Behavioral Economics

Examples of behavioral economics are all around us, from gamblers who are willing to keep betting even when they think they will lose, to people saying they want to save for retirement, or start exercising or stop smoking, yet do no such things. Behavioral economics delves deep into the biases which affect our decision-making. It considers factors such as human emotion, our propensity for loss aversion, how we are at times impatient or wildly overconfident, how we procrastinate, our forces of habit, our intrinsic motivations and much, much more.[1] Behavioral economics is an exciting new area of research which is having a profound impact on the entire discipline of economics. What we can learn from behavioral economics has powerful implications for the way businesses and teams operate, as well as re-framing how governments should develop key areas of public policy and wider economic policy interventions.

Behavioral Economics in Business

Understanding behavioral economics is essential for any business that wants to be successful in today’s economy. Firstly, it can help us reflect on our own (and our teams’) behavior, and the choices that we make in the workplace. We can then identify and eliminate sources of internal irrational bias within ourselves and others. Secondly, behavioral economics offers a powerful insight into the behavior of customers. Customer choices about whether or not to buy something, when to buy it and indeed why they choose one product over another are strongly influenced by behavioral factors.These include what other people are doing, our own past behavior, what is currently available, offers and promotions, social norms, our belief systems and how a choice is framed, as well as our brand perceptions and associations.

A deeper understanding of behavioral economics can help organizations to think more creatively about the relevance of these issues for the creation, development, marketing, advertising and communication of new products and services. The success of a product very much depends on how it is launched and positioned in the market, and this process can be greatly improved by having an awareness of the irrationality of human behavior and our decision-making foibles.

What the Experts Say

Economics pioneer Adam Smith was the first to mention the idea of behavioral economics in his classic text The Theory of Moral Sentiments, in which he described the idea that our behavior is determined by a struggle between two processes which he termed the ‘passions’ and the ‘impartial spectator’.[2] Smith was strongly aware of the limitations of the impartial spectator when it comes to making decisions, and that it could be quickly led astray by intense passions or irrationality.

The field of behavioral economics really came alive through the work of Daniel Kahneman and Amos Tversky. As early as 1979, these two distinguished psychologists talked about the concept of prospect theory, which argues that people frame economic decisions and choices in terms of whether they see them as a loss or a gain.[3] Later coined as loss aversion, this early work set the foundation for Kahneman and Amos’ later publications Choices, Values and Frames and the international bestseller Thinking Fast and Slow, which is dubbed ‘the bible of behavioral economics’.[4] Kahneman was awarded the 2002 Nobel Memorial Prize in Economics for his work in prospect theory.

Mainstream Behavioral Economics is Born

Behavioral economics reached mainstream public attention with the publication of three key books, namely Freakonomics, Predictably Irrational and Nudge. Written by economist Steven Levitt and co-author Stephen Dubner, Freakonomics burst onto the economics scene in 2005.[5] Like many behavioral economists, the authors disagree with the traditional model of rational economic decision-making. Using a series of quirky case study examples, such as teachers who help their students cheat and drug dealers who live with their mums, they argue that at its most basic level, our economic decisions are based on incentives.

Predictably Irrational is the work of esteemed behavioral psychologist Dan Ariely, published in 2008.[6] Ariely introduces a number of simple experiments which he conducted that highlight the different irrational elements of our decision-making processes at work. Ariely has followed up this key work with The Upside of Irrationality in 2010 and The (Honest) Truth About Dishonesty in 2012.[7]

The last in the behavioral economics trilogy, Nudge, by Richard Thaler and Cass Sunstein was published in 2008.[8] It is about decision-making, and how people often make poor decisions because of the way in which information is presented. The authors make a strong case for the use of nudge theory in public policy development, which argues that positive reinforcement and indirect suggestion of improved choices can achieve better decision-making. The power of nudge theory is such that Sunstein was former US President Obama’s top advisor on regulatory affairs, and in the UK, the government has set up its own Behavioral Insights Team, called the Nudge Unit.

Behavioral Economics Now

he impact of behavioral economics is such that it is now used by government policy makers around the world, as well as by financial institutions such as the World Bank. It is also starting to filter down to forward thinking organizations as well. For example, Domino’s Pizza has become one of the first companies in the UK to use behavioral economics to inform its marketing strategy.[9] One thing is certain, behavioral economics is here to stay, and it will play an ever greater role in the development of our economy and our society as a whole.