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Behavioural Economics: You aren’t as Rational as You Think

Behavioural Economics

Behavioural EconomicsIt turns out that you aren’t as rational as you may have thought. So, traditional economic theories that assume you are, are… well, flawed. We need an approach that accounts for self-interest and lazy mental short-cuts. Enter Behavioural Economics.

We’ve already told the foundation story of Behavioural Economics in our Management Thinkers series. There we looked at the two men who received Nobel Prizes in Economics for their work in the field:

  1. Daniel Kahneman won his in 2002
  2. Richard Thaler won his in 2017

Why Do We Need Behavioural Economics?

As I said, humans aren’t rational creatures. Yet traditional economics has been making that (wrong) assumption since the start. It’s a reasonable assumption to make, for two reasons:

  1. You’d expect it to be true where commerce and money are concerned.
    You’d think that, to a large extent, our heads would rule our hearts and we’d make the logical choices at each point
  2. It makes things simpler.
    Rational choices follow rules and we can and have been codifying those rules. And they allow us to build equations that let us start with a known condition, enter some data, and calculate outcomes.

So, what’s wrong with Traditional Economics?

Well, it turns out that both those reasons are faulty.

Even in the most reason-led environments, humans let our emotions influence our decisions. But that’s not the worst of it. Kahneman and Tversky’s big realisation is that your mind takes short-cuts. And those follow rules that aren’t always correct. They create in-built biases in our decision-making. And they lead us to irrational answers, because they cut out the reasoning stage.

And, while it’s true that traditional economists are able to create handy-dandy equations, it’s simply not true that they reliably forecast outcomes. The old saying is true, that you’ll get as many forecasts as you have economists in the room. If the equations really worked, you’d get one forecast, and it would always be correct!

What is Behavioural Economics?

So, to address these shortcomings, behavioural economics puts the effects of human behaviour into economic theories. That behaviour includes:

  • emotional responses
  • acting out of self-interest
  • vindictiveness
  • generosity
  • confusion
  • bias and prejudice
  • attentional focus and blindness (being drawn to some things, while failing to notice others)

The Behavioural Economics Research Method

And the methodology of behavioural economics draws largely from the discipline that gave rise to it: psychology. It is observational and experimental. This is its strength… and its weakness:

  • The strength of the methodology, is that it sets up situations and observes what people actually do
  • The weakness is the weakness that all social science experimentation often bears:
    • small sample sizes
    • unrepresentative test subjects
    • the artificiality of test conditions

However, the results have been impressive. Time and again, organisations are able to influence the choices that people make, by designing how they interact with us to use the principles of behavioural economics.

Principal Users of Behavioural Economics

Whilst you’ll find the principles of behavioural economics in many spheres, the big ones are;

  • Public and social policy
    Many democratic Governments have employed experts (the US and UK Governments employed Thaler). They set up units that aim to ‘nudge’ citizens to make the ‘right’ choices. Less democratic Governments, by the way, have no need to nudge, when they can shove or even compel. But this does open up a moral philosophy debate that I’ll steer well clear of!
  • Marketing
    Who’d have thought that a playbook on influencing people’s choices may be of interest to marketers and advertisers? Well, it is. Likewise, it’s also greatly used by…
  • Retailers
    How and where things are displayed in store, the decorations, music, and smells are all designed with care, to nudge you and me into making purchases. and when there is no store (like the BIG online retailers), they can carry out hundreds of small behavioural economics experiments every month. And they do.

Some of the Key Principles of Behavioural Economics

There are a number of big principles that govern human behaviour, which behavioural economics has identified. Let’s take a look at eight of them.

People want to do ‘the right thing’

We are wired for fairness, and also reciprocation. But we also feel that some things should be outside this cultural rule-set. So, for example, if your guests insisted on paying for your hospitality, you would reject it.

We have expectations of ourselves that influence how we behave

We want our actions to be consistent with our values and any commitments we have made. When they are not, they cause ‘cognitive dissonance’ – a kind of mental discomfort that we often recognise as conscience.

We form habits that also drive our behaviours

We do this often without us consciously thinking about them. Habits are hard to change – it’s often easiest to create new ones that supersede the old ones.

We don’t like change

And we have a bias towards maintaining the status quo bias. It’s a kind of inertia. Also connected (in my way of thinking) is our time bias. The present will weigh more heavily than future in our decision making. £100 today is worth more to us than £150 next year. Marshmallows anyone?

If you do want to change people, you need to involve them

In psychology-speak, you need to give them a sense of ‘agency’. On the other hand, reasons and incentives are rarely enough.

Other people’s behaviour matters to us

We like to fit into ‘social norms’. It’s a drive to conform, I suppose. People often choose what to do by observing others and copying them. So what of counter-cultural behaviours? Well, that’s just people trying to fit in with a different, less conventional, set of norms.

People value losses at a higher rate than equivalent gains

This makes us ‘loss-averse’ and causes us to hang on to what we already label as ‘ours’.

We are rubbish at logical mental calculation when we make decisions

And we are prey to all sorts of biases. So, we:

  1. put too much weight on recent events (and too little on distant ones)
  2. can’t calculate probabilities well and give too much weight to catastrophic but unlikely events
  3. spot things that are familiar and build patterns around them, neglecting the unfamiliar counter-examples
  4. automatically trigger all sorts of emotional baggage that colours our decisions
  5. are strongly influenced by how a problem is posed, and the way information is presented to us

What is Your experience of Behavioural Economics?

We’d love to hear your experiences, ideas, and questions. Please leave them in the comments below.

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