Behavioral economics: what it is and how it explains decision making

Economics is a complex science and, as such, has different branches and conceptions. One of them is quite interesting because it goes against traditional economic ideas. We are talking about behavioral economics.

Contrary to what most economists believed until relatively recently that human beings are not rational beings, even in their economic decision-making. People buy, sell and make other financial transactions with our reason clouded by our desires and our emotions.

In many cases, the behavior of markets, directly dependent on the behavior of consumers and investors, can not only be explained by classical economics, but rather by psychology, and behavioral economics is the midpoint between the two disciplines. Let’s see below.

    What is behavioral economics?

    Behavioral economics, also called behavioral economics, is a branch of knowledge that combines aspects of economics, such as microeconomics, with psychology and neuroscience. This science argues that financial decisions are not the result of rational behavior, but rather the product of irrational impulses from consumers and investors. Economic phenomena are the result of various psychological, social and cognitive factors that affect our decision making and, therefore, the economy.

    The main premise of behavioral economics goes against classical ideas of economics. Traditionally, economics has held that humans behave rationally when it comes to economic movements, buying, selling and investing in a totally thoughtful way. Behavioral economics argues that markets don’t move on the basis of rational algorithms aloneBut it is influenced by the cognitive biases of buyers and investors, because at the end of the day they are people and like everything else their behavior is manipulated in one way or another.

    Thus, behavioral economics considers that the market and its associated phenomena must be studied and interpreted in terms of human behavior, understood in its most psychological sense. Human beings keep having appetites, feelings, emotions, preferences, and prejudices that don’t go away when we walk into a supermarket, invest in the stock market, or sell our house. Our decisions will never be freed from our mental states.

    It is from this perspective that behavioral economics is primarily interested in understand and explain why people behave in a different way than had been assumed with classical business models in hand. If people were as rational as traditional economic positions support financial movements and phenomena should be easier to predict, fluctuating only with environmental issues such as lack of resources in a given material or diplomatic conflicts.

    Historical context

    As unbelievable as it sounds, since its inception, economics has been linked to psychology. In the treatises of famous economists Adam Smith and Jeremy Bentham relationships are made between economic phenomena and the conduct of human beings, seen as something that can hardly be called wholly rational and predictable. However, neoclassical economists distanced themselves from these ideas, trying to seek explanations for market behavior in nature.

    It was not until the twentieth century that these conceptions would be taken up on the irrationality of human beings and on the way in which their prejudices, their emotions and their appetites influence the behavior of the large market. In the middle of this century, the role of human psychology in its economic decision-making was reconsidered., Leaving aside what human beings think meditatively about what they buy and what they sell, at what price or whether it makes sense for them to do so.

    In 1979, what is considered the most relevant text on behavioral economics was published, “Prospect Theory: Decision Making Under Risk,” by Daniel Kahneman and Amos Tversky. In this work, the two authors attempt to show how knowledge of behavioral sciences, in particular cognitive and social psychology, can explain a series of anomalies that have arisen in what is called rational economics.

    Behavioral economics assumptions

    There are three main assumptions that define behavioral economics:

    • Consumers prefer some products to others.
    • Consumers have a limited budget.
    • With given prices, according to their preferences and budget, consumers buy goods that give them greater satisfaction.

    Behavioral economics calls this satisfaction in the purchase of products and services as “utility”. While in traditional macroeconomics it is established that people make economic decisions to maximize utility, using whatever information they are aware of, in behavioral theory it is argued that individuals have no preferences or preferences. beliefs, nor that their decisions are standardized. Their behavior is much less predictable than previously thought and therefore it is not possible to predict which product they will buy but it influences their choice.

    Behavioral economics according to Daniel Kahneman

    As we have mentioned, one of the key figures in behavioral economics is Daniel Kahneman, who won the Nobel Prize in Economics in 2002 for his studies on the complexity of human thought as applied to market behavior. Among his best-known books we have “Think Fast, Think Slow”, Text in which he exposes a theory on the two cognitive systems that coexist in our brain.

    The first of these systems is intuitive and impulsive, which causes us to make most of the decisions in everyday life. This system is what is influenced by fears, delusions, and all kinds of cognitive biases. The second of the systems is more rational, responsible for analyzing the intuitions of the first system to make decisions based on them. According to Kahneman, two systems are needed, but they struggle to stay in balance, which is necessary in order to be able to make good decisions.

    Behavioral economics according to Richard Thaler

    Another of the modern figures in behavioral economics is Richard Thaler, who won the Nobel Prize in economics in 2017 with his push or “nudge” theory. In his theoretical proposition he argues that humans are not always prepared or able to make the decisions that are best for them and that is why sometimes we need a helping hand to decide, whether we are making the right decision or not.

    To understand Thaler’s boost theory, let’s imagine: we are in a supermarket. We have been far-sighted and put together a shopping list. We try to choose the products directly, trying to focus on what we have come to buy. However, upon entering the establishment we see at the entrance a large sign indicating a 2×1 offer of chocolate bars, something that we did not want and should not buy but seeing this ad we decided to l ‘include in the shopping cart.

