What is Behavioral Economics?

November 24, 2020

Traditional economics assumes that people are rational, but compelling research in the field of behavioral science says … not so much. Behavioral economics is the study of decision-making and, human decision-making is, many times, very irrational. 

We make decisions with emotion. We use heuristics (or rules of thumb) to short-cut optimal decision-making. We don’t calculate the opportunity cost of our actions. We look to others to guide us. We over-prioritize present benefits vs. future benefits. 

Imagine, for example, that one morning you stroll to get breakfast and spot a long line at a brunch spot. Next door, an almost identical restaurant has a similar menu and similar prices. The only difference is that there’s no line; it’s nearly empty. 

You now have a decision to make. Do you wait in line, or do you go to the empty cafe? 

A rational person wouldn’t think twice. They value their time and money, so they’d slide right past the line and walk into the empty cafe. 

But if you’ve ever seen long brunch lines, you know that most people are not rational. 

We are not rational

Instead, we take decision shortcuts. A long line is a cue to us that other people have made the decision to wait. It signals that other people like eating at the busy restaurant. Waiting for an hour may not be the entirely rational choice (especially if you’re hungry!), but it’s exactly the type of decision we make on a regular basis. 

Enter behavioral economics

Oxford Languages defines behavioral economics as: “a method of economic analysis that applies psychological insights into human behavior to explain economic decision-making.”

In other words, behavioral economics (BE) studies why we make decisions like going to the busy brunch place. 

The foundational elements of behavioral economics 

Traditional economic theory assumes we’re all rational, and that we maximize our utility (total usefulness or satisfaction) at all times. 

But if we always acted in our best interest, we’d all have bikini bodies, never overeat, and exercise regularly. We’d also have tons of money saved for retirement and we’d never overspend. (Behavioral economics has particularly interesting findings around financial matters.) 

Behavioral economics makes no such assumption of rationality. Instead, it relies on two fundamental principles:

  1. We are influenced by the environment within which we make our decisions. Brunch lines; marketing campaigns to entice us to buy things; and even small changes in how a question is asked, can and do change our behavior.
  2. We don’t always act in our best interest. A rational model predicts that if we wanted to lose weight, we would stop eating unhealthy food and exercise more. So how do you explain the fact that while many people want to lose weight, they struggle with diet and exercise? 

The flaw in the rational model 

In the rational model, a big reason given as to why people don’t act in their best interest is lack of information. If we only knew how many calories that cake had, we wouldn’t eat it. If we only knew how bad texting and driving was, we wouldn’t touch our phones in the car. 

If this were true, the logical “solution” would be education: If you teach people how to eat better, how to exercise, or how to save, they’ll do just that.

However, in most domains research shows that simply providing information doesn’t lead to behavior change. Everyone knows texting while driving is bad, and that salad is healthier than cake. But giving someone that knowledge doesn’t magically have them opting for a salad when that burger just looks so juicy. 

The same thing applies to financial education. Teaching financial literacy, for example, has almost no effect on people’s savings. One analysis looked at over 200 programs teaching financial literacy and found that on average, the programs account for a miniscule 0.2% of variation in financial behavior. 

In other words, between $700-800M dollars are spent teaching financial literacy in the U.S. every year — but those programs account for less than half a percent of behavior change. 

This brings us to right the third fundamental principle of behavioral economics: 

  1. Giving people information doesn’t change behavior

“When you teach people something, they remember,” says Dan Ariely, behavioral economics expert. “But do they execute? Rarely.”

Information alone is almost never powerful enough to change our behavior. Fortunately there are a number of other forces that do influence us to either do or not do something. 

What are those forces?

That’s exactly what behavioral economics is all about.

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