What Is Behavioral Economics?

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It differs from neoclassical economics, which advocates that the decisions of humans are driven by their choices, preferences, and self-interest. The former, on the contrary, specifies how likely people are to choose options that are neither rational nor self-interest-driven, rather the most unpredictable ones.

Key Takeaways

  • Behavioral economics is a part of economics that identifies the difference between what people should do and what they do.This concept makes it easier for users to simplify decision-making mechanisms and construct economic models that are easily understood.The principles of behavioral economics have been derived based on the determinants, like feasibility of options, self-control, circumstances, others’ opinions, biases, and paternalism.The domain plays a vital role in stock trading and commercial industries, given the trading and consumer behavior it helps identify.

Behavioral Economics Explained

Behavioral economics is the domain that refutes the area of economics that talks about rationality, preferences, and self-interest as the significant determinants leading to human decision-making. Instead, this is the part of the subject that states how human beings make decisions based on various other determinants that have nothing to do with their preferences, rationality, obviousness, or self-interest.

This area of economics focuses on several principles that influence the decisions of individuals and entities. First, it advocates how different feelings and emotions can lead to unpredictable changes in human behavior, thereby affecting the conclusions or decisions they reach at the end. For example, even though one knows that investing in a particular scheme would reap future profits, they might not go for it, realizing the regular payments they must make until the amount matures. Similarly, another person focuses on the income in the long run and chooses to invest in the deal.

Behavioral economics theories state that people’s decisions vary, depending on their opinion, thought-process, circumstances, preferences, etc., which differs from person to person.

Principles

Behavioral economics revolves around a few principles, which advocate how people might have different choices, opinions, or decisions from what is perceived to be rationally correct. It emphasizes how what people should do differs from what they choose to do. This domain of economics help people derive policies based on the unpredictable responses of individuals, especially customers.

Based on the determinants that drive human decision-making, here are a few principles derived to explain behavioral economics better:

Principle #1 – Search for Feasibility

Humans tend to choose the most feasible option, from a food item to order to a suitable location to construct their house. However, the most feasible option doesn’t always need to be the right option.

For example, a good location can be good from a conveyance perspective but might not be good in terms of the type of crowd around. In that case, people might face difficulties and realize their chosen option was wrong. In short, though feasible options tend to drive the decision, humans might opt for the wrong option, which seems right at that moment.

Thus, businesses aiming to target a customer base must try to exhibit features of the products that look like the most feasible choice for people at that moment. This trait or principle helps boost sales figures significantly.

Principle #2 – Comparison of Circumstances

The following principle influencing individuals’ and entities’ behavior and decisions is how they relate their circumstances and reference points.

For example, the willingness to invest in a plan depends on the returns in the long run. Here, the expected returns are the reference point, which requires a thorough study to understand how individuals would relate their circumstances with it and decide on their investment plans. 

Usually, the losses incurred are higher than the gains reaped out of an opportunity of equal magnitude. Still, people take this chance. This avoidance of loss is loss aversion. It happens as the few early chances indicate the trials of humans. As they gain experience, they become better. However, by then, the loss is already heavier than the gain.

Principle #3 – Self-Control Issues

Human beings have significant self-control issues. They decide to quit their addiction at one moment and fail to follow the same the next moment. They impose self-restrictions but forget to stick to them for a long time. Behavioral economics attempts to specify this trait of the subject, which is yet another determinant that influences an individual’s decision-making. The present bias of decision-makers can lead to opposite decisions if they lose self-control. 

Principle #4 – Emphasize Others’ Opinions

This is one of the principles of behavioral economics that advocates how, sometimes, material payoffs take a backseat, with others’ opinions, intentions, offerings, and actions becoming more critical to consider before making a decision. For example, suppose parents offer two candies to their three children. While the youngest one agrees and accepts the candies happily, the oldest refuses to take them as he feels he is older than the other two and deserves more than two candies. 

