Behavioral economics: what it is and how it explains decision-making

Economics is a complex science and as such has different branches and conceptions. One of them is quite interesting since it goes against the current with respect to classical economic ideas. We talk about behavioral economics.

Unlike what most economists believed until relatively recently that human beings are not rational, even in their economic decision-making. People buy, sell and carry out other financial transactions with our reason clouded by our desires and emotions.

On many occasions the behavior of the markets, directly dependent on the behavior of the consumers and investors, it cannot be explained solely with classical economics, but rather with psychology, and behavioral economics is the middle ground between the two disciplines. Let's see it next.

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What is behavioral economics?

Behavioral economics, also called behavioral economics, is a branch of knowledge that combines aspects of economics, such as microeconomics, with psychology and neurosciences

. This science maintains that financial decisions are not the result of rational behavior, but rather the product of irrational impulses from consumers and investors. Economic phenomena occur as a consequence of various psychological, social and cognitive factors which affect our decision-making and, consequently, the economy.

The main premise of behavioral economics runs counter to classical ideas in economics. Traditionally, economics defended that human beings behaved rationally in as far as economic movements are concerned, buying, selling and investing in a totally meditated. Behavioral economics holds that markets do not move solely based on rational algorithmsInstead, it is influenced by the cognitive biases of buyers and investors, because after all they are people and like any other their behavior is manipulated in one way or another.

Thus, behavioral economics maintains that the market and its associated phenomena must be studied and interpreted in terms of human behavior, understood in its most psychological sense. Human beings do not stop having appetites, feelings, emotions, preferences and biases. which do not disappear when we enter a supermarket, invest in the stock market or sell our home. Our decisions will never get rid of our mental states.

It is with all this in mind that behavioral economics is interested, above all, in understand and explain why individuals behave differently from what had been hypothesized while having classical economic models in hand. If people were as rational as traditional economic positions hold, financial movements and phenomena should be more easily predictable, only fluctuating depending on environmental problems such as lack of resources in a certain material or conflicts diplomats.

Historical background

As surprising as it may seem, economics was connected with psychology from its inception. In the treatises of the famous economists Adam Smith and Jeremy bentham some relationships are established between economic phenomena and the behavior of human beings, seen as something that can hardly be classified as something totally rational and predictable. However, neoclassical economists distanced themselves from these ideas, trying to find explanations for the behavior of the market in nature.

It would not be until the 20th century that these conceptions about how irrational human beings are and how their biases, emotions and desires influence the behavior of the large market. In the middle of that century, the role of human psychology in economic decision-making was again taken into consideration., leaving aside the fact that human beings reflectively meditate what they buy and what they sell, at what price or if it pays to do so.

In 1979, what is considered the most relevant text of behavioral economics was published “Prospect theory: Decision Making Under Risk”, by Daniel Kahneman and Amos Tversky. In this book, both authors try to demonstrate how the knowledge of the behavioral sciences, especially cognitive and social psychology, allow to explain a series of anomalies that occurred in what is called the economy rational.

Assumptions of behavioral economics

There are three main assumptions that define behavioral economics:

• Consumers prefer certain goods over others.
• Consumers have a limited budget.
• With given prices, based on their preference and budget, consumers buy goods that give them greater satisfaction.

Behavioral economics denominates this satisfaction in the purchase of products and services as "utility". While in traditional macroeconomics it is established that people make economic decisions to maximize profit, using all the information from which they are be aware, in behavioral theory it is argued that individuals do not have preferences or standard beliefs, nor that their decisions are standardized. Its behavior is much less predictable than previously believed and therefore it is not possible to predict which product you are going to buy but it is possible to influence your choice.

Behavioral economics according to Daniel Kahneman

As we have mentioned, one of the key figures in behavioral economics is Daniel Kahneman, who won the Nobel Prize for Economy in 2002 thanks to his studies on the complexity of human thought applied to the behavior of markets. Among the best known books of him we have "Think fast, think slowly", text in which he exposes a theory about the two cognitive systems that coexist in our brain.

The first of these systems is intuitive and impulsive, which leads us to make most decisions in daily life. This system is the one that is influenced by fears, illusions and all kinds of cognitive biases. The second of the systems is more rational, in charge of analyzing the intuitions of the first system to make decisions based on them. According to Kahneman, both systems are needed, but they have trouble staying in balance, which is necessary to be able to make good decisions.

Behavioral economics according to Richard Thaler

Another of the modern figures of behavioral economics we have in Richard Thaler, who won the Nobel Prize in economics in 2017 with his theory of the push or "nudge". In his theoretical proposal maintains that human beings are not always prepared or trained to make the decisions that are best for them And that is why sometimes we need a little push to decide, either by making a correct decision or one that is not.

To understand Thaler's theory of nudge, let's imagine we are in a supermarket. We have been far-sighted and we have made a shopping list and we try to go for the products directly, trying to focus on what we have come to buy. However, when entering the establishment we see a large poster at the entrance that shows a 2x1 offer of chocolate bars, something that we neither wanted nor should buy but that, upon seeing that ad, we decided to include it in the trolley.

