Behavioral economics has influenced various aspects of society, it reshaped our perspective on how we analyzed human behavior and irrational decision making.
Behavioral economics integrates elements of economics and psychology to understand human behavior, which is largely shaped by emotions, biases and social pressures. Unlike traditional economic theory, which assumes that individuals are well informed and have clearly defined preferences, behavioral economics explores why people often make decisions that may not be rationally defined in neoclassical economics theory.
Economics traditionally assumes that consumers act in their rational self-interest, making decisions which maximize their satisfaction and wellbeing. Moreover, traditional economics is completely based on the theory that individuals have complete information about market price and possible alternatives, allowing them to make decisions with outmost certainty. However, behavioral economics opposes the ideas of the neoclassical economics theory and believes that human behavior is far more complicated and is influenced by emotions, biases and social pressures, often leading to decisions that stray from purely rational thinking.
For a better understanding of behavioral economics, one must understand Bounded rationality, bounded self-control, bounded selfishness. Bounded rationality was a concept developed by Herbert Simon, a Nobel prize winner in 1971. Bounded rationality suggests that consumers are only rational within limits meaning consumers seek a more satisfactory outcome than optimal. The same concept applies to bounded self-control which suggests self-control is only exercised within limits and bounded selfishness states the same that one is only selfish and selfless within limits.
While traditional economics assumes that individuals end up making logical, well informed and rational decisions, real world scenarios can end up being a little different as consumers may rely on mental shortcuts or lack self-control. To help the consumers with decision-making businesses and government have developed certain strategies like nudges, bias and heuristics.
Nudges
Nudges can be seen as subtle changes to one’s surroundings that influence the choices of people without restricting their freedom of choice. Nudges can also come across as a way to manipulate consumer choices which lead them to make certain desired decisions. The purpose of nudge is to make it easier for consumers to make decisions and use the confused state of mind during the decision-making process and use it as an opportunity to manipulate consumers to do what the business or association wants from them. Nudges are mostly intended to help consumers make better decisions that benefit them and others around. An example can include placing healthier food options at eye level in cafeterias, this will eventually force people to switch to a heathier diet. One example we see in our everyday life are the disturbing images on a cigarette packet, these help consumers realize the consequences and will eventually steer them out of the unhealthy habit. Moreover, a research paper released by Dennis Hummel and Alexander Maedche in 2019 in addition to 100 other published studies show that 62% of Nudge treatments are statistically significant and have effective impacts on consumers. Nudges can be extremely effective, and they do help people make better decisions, eventually helping people better themselves but they raise ethical concerns about manipulation, consumers are not aware of the extent of change can a nudge bring to their life and for this exact reason a debate centers around whether the government and business should be allowed to proceed with nudges.
Biases
Biases refer to systematic errors in thinking or evaluating, they affect consumer choices and there are a few different types of biases like Anchoring, Framing and over confidence.
Anchoring Bias – When people rely heavily of the first piece of information they get, even if it proves to be irrelevant. When an individual encounters a reference point their internal judgement tends to stay close to it. For example, you see a pair of shoes that cost $200 and then you find that exact same pair somewhere else for $150 and thinking it’s a bargain you go for that deal but later you discover that the same thing costed $100 in another shop.
Framing Bias – This is a type of bias solely affected by how the choices are presented to decision- makers. For example, consumers prefer food whose labels are described as 80% lean instead of 20% fat, a rational consumer would find both to be indifferent. Another example can include a very similar pair of shoes made from the same material; a consumer would be willing to pay a lot more for the same product in a boutique compared to a local discount store.
Over confidence bias – Consumers and individuals overestimating their own knowledge and ability, which leads to poor decision making. Consumers usually ignore risks and alternatives, making them worse off.
Heuristics
Mental shortcuts for decision-making, usually when faced with uncertainty or incomplete information. As the human brain has its limitations, people rely on heuristics or mental shortcuts.
Availability heuristics- a mental shortcut that leads people to overestimate the likelihood of events which are easily remembered. Making probability judgments based on what comes to mind.
Representativeness heuristics – Categorizing events and objects based on familiarity or existing situations. This is a mental shortcut which helps one estimate the probability of and event based on familiarity to a known situation. Instead of comparing one situation to all probability’s evaluation is done through resemblance. For example, during a coin toss the probability of 4 heads in a row seems less than 2 heads and 2 tails even though the probability is pretty much equal.
Anchoring heuristics – When one starts of with an initial idea and sticks to it adjusting their beliefs based on the initial thought, relying on the first piece of information as a mental shortcut to save time, this is very similar to the anchoring bias.
Biases and Heuristics are both cognitive shortcuts that influence one’s choice. Looking at both through a broad perspective can lead to confusion as they can come out to be quite similar, but heuristics are mental shortcuts that allow quick judgement while biases are predictable errors that arise from relying on these shortcuts.
Behavioral economics allows for a more realistic view on human behavior, by using the phycological influences of nudges, biases and heuristics one can understand the jist of human behavior. While people can never be perfectly rational, behavioral economics aids us to understand what is possible to understand.
By- Aarav Mehta
