Behavioral Economics — when economics meets psychology

Thought experiments

Imagine you are picking yogurt at a supermarket, and there are two choices: Yogurt A says “90% Fat-free” while Yogurt B says “10% Fat”. Which one would you choose, if you’re on a diet?

A shirt sells for $200 dollars under two different scenarios. If today is the last day to take advantage of its $200 Black Friday price, would you buy it? If today is the first day it goes back to its original $200 price, would you do the same?

Suppose you have $10,000. In one scenario, the $10,000 is your salary after one month of hard work. In another, the $10,000 is your earning from gambling in a casino. Would you have the same attitude spending the money?

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If in the above thought experiments, you realized that Yogurt A and B are the same; you get the same satisfaction no matter the $200 shirt is on sale or at its original price, and you will treat the $10,000 salary and the $10,000 gambling prize the same… Then your rational thinking has overcome your perceptual thinking. From the perspective of economics, you are a “rational economic man.”

But in real life, most people are easily attracted by the “90% Fat-Free yogurt”, the $200 “sale price”, and lavishly spend unexpected earnings from gambling.

The rise of behavioral economics

Traditional economics analyzes people’s economic behaviors on the basis that people are rational. A “rational economic man,” or “homo economicus,” is someone who always seeks to maximize their own interests when making decisions, conducts shrewd calculations and behaves consistently. But from the above thought experiments, you may have realized that people are not completely rational. On the contrary, in daily life, most of our behavioral decisions are not made after careful deliberation and calculation.

Think about Black Fridays. Faced with the dazzling sales and promotions offered by businesses, you probably couldn’t help but purchase a bunch of things that you may not need at all. Therefore, although the hypothesis of “rational economic man” is simple and neat, it’s insufficient to explain people’s complex economic behavior.

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Some economists believe that more realistic factors should be added to economics. Behavioral economics, which provides a more realistic psychological basis for people’s actions, enhances the explanatory power of economics. Behavioral economics studies how people’s behavior systematically deviates from the “homo economicus” assumption. Simply put, behavioral economics is the study of the irrational aspects of human behavior.

Behavioral economics is not a new subject, but it hasn’t made much noise in mainstream economics. The Prospect Theory proposed by Daniel Kahneman and Amos Tversky in 1979 and Richard Thaler’s research on consumer choice laid the foundation for behavioral economics. Their work enabled the discipline to gradually develop. 2002 was a milestone year in the development of behavioral economics — Kahneman became the first scholar to win the Nobel Prize in Economics in the field of behavioral economics. In 2017, the Nobel Prize in Economics went to Thaler, and people’s attention was once again drawn to behavioral economics.

Real-world applications

Behavioral economists believe that as long as we have mastered people’s way of thinking, we can design various selection environments so that people can make better choices for themselves, their families and society at large.

In his book “Nudge,” Thaler mentioned this experiment: it tests whether the way food is placed will affect students’ choices when the type of food supplied is not changed. A dozen of schools that participated in the experiment arranged food in different ways in their cafeterias — some put desserts in the front row, some put them in the back row, and some put them in a separate row; At a height that is level with the children’s sight, some schools put French fries, while others put carrot sticks.

Results show that changing the placement of food can make their sales volume shift by as much as 25%. Putting healthier and more nutritious foods in handy and easy-to-notice places can influence students’ choices and increase their consumption of healthy foods. Constructing people’s choices is one of the practical applications of behavioral economics.

Takeaway

Our decisions are executed by a set of automatic “biological algorithms”, and we usually fail to realize their existence. Therefore, being aware of and observing your own decision-making mechanism will help you break out of its limitations and enable you to make truly free and rational choices.

Be true to education; be true to yourself.