Although we had the shopping list made in advance, in which we did not include those tablets of chocolate, seeing that they were on sale has given us that little push to buy them, even knowing that we needed. If for example they had not indicated that they were on sale but they would have sold the tablets at the same price they cost us surely we would not have stopped to think about going to buy them and, in a rational way, we would have avoided their purchase by being outside the ready.

Homo economicus

We have another of Richar Thaler's valuable contributions to the field of behavioral economics in the homo economicus or “econ”, which is the equivalent of the “buyer persona” of the marketing world. Thaler presents us with this imaginary hominid as the idea of ​​the client to whom a certain product or service is directed, that is, the ideal prototypical buyer which was thought of when that object or service was designed.

Thaler indicates that practically since the founding of the economy the buyer / investor has been seen as a being that obeys only and exclusively logical and rational criteria, as we have mentioned before. Classical economics wrongly presupposes that human beings put aside their wills, fears, socioeconomic conditions or risk profile when he was in any economic activity, as if suddenly his subjectivity disappeared and was pure rationality.

Richard Thaler has stated that this is not even remotely so. In fact, the reasons why he has been awarded the Nobel is to have discovered the limitations of supposed human rationality in economic decision-making, show that our senses deceive us, as with optical illusions, and that biases influence the way we buy and sell.

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Psychological phenomena and economic decision making

As we said, human decision-making does not respond only to rational criteria and these decisions are not detach from subjectivity when taken with situations related to the economy, such as the sale of products and services. Next we are going to see some phenomena that occur in economic decision-making.

1. Information avalanche

The average consumer is exposed to many options and characteristics when he wants to choose a service or a product. So much variety can confuse you, receiving a veritable flood of information that makes you choose randomly or even block yourself and make no decisions.

2. Heuristics

Many times consumers they take shortcuts in their decisions to avoid evaluating the products or doing research on which is the best. Thus, for example, instead of analyzing all the products, they limit themselves to buying the same as their friends or family members have bought, or are influenced by the one they first saw on television or in other media announced.

3. Fidelity

Although there are better, newer or more popular products, it is often the case that consumers tend to be loyal to the products or services they were already consuming. They are reluctant to change supplier or brand for fear of making a mistake. Here the principle of "better known bad than good to know" would apply.

4. Inertia

Consumers generally don't switch products or suppliers if it means putting in a bit of effort and stepping out of their comfort zone. There is a moment when once we have become accustomed to our life-long product or service, we end up consuming it again, without thinking about changing it or even considering it.

5. Frame

The consumers are influenced by the way the service or product is presented to them. Simple things like packaging, colors, product placement on shelves, or the prestige of the brand are enough for us to decide to buy a product whose value for money is quite bad.

An example of this we have in the cocoa cookies with cream, cookies that all supermarkets sell under their own private label and, also, the commercial brand version. Whether we buy them white label from any supermarket or if we buy the same ones that are advertised on TV, we are buying exactly the same cookies, since they are made with the same ingredients and with the same process, only changing the shape and the packaging.

According to classical economics, as consumers we would all end up buying the cookies that are sold at the price lower or whose quantity-price pay off since, after all, the quality of all cookies is the herself. However, this is not the case, being the commercial brand (which the reader will surely think of right now) the one that has the most sales. The simple fact of being on TV and having more "prestige" makes us prefer that brand.

6. Risk aversion

Consumers prefer to avoid a loss rather than gain something, which is why they are also less in favor of changing the service or product even having reviews that indicate that it is better.

Bibliographic references:

• Kahneman, D. (2011) Thinking, Fast and Slow, Farrar, Straus and Giroux, ISBN 978-0374275631. (Reviewed by Freeman Dyson in the New York Review of Books, Dec 22, 2011, pp. 40–44.) Translated into Spanish as: Think fast, think slowly ISBN 9788483068618
• Kahneman, D., & Tversky, A. (Eds.) (2000) Choices, values ​​and frames. New York: Cambridge University Press.
• Kahneman, D., Slovic, P., & Tversky, A. (1982) Judgment Under Uncertainty: Heuristics and Biases. New York: Cambridge University Press.
• Thaler, Richard H. (1992). The Winner's Curse: Paradoxes and Anomalies of Economic Life. Princeton: Princeton University Press. ISBN 0-691-01934-7.
• Thaler, Richard H. (1993). Advances in Behavioral Finance. New York: Russell Sage Foundation. ISBN 0-87154-844-5.
• Thaler, Richard H. (1994). Quasi Rational Economics. New York: Russell Sage Foundation. ISBN 0-87154-847-X.
• Thaler, Richard H. (2005). Advances in Behavioral Finance, Volume II (Roundtable Series in Behavioral Economics). Princeton: Princeton University Press. ISBN 0-691-12175-3.
• Thaler, Richard H., and Cass Sunstein. (2009). Nudge: Improving Decisions About Health, Wealth, and Happiness. New York: Penguin. ISBN 0-14-311526-X.
• Thaler, Richard H. (2015). Misbehaving: The Making of Behavioral Economics. New York: W. W. Norton & Company. ISBN 978-0-393-08094-0.