Behavioural Economics

In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction. This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. Alas Behavioural economics explains that humans are not rational and are incapable of making good decisions.

Behavioural economics draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models. Decisions such as how much to pay for a cup of coffee, whether to go to graduate school, whether to pursue a healthy lifestyle, how much to contribute towards retirement, etc. are the sorts of decisions that most people make at some point in their lives. Behavioural economics seeks to explain why an individual decided to go for choice A, instead of choice B.

Because humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if Charles wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories. Behavioural economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall off of the weight loss bandwagon, showing his lack of self-control.

One application of Behavioural economics is heuristics, which is the use of rules of thumb or mental shortcuts to make a quick decision. However, when the decision made leads to error, heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game theory, can also be applied to Behavioural economics as game theory runs experiments and analyzes people’s decisions to make irrational choices. Another field in which Behavioural economics can be applied to is Behavioural finance, which seeks to explain why investors make rash decisions when trading in the capital markets.

Companies are increasingly incorporating Behavioural economics to increase sales of their products. In 2007, the price of the 8GB iPhone was introduced for $600 and quickly reduced to $400. What if the intrinsic value of the phone was $400 anyway? If Apple introduced the phone for $400, the initial reaction to the price in the smartphone market might have been negative as the phone might be thought to be too pricey.

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