The Transforming Paradigm of Behavioral Economics
Have you ever experienced a hit of dopamine when you see the word ‘free’? Have you ever feared losing what you have more than gaining something you don’t have? Or probably you must have left or procrastinated your purchase when given myriad options? The reason for all these questions is attributed to Behavioral Economics.
Today, behavioral economics is embedded in all spheres of life. Governments are inculcating behavioral insights into policy. Commercial businesses are using it to guide their marketing strategies. Even in the silos of academia, most researchers are keen to bring the subject into action to connect their research with insights from behavioral economics.
WHAT IS BEHAVIORAL ECONOMICS?
Behavioral Economics assimilates psychology into economic decision-making. In other words, it deals with the cognitive, emotional, cultural and, social factors influencing the decision-making of individuals and institutions. Indeed, it is the crossbreed of psychology and economics.
Behavioral Economics has been the context of myriad works throughout the history of economics. The classical period of economics witnessed close association of microeconomics with psychology. Economists like Adam Smith, Jeremy Bentham, and myriad others wrote extensively on the psychological underpinnings of utility. Moreover, the neoclassical economics gave rise to the concept of homo economicus, establishing humans as rational, as was witnessed in the works of economists such as Gabriel Tarde, George Katona, and Laszlo Garai.
Nevertheless, it was the Father of Economics, ‘Adam Smith’ who introduced behavioral economics in 1975 in his book ‘The Theory Of Moral Sentiments’.
The advancement of behavioral economics between the two milestones of the 2002 Nobel Prize awarded to economic psychologist Daniel Kahneman, alongside Vernon L. Smith and the 2017 Nobel Prize awarded to behavioral economist Richard Thaler emulates the emergence of behavioral economics from a theoretical subject to a subject that has expansive real-world relevance.
Behavioral Economics is indeed an enormous literature and focuses on myriad themes including behavioral analyses of incentives; social influences; bias, and risk; time and planning; and impacts of personality and emotions on decision-making.
It underscores the noticeable behavior of humans in accordance with ‘bounded rationality’ assuming their rationality to be limited by their decisions, cognition, and the time available.
The subject demystifies oodles of choices individuals make, thereby exposing our inherent biases and approaches to everyday activities. These biases can take forms ranging from projection bias, referring to people’s assumptions that their preferences will remain unchanged over time, to confirmation or hindsight bias, implying the tendency of individuals to support information that adheres to their values.
BEHAVIORAL ECONOMICS IN REAL WORLD
Behavioral Economics draws on psychology and economics to traverse why people seldom make irrational decisions and how their behavior does not follow the predictions of economic models. It seeks to explain why an individual decided to go for a particular choice instead of another.
“There are too many options, I can’t decide.”
“I worry about failure, but I’m feeling dumb.”
These statements keep wavering in our minds often and have been termed as ‘decision paralysis' in economics. While we all yearn for more choices, but confronting them becomes a cognitive burden rather than a mere delight. Research exhibits that offering a multitude of choices diminishes the ability of consumers to buy anything and if they do buy, they are less satisfied with their selection.
In fact, over choice has been analogous to unhappiness, decision fatigue, and choice deferral-avoiding making a decision altogether.
Behavioral economics underscores copious theories ranging from prospect theory to the nudge theory of consumer behavior.
Indeed, a majority of people purchase insurance plans, overlooking the fact that it is an excellent instance of prospect theory at work. While making the purchase, they tend to overshadow small probabilities to guard against losses. Prospect theory, proposed by psychologists Daniel Kahneman and Amos Tversky in 1979 sheds light on how people choose between different options and estimate the perceived likelihood of these options.
If given a chance to choose between $900 or take 90% chance of $1000, most people choose the former, irrespective of the fact that the outcome is the same in both cases.
Prospect theory delves into biases such as certainty bias referring to overweighing certain options, isolation effect referring to people’s tendency to disregard elements common to both options, and last but not the least, loss aversion implying that people minimize losses.
Also, with Richard Thaler being facilitated with the Nobel Prize in Economics for his work on behavioral economics, nudges have become extremely prevalent in our everyday lives.
Would you like an extra-large fry with your burger? This indeed can be best explained with nudge theory, implying that small suggestions and positive reinforcements alter consumer behavior.
Nudges are widely used by e-commerce platforms to propel consumers into purchasing a product. Not only this, nudges are prevalent within the realm of governance. For instance, the UK government nudged people into washing hands and wearing masks rather than enforcing strict quarantine measures. Besides, the Swachh Bharat Abhiyan is based on nudges pushing citizens towards a healthier environment.
Nudge politics is widely prevalent in India manoeuvring people towards desirable behavior while exercising their freedom to choose. The nudge policies contribute towards increasing tax compliance in India, reducing the dropout rate in poor families, and increasing the savings rate.
THE CASE OF AMAZON – NUDGE THEORY AT WORK
In the time of the global pandemic when the whole nation was stuck at home, Amazon came to the rescue keeping up with the needs of the people. In fact, Amazon has successfully deployed nudge to make buying faster and convenient. The remembering of card details is a convenience nudge that Amazon uses. But that’s not all, the ‘Recommended for you’ section is a blessing in disguise, thereby nudging customers to buy more by offering personalized products. There is no iota of doubt that Amazon’s adjustment of behavioral nudges is truly remarkable.
The concept of nudge theory can be vividly applied to myriad issues ranging from gender equality, savings, tax compliance to credit quality.
Behavioral economics occupies an inherent part of our lives.
Companies are increasingly incorporating behavioral economics to upsurge the sales of their products. For instance, a soap manufacturer produces the same soap but markets them in two different packages to appeal to different groups. One package targets all soap users while the latter is for consumers with sensitive skin.
BEHAVIORAL ECONOMICS OF ANIMALS
Surprisingly, behavioral economics is not only confined to humans but also applies to animals.
It often goes unnoticed how a dog makes an intended exchange for one bone for another with another dog, exemplifying its inherent self-interest. Even the father of modern economics, John Maynard Keynes ascribed irrational choices and biases to “animal spirits”.
For instance, A female paper wasp, who recruits “helper” wasps to raise her offspring is essentially making a trade in exchange for childcare and can eject a helper who doesn’t withstand its expectations.
Well, we are not alone, animals too experience dilemmas in making decisions.
The insights from behavioral economics are now changing mainstream economics. Behavioral macroeconomics is yet another key area that has been neglected until recently. New methodologies are coming onboard ranging from agent-based modeling to machine learning. If these new methods are deployed in evolving coherent behavioral macroeconomic models, it will ensure that behavioral economics will generate an exciting and innovative range of insights in the forthcoming years.
However, all is not well with behavioral economics. Behavioral economics is amassing criticism for being extensively based on research that confronts shortcomings while not representing real economics. Moreover, behavioral economics is a one-dimensional approach to comprehend human behavior and doesn’t take into account the internal influences including moods, thoughts, and feelings.
Nevertheless, behavioral economics is indeed a prominent tool in comprehending decision-making, changing consumer behavior, imputing behavioral finance, and understanding its impact on diverse subjects.