ intentions. 

More recently, Richard Thaler was awarded the 2017 Noble Prize for his work on behavioral finance and behavioral public policy. Thaler developed theories surrounding the ways limited rationality, social preferences, and lack of self-control influence decisions. He's most popular for the idea that "nudging" (influencing people's behaviors through the design of choice architecture grounded in human psychology) can change how people make decisions. 

How is behavioral economics used today?

In the modern world, individuals are becoming ever more aware of how the decision-making process is affected by external and non-rational influences. This knowledge can help economists in various sectors improve communication to better serve consumers. 

Governments, businesses, and organizations use behavioral economics to influence consumers’ decisions in different situations. For example, politicians base campaigns heavily on the principles and ideas of a certain demographic target. Businesses develop marketing campaigns designed to evoke an emotional response from their target audience. Psychologists, financial advisors, and other professionals can even use principles of behavioral economics to help individuals make better decisions. 

What are the different types of human behavior in economics?

It's clear that emotions and external factors influence decision-making. Yet, it can still be challenging to understand exactly how the process works. Often, individuals rationalize irrational behavior to support making the decision they desire. As a result, decisions can appear to be logical under certain circumstances. 

The study of behavioral economics attributes five specific factors that influence the decision-making process.

Bounded reality

The best-made decisions are based on a wealth of accurate information from various sources. However, many decisions must be made quickly without the opportunity to conduct adequate research. In other words, individuals make decisions based on the knowledge they have. Unfortunately, this information is often limited and can even be false. 

An individual's information can be limited based on a lack of expertise, lack of available information, and time-based decisions. Without time to conduct research on every choice, people must select a satisfactory option based on what they know (or what they think they know). Unconscious biases, errors, and misinformation can sway these decisions. 

Cognitive bias

All individuals make decisions based on information they know or think they know. Cognitive biases are unconscious errors in thinking that lead people to make decisions based on established concepts that may or may not be accurate. 

While biases simplify complex decisions and allow us to make a choice faster, they can distort our perception of reality. Since cognitive biases are often based on incomplete or distorted information, they can lead to irrational decisions.

Behavioral economics suggests that individuals can have cognitive biases that result in decisions subconsciously based on everything from logo color to the city where the company is headquartered in. Other cognitive biases may be based on stereotypes or partial information, like forming a view of a situation solely based on the headline of a news story without reading the article. 

Choice architecture

The layout of choices can affect the decisions you make. Consider how displays are placed in your favorite department store or the layout of a supermarket. Products are placed at eye level to grab attention and distract shoppers from mindfully going to grab the items on their list.

While a common example of choice architecture states that fruits and vegetables are placed at the beginning of a cafeteria line to inspire healthy eating choices, a quick Google search of a supermarket layout might make you think differently. 

A common theory about grocery store layout suggests that colorful produce near the front of the store induces hunger in shoppers, prompting them to shop with their stomachs. It's also suggested that shoppers are more likely to splurge on less healthy choices to reward themselves for the healthy decisions they've already made. In either case, the layout, or choice architecture of food layouts, influences purchases. 

Discrimination

People make choices based on their view of the world. Since an individual's perception is partially based on experiences, beliefs, and values, these choices can be skewed in a particular direction. 

Discrimination-based choices occur when an individual sees a choice as favorable simply because they have a preconceived aversion to the alternative. This selection-making process is irrational because it's not based on facts or evidence.

Herd mentality

Consumer decisions and even actions are often influenced by what others are doing. This can often be attributed to a fear of missing out on an experience or conformity bias (the desire to cultivate a sense of belonging to a specific group). Decisions driven by herd mentality cause people to copy others' behavior rather than follow their own independent judgment. 

As a result, they may, for example, purchase an item they usually wouldn't be interested in when they see others doing so. Trends likely wouldn't exist without herd mentality. 

Principles of behavioral economics

Emotions and external factors play a significant role in how behavioral economics affect decisions. However, there are specific guiding principles also believed to irrationally influence decisions. The primary principles of behavioral economics include:

Mental accounting

Certain situations lead people to think of the same amount of money in different terms. Mental accounting is the act of making a decision based on temporary economic circumstances. 

