Behavioral Economics 101

Michelle Philippon - Business Development Specialist


Have you ever wondered why investment companies have automatic renewals for 401Ks? Or why gyms are deliberately designed for people not to show up?[i] Or why charities provide you with suggestions when you are making a donation (for example, $50, $100, or $150) instead of just letting you donate as much as you feel called to?

I’m about to let you in on a secret. There is a deep and deliberate methodology behind this. It’s called behavioral economics, and it’s a popular field of study that is being applied everywhere today, from marketing and advertising companies to organizational development firms and nonprofits like the World Bank.

Behavioral Economics: A Definition

According to traditional economic theory, any decision a human being makes is for one reason only: satisfaction. This is referred to as “maximizing utility.” Utility, in this case, focuses on the end gain of the action one may embark on. In order to gain satisfaction, a thorough exploration of all of the available options will be conducted. In addition, the decisions which are made are supposed to be founded in and to demonstrate rationality.[ii]

But according to behavioral economics, people don’t really behave this way. We don’t always make decisions to maximize our utility. We are most often quite irrational and illogical in our decision-making.

BEworks, a behavioral economics organization, explains that behavioral economics “offers the scientific insights of psychology and the scientific method of experimentation to people in the business of changing behavior.”[iii] It looks into the way people really think and make decisions, breaks down the overarching patterns and trends, and then can be used to change people’s behavior.

In essence, it combines the fields of psychology and economics to develop a more realistic model of human behavior when applied not only to the world of economics, but to every aspect of life itself.

There are a few key principles that make up the basis of this theory:

The Automatic System and the Reflective System

In Cass Sunstein and Richard H. Thaler’s 2008 book Nudge, they define two different systems of thinking that all humans have: the automatic system and the reflective system.[iv]

Automatic System Reflective System
Uncontrolled Controlled
Effortless Effortful
Associative Deductive
Fast Slow
Unconscious Self-Aware
Skilled Rule-following

 

What is interesting is when both systems are applied. Voters, for example, will often use their reflective system to make decisions. In fact, both systems are often at war with one another, and the automatic system can easily dominate the reflective system in the decision-making process.[i]

Anchoring

Another principle of behavioral economics is anchoring. Anchoring consists of a numerical amount one will assign value to that will continue to serve as the price comparison regardless of how logical it is. It will, in short, be the constant standard or starting point. Anchoring itself often is quite random, so much so that it is also referred to as “arbitrary coherence.”[ii]

An example of anchoring that Dan Ariely points to in his 2008 book Predictably Irrational is that of relocating to a new city and comparing housing prices. If, for example, one was to move from New York City to Toledo, Ohio (where COACT is located), one would hold New York City housing prices as the standard, and anything in Toledo would seem cheap in comparison. The opposite would occur if someone from Toledo would move to New York City; although housing prices, to a native New Yorker, may not seem to be completely affordable, they still would be seen as normal, whereas to the Toledoan (if I may coin a word), they would seem exorbitant.

Scarcity

For years, the advertising industry has utilized the principle of scarcity to induce more sales. By creating a scarcity—which, I must point out, is often false—and an accompanying “aggressive call to action,” people will act to avoid missing out. Think, for example, of many a ploy used in marketing: “Last chance deal!” “50% off until Friday!”  By inventing a “sense of urgency,” people will believe that a product is more valuable.[iii]

Too Many Choices

Behavioral economics researchers have also found that people don’t fare well when faced with too many choices. Shahram Heshmat points out in a Psychology Today article that “Schwartz (2004) showed that when shoppers had to choose among 20 choices of jams (or 6 pairs jeans) experience conflict and are less satisfied with their final selection.” Schwartz found that shoppers who had fewer choices were more satisfied with their selection overall. Heshmat then states, “Too many attractive options make it difficult to commit to any choice, and after the final selection one remains anxious about the missed opportunities (maybe the other pair of jeans was a better fit).”[iv]

Framing

Similar to anchoring, the principle of framing in behavioral economics is when we use a context—a reference—to make comparisons. Framing helps people to differentiate between prices and brands. Monetary value is placed on what the brand itself represents, especially in relation to other brands.[v] Quality is tied directly to the price one is willing to pay or believes an item should cost.

This is why, for example, we’re willing to spend $5.00 or more on a fancy caffeinated beverage at Starbucks when you can probably get the same exact drink (with perhaps a less fancy name, of course) at Dunkin’ Donuts. Starbucks deliberately justified its higher prices at the onset by defining its beverages as higher quality than others.  The atmosphere was important, too: a Starbucks coffee shop, we’ve been convinced to think, is somehow more sophisticated and higher-end than its competition. We (literally) bought into this, hook, line, and sinker.  That’s why we’ll hand over half our paycheck for a Starbucks experience: because we’ve been conditioned to believe that it is worth more.

Additionally, the language used to describe products can be manipulated to change the perceived value of a product. For instance, in one study by Brian Wansink, food with “flowery” descriptors like “Succulent Italian Seafood Filet” and “Tender Grilled Chicken” was more likely to be selected off a menu than if the name of the food itself was solely printed.

Conclusion

There are other key findings and elements in behavioral economics—most of which are startling. You’d never guess how much of our lives are swayed and influenced by the application of this theory. I encourage you to keep your eyes open, question everything, do your homework, and then apply what you find. There are numerous resources currently available, from books to blog posts, TED Talks, and think tanks, and you’ll discover that regardless of your industry, regardless of your product or service or your buyer types, you will learn that there are main takeaways that you can apply to your business.

 

iVanek Smith, Stacey. “Why We Sign Up For Gym Memberships But Never Go To The Gym.” NPR Planet Money, 30 Dec. 2014. http://www.npr.org/sections/money/2014/12/30/373996649/why-we-sign-up-for-gym-memberships-but-don-t-go-to-the-gym

iiHeshmat, Shahram.  “Satisfying vs. Maximizing.” Psychology Today, 13 June 2015. https://www.psychologytoday.com/blog/science-choice/201506/satisficing-vs-maximizing

iii“Behavioral Economics in Action.”  BEworks, Feb. 2015. http://beworks.com/wp-content/uploads/2015/02/An-Intoduction-to-BE.pdf

ivSunstein, Cass and Richard H. Thaler, Nudge. Caravan Books, 2008. Print. Pages 29-30.

vAbumrad, Jad and Robert Krulwich. “Choice.” Radiolab. http://www.radiolab.org/story/91640-choice/

viAriely, Dan. Predictably Irrational: The Hidden Forces That Shape Our Decisions. HarperCollins Publishers. New York, NY: 2008.  Page 30. Print.

viiColon, Geoffrey. “Is Behavioral Economics the Key to Better Marketing?” LinkedIn, 24 June 2015. Web.  https://www.linkedin.com/pulse/behavioral-economics-key-better-marketing-geoffrey-colon

viiiHeshmat, Shahram.  “Satisfying vs. Maximizing.” Psychology Today, 13 June 2015. https://www.psychologytoday.com/blog/science-choice/201506/satisficing-vs-maximizing

ixBarden, Phil. “Brands as Frames.” Decode Marketing. Behavioral Economics Guide 2014. Behavioral Science Solutions, Ltd., 2014. http://www.behavioraleconomics.com/BEGuide2014.pdf

Questions or comments? Please contact Michelle Philippon at mphilippon@teamCOACT.com.