The middle one observes the situation and accepts the offer without worrying about what she deserves. It is because the child does not want to remain empty-handed. While the first child knows what he wants, he chooses to have nothing over having less, the second child knows she wants at least something, if not more.

Principle #5 – Behavioral Biases

Though behavioral biases tend to be ineffective if it comes from a small portion of the population, the same throws a significant impact when coming from a majority of the population. For example, the biases of a small portion of traders will not affect the total stock market as their beliefs won’t influence the decisions of the major players in the trading sector. As a result, the effects would reflect the rational outcome. 

Principle #6 – Paternalism

The last on the list of principles of behavioral economics is paternalism, which helps control behavioral biases. Here, the authorities in the country take charge and introduce policies to improve the lives of the citizens. However, they do not give the population any freedom to choose. 

In behavioral economics, paternalism is said to cause other problems. This includes the overconfidence of the government or the authorities in introducing plans that might not positively affect people’s lives. 

Examples

Let us consider the following behavioral economics examples to understand the concept better:

Example #1

Myra wants a couch cover like the one she saw at her friend’s house. She takes the address from her friend, visits the shop, and chooses the same cover design for her couch. The shopkeeper says it’s worth $150, which surprises her. This is because her friend paid $130 for the same product. So, she bargained and tried to get it at the same price. 

If Myra had come across the product at her friend’s house before noticing it, she would have readily agreed to pay the price. However, in the current instance, she looks at the product and its price from her friend’s perspective. It is a simple example of how people’s behavior or situations affect their economic activities.

Example #2

The US housing bubble that led to the 2008 financial crisis indicates the effect of behavioral biases on the market if that involves a large population. During that phase, the lenient interest rates drove most people to take home loans, which led to significant defaults when the interest rate rose suddenly. This led to the entire stock market crash, affecting the global economy.

Importance

Behavioral economics helps understand consumer behavior, which might be unpredictable. However, if studied thoroughly, the bent of mind of customers could be assessed.

In addition, the principles, when properly taken into consideration, let businesses analyze the latest trend in the market. The trends tend to influence the decision-making of the people around them. This intervention or influence is called a nudge in behavioral economics.

Criticisms

Behavioral economics is a domain that is individual-driven. The way it affects individual decision-making is the same, but the decisions made or conclusions reached as a result entirely depend on the nature, circumstances, unbounded rationality, self-interest, thought process, and behavior of one individual. Hence, the inferences gathered for one might not be the same as that derived for the other. 

Behavioral Economics vs Behavioral Science

Behavioral economics and behavioral science are two terms that might appear and sound similar, but they are different. So, let us have a look at the difference between the two terms:

  • Behavioral economics is the area of economics that deals with how human behavior influences an individual’s economic decision-making. On the other hand, behavioral science explains the role and impact of human psychology and emotions in overall decision-making. In short, the latter is a much broader term.The former discusses the difference between what people should do and what they do. On the contrary, behavioral science involves the study of emotions, memory processes, moral learning, and other factors affecting human decision-making.

This article has been a guide to what is Behavioral Economics. We explain its principles, importance, criticisms, examples, and comparison with behavioral science. You may also find some useful articles here –

Framing is a principle that states that the information gathered is dynamic, and its nature depends on how, when, and where it is gathered or communicated. It is an essential concept of behavioral economics as it helps understand how people’s decisions are likely to be affected and framed depending on how communication or detail is derived.

Nudge, technically, is defined as an intervention in the choice architecture that tends to bring about a predictable change in the decisions made by people. In the process, no alternative is forbidden, or there is no choice restriction. It is just the intervention that may affect economic decisions. However, for the interventions or disturbances to be called a nudge, they should be negligible.

Behavioral economics helps people understand how likely people are to choose an unpredictable alternative, even though the indications depict a different choice. The study helps people understand consumer behavior and analyze individuals’ behavioral patterns to identify their inclination or bent of mind.

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