Behavioral economics: a new perspective on decision making
Changing our understanding of how we make economic decisions
Introduction
Traditional economics is based on the idea that individuals are rational beings who make economic decisions in their own self-interest. However, behavioral economics, a discipline that merges economics with psychology and cognitive sciences, has demonstrated that humans are not as rational as once believed.
Behavioral economics acknowledges that humans are subject to a range of cognitive and emotional biases that can influence their economic decisions. Furthermore, these biases can lead to choices that are not necessarily in the best interest of the individual or society.
Companies and organizations are increasingly adopting the principles of behavioral economics to better understand their customers, design and offer more personalized products, improve internal decision-making, and create more effective marketing strategies
The goal of behavioral economics, and those who work with it, is to understand how these biases influence economic decision-making. By understanding these biases, we can design interventions -nudges- that help people make more informed and beneficial decisions.
The Rational Homo Economicus
Classical economics relies on the model of Homo Economicus -or Econs, as theorists such as Kahneman or Thaler call them- a rational human who always acts in their own self-interest. However, behavioral economics, along with other modern economic theories, has proven this model to be inaccurate.
Humans are subject to a range of cognitive biases that can influence their economic decisions. These biases include, among others:
- Anchoring Bias: The tendency to give too much importance to the first information we receive. This initial information, or “anchor,” can disproportionately influence the final decision, even if it is irrelevant to the decision.
- Confirmation Bias: Occurs when people selectively seek, interpret, and remember information to confirm their preexisting beliefs or hypotheses.
- Sunk Cost Fallacy: The tendency to continue investing in something not working just because a lot has already been invested. People often give more importance to past costs than future costs.
- Loss Aversion: People feel more pain from losing something than pleasure from gaining the same. This bias is rooted in the natural tendency to value losses more than gains.
- Endowment Effect: Occurs when people overvalue the objects they possess simply because they own them.
These biases, just a few of the over 200 studied, can lead to choices that are not necessarily the best for the individual or society. For example, anchoring bias can lead people to make investment decisions based on incorrect information, and confirmation bias can cause individuals to ignore information contradicting their existing beliefs.
The Irrationality that Defines Us
A key concept in behavioral economics is the idea of “rational irrationality.” Often, our decisions may seem irrational at first glance, but by delving deeper and analyzing the decision’s context, we discover they are rooted in coherent thought patterns and, in certain contexts, can make sense. For instance, loss aversion may explain why people are more prone to take risks to avoid losses than to pursue gains. This bias may be irrational in some contexts but adaptive in others.
Cognitive Biases and their Impact on Financial Decisions
For a few years now, I have been interested -and it’s the area of study in which I specialize- in developing tools and methods to help investors make more informed and rational decisions, taking into account the impact of cognitive biases on financial investments. Cognitive biases can have a significant impact on financial decisions, leading to uninformed investment decisions, saving less money, and taking more risks than necessary. Understanding these biases is crucial for making more informed financial decisions. This involves learning about cognitive biases, being aware of how they can influence decisions, and devising a plan and method to avoid making irrational decisions influenced by these biased disturbances.
Nudging and Choice Design
On the other hand, behavioral economics -or behavioral economics- not only seeks to understand but also to improve economic decisions. This is where the concept of nudging comes into play -a concept introduced by Thaler and Sunstein in their eponymous book.
Nudging is a technique that uses psychology to influence people’s decisions in a subtle and non-coercive way. For example, a government could use nudging to increase recycling rates by placing more visible recycling bins on the streets. Nudging can be a powerful tool to help people make more informed and beneficial decisions, but it can also be intentionally used to bias people towards less beneficial behaviors or to serve the interests of third parties.
In this sense, price psychology and color psychology are two concepts that can be used in nudging to create an even greater impact. For example, price psychology can be used to attract customers with low prices or create a perception of quality with high prices. Color psychology can also be used to capture visitors’ attention with vibrant colors or create a sense of trust with cool colors.
Practical Applications
Companies and organizations are increasingly adopting the principles of behavioral economics to better understand their customers, design and offer more personalized products, improve internal decision-making, and create more effective marketing strategies. For example, a company could use behavioral economics to design a website that makes it easy for users to find the information they need. Or an organization could use behavioral economics to create an incentive program that motivates employees to save more money.
Thus, behavioral economics has the potential to improve decision-making in a wide range of contexts and applications.
Conclusion
Behavioral economics is an emerging discipline that is changing our understanding of how we make economic decisions. Traditional economics assumes that individuals are rational beings who always act in their own self-interest. However, behavioral economics has shown that humans are subject to a range of cognitive and emotional biases that can influence their economic decisions. These biases can lead to choices that are not necessarily the best for the individual or society.
Behavioral economics not only seeks to understand these biases but also to improve economic decisions. This is where the concept of nudging comes in. Nudging is a technique that uses psychology to influence people’s decisions in a subtle and non-coercive way.
Thus, nudging has the potential to improve decision-making in a wide range of contexts and applications. For example, companies can use nudging to increase sales, governments can use nudging to improve public health, among other examples.
In conclusion, behavioral economics is an important discipline that has the potential to improve decision-making in a wide range of contexts.
