Behavioral Economics 101
Have you ever wondered why investment companies have automatic renewals for 401Ks? Or why gyms are deliberately designed for people not to show up? 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.
To gain satisfaction, a thorough exploration of all the available options will be conducted. In addition, the decisions which are made are supposed to be founded in and to demonstrate rationality.
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.”
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:
1) 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 (see pages 39-30).
|Automatic System||Reflective System|
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.
Another principle of behavioral economics is anchoring. Anchoring consists of a numerical amount one will assign a 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.
As Dan Ariely explains in his 2008 book “Predictably Irritational,” anchoring itself often is quite random, so much so that it is also referred to as “arbitrary coherence.”
An example of anchoring that Ariely points to is that of relocating to a new city and comparing housing prices.
If, for example, you were to move from New York City to Toledo, Ohio (where COACT is located), you 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.
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.
4) 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).”
Akin 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. 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.
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.
If you’re interested in learning more about behavioral economics, here are some excellent resources to check out:
- Ariely, Dan. “Predictably Irrational: The Hidden Forces That Shape Our Decisions.” HarperCollins Publishers. New York, NY: 2008. In this book, Ariely helps us to understand why humans don’t really make smart, rational choices in real life.
- Sunstein, Cass and Richard H. Thaler, “Nudge.” Caravan Books, 2008. Sunstein and Cass’s exploration of why we make decisions is a must-read to understand behavioral economics. (In fact, Thaler won the 2017 Nobel in Economics for his work in this field!)
- BEWorks, the world’s first management consulting firm dedicated to solving business and policy challenges using behavioral economics. They have a wealth of different videos, reports, and other research.
- In his famous TED talk, Rory Sutherland delves into different examples of behavioral economics and how we can apply this to problem-solving.
*Note: This article was originally published in February 2016 and has been updated and revised for relevance.