For example, an investor may be willing to take on a risky or expensive investment after receiving a yearly bonus. In another situation, shoppers may be willing to make more extravagant purchases when using a credit card rather than forking over the same amount of cash. 

While an individual's overall economic position dictates what they can afford, a temporary circumstance or even form of currency doesn't provide a foundation for a rational decision. 

Heuristics

Since humans don't have the time to carefully research every decision throughout the day, the mind takes mental shortcuts, called heuristics, to make decisions. While heuristics are essential to making decisions in a reasonable time frame, they can lead to irrational choices. 

Decisions made under pressure or during times of uncertainty may force individuals to rely on information that is non-representative or false. Even if the results are optimal, the decision isn't based on rational thinking.

Framing effect

How choices are presented to an individual can influence the way they're perceived. The framing effect highlights the positive or negative aspects of a decision based on how you want an individual to react. 

Tversky and Kahneman's prospect theory illustrated this by framing gambling in terms of losses or gains. By framing a gamble in terms of a potential loss instead of a potential win, it becomes a less attractive prospect. 

Sunk cost fallacy

When an individual has invested in a decision, it's more challenging to let go. Sunk-cost fallacy is the emotional attachment to costs that have been incurred in the past. It’s the tendency to continue with a plan even if the present costs outweigh the potential benefits. To avoid feelings of regret, fear, or loss, people want to continue with an original plan believing it will eventually pay off. 

Signs of sunk cost fallacy include:

  • Resistance to change

  • Irrational decision making

  • Defending an ineffective or outdated process

  • Fear of admitting failure

Loss aversion

Also part of the Tversky and Kahneman prospect theory, loss aversion is the idea that people are more averse to losses than they are eager to make gains. 

When individuals are more influenced by the possibility of a loss than the ability to make gains, they make decisions out of an abundance of caution. This occurs even when the likelihood of a loss is more improbable than that of a gain.

Cognitive dissonance

The theory of cognitive dissonance suggests that people avoid choices that create conflicting emotions. If an individual's choice is inconsistent with their values or beliefs, they don't have a way to rationalize their actions. 

This can occur when the introduction of new information causes one to question long-held beliefs or when a person holds two contradictory beliefs at the same time. Such irrational decisions may be justified by delegitimizing the source of the information.

Choice overload

When faced with too many choices, some individuals might avoid making a decision entirely. Also referred to as overchoice, choice overload is a phenomenon associated with having too many choices. Rather than taking the time to comb through all options, people focus on the first option available or don't make a purchase at all. 

Choice overload may be the result of multiple factors, including a large number of options, time constraints, decision accountability, and uncertainty. 

Examples of behavioral economics

While you may not be familiar with the concept, you've likely seen behavioral economics used by businesses in practically every industry. Every advertisement is designed around product strengths instead of weaknesses. After all, it wouldn't make sense to point out potential weaknesses of a new product or service. 

Framing is only one way to use behavioral economics in business. From product development to sales, businesses can use behavioral economics to align with the decision-making process of their customers. 

Consider how these examples illustrate the principles of behavioral economics:

Loss aversion in the form of a flash sale

When an individual is notified of a sale that will end within a few hours, they may be likely to purchase a product they don't need or didn't even think they wanted before being alerted to the sale.

Payment plans encourage mental accounting

When a consumer purchases a new phone, they typically aren't faced with the full price of the latest piece of hand-held technology. The price of the phone is incorporated into the service plan, which lasts months or years. If they were paying for the full price all at once, it would be more difficult to rationalize the greater expense based on the functionality provided by a smartphone. 

Avoiding choice overload by creating a niche

When a company specializes in a highly complex product or service, its focus isn't divided among many products. As such, consumers are more likely to trust the brand's expertise to deliver a superior product. 

Businesses in all industries create advertisements featuring celebrities using their products. The rise of social media allows brands to leverage user-generated content to convince consumers to avoid missing out on an exciting trend by purchasing the product or service.

Strategic pricing to overcome cognitive bias

A consumer may have a preconceived notion that they would never pay over a certain amount for a product or service. But when the price is decreased by a few dollars (or even a single penny), sales increase. This is why products are often priced at $995 or $999 instead of $1,000. For less expensive products, the same effect applies to pennies instead of dollars. For example, inexpensive toys are priced at $1.99 instead of $2.00.

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