    Even though we had made the shopping list in advance, in which we had not included these chocolate bars, the fact that they were on offer made us buy them, even though we knew we had none. had no need. If, for example, they had not indicated that they were on offer but had sold the pills at the same price that they probably cost us, we would not have stopped thinking about going and buying them and, rationally, we would have avoided buying. them not to be on the list.

    The economic man

    Another valuable contribution of Richar Thaler in the field of behavioral economics is homo economicus or “econ”, which is the equivalent of the “buyer persona” in the marketing world. Thaler presents this imaginary hominid to us as a customer idea to which a particular product or service is addressed, i.e. the ideal prototypical buyer what was thought during the design of this object or service.

    Thaler indicates that practically since the founding of the economy, the buyer / investor has been seen as a being who obeys only and exclusively logical and rational criteria, as we have already mentioned. Classical economics mistakenly assumes that human beings put aside their wills, fears, socio-economic conditions, or risk profile when they were in an economic activity, as if their subjectivity suddenly vanished and became a reality. pure rationality.

    Richard Thaler said that’s not even the case remotely. In fact, the reasons why he received the Nobel is to have discovered the limits of assumed human rationality in economic decision-making, To show that our senses deceive us, as with optical illusions, and that prejudices influence the way we buy and sell.

      Psychological phenomena and economic decision making

      As we have said, human decision-making does not only meet rational criteria and neither are these decisions detached from subjectivity when taken with situations related to the economy, such as purchasing. and the sale of products and services. Below we will see some phenomena that occur in economic decision making.

      1. Avalanche of information

      The average consumer is exposed to many options and features when choosing a service or product.. So much variety can be confusing, receiving a veritable avalanche of information that causes you to end up choosing at random or even stalling and not making any decisions.

      2. Heuristics

      Many times consumers take shortcuts in their decisions to avoid valuing products or researching what is best. So, for example, instead of analyzing all the products, they simply buy the same thing that their friends or family bought, or get swayed by what they saw for the first time on TV or in other places. ‘other advertising media.

      3. Loyalty

      Even though there are better, newer or more popular products, it is often the case that consumers are generally loyal to the products or services they were already consuming. They hesitate to change supplier or brand for fear of making a mistake. Here, the principle of “fool better known than wise to know” would apply

      4. Inertia

      Consumers usually don’t switch products or suppliers if that means having to invest a little effort and step out of their comfort zone. There is a time when once we get used to our product or service of a lifetime, we end up consuming it again., Without thinking of changing or increasing.

      5. Marco

      consumers they are influenced by the way the service or product is presented to them. Things as simple as the packaging, the colors, the location of the product on the shelves or the prestige of the brand are enough because we decide to buy a product the value for money is pretty bad.

      An example of this is the cocoa cream cookies, the cookies that all supermarkets sell with their own white label and also the brand version. Whether we buy them white label in any supermarket or buy the same ones that advertise on TV, we buy the exact same cookies because they are made with the same ingredients and with the same process. , by changing the shape and packaging just a little.

      According to classical economics, as consumers we would all end up buying the cookies that are sold at the lowest price or the price of the quantity that comes to mind because, in the end, the quality of all of them. cookies is the same. However, this is not the case, as the brand (which the reader is surely thinking about right now) has the most sales. The simple fact of going out on TV and having more “prestige” makes us prefer this brand.

      6. Risk aversion

      Consumers prefer to avoid a loss before they gain somethingThis is why they are also less favorable to the change of service or product, even having reviews indicating that it is better.

      Bibliographical references:

      • Kahneman, D. (2011) Thinking Fast and Slow, Farrar, Straus and Giroux, ISBN 978-0374275631. (Reviewed by Freeman Dyson in the New York Review of Books December 22, 2011 pp. 40-44.) Translated into Spanish as: Think fast, think slow ISBN 9788483068618
      • Kahneman, D. and Tversky, A. (Eds.) (2000) Elections, values ​​and frameworks. New York: Cambridge University Press.
      • Kahneman, D., Slovic, P. and Tversky, A. (1982) Sentence under uncertainty: heuristics and bias. New York: Cambridge University Press.
      • Thaler, Richard H. (1992). The winner’s curse: paradoxes and anomalies in economic life. Princeton: Princeton University Press. ISBN 0-691-01934-7.
      • Thaler, Richard H. (1993). Advances in Behavioral Finance. New York: Russell Sage Foundation. ISBN 0-87154-844-5.
      • Thaler, Richard H. (1994). Almost rational economy. New York: Russell Sage Foundation. ISBN 0-87154-847-X.
      • Thaler, Richard H. (2005). Advances in Behavioral Finance, Volume II (Series of Round Tables in Behavioral Economics). Princeton: Princeton University Press. ISBN 0-691-12175-3.
      • Thaler, Richard H. and Cass Sunstein. (2009). Nudge: Improve decisions about health, wealth and happiness. New York: Penguin. ISBN 0-14-311526-X.
      • Thaler, Richard H. (2015). Inappropriate behavior: creating a behavioral economy. New York: WW Norton & Company. ISBN 978-0-393-08094-0.

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