What Is Behavioral Economics?

Consider this. Last night, you used a coupon to get an $8 discount on your $80 steak dinner. Today, as you’re driving through your favorite fast food chain, a sign gleefully informs you that the $8 burgers are on a buy one get one free promotion, just for today. Which of these deals feels like a bigger win to you?

In traditional economics both of these deals are equally appealing. After all, they both save you $8. The fact that one grants you an extra burger, and the other a 10% discount on steak, is irrelevant. $8 saved is $8 saved, no ifs, no buts, and context be damned.

Meanwhile, a behavioral economist would offer a different perspective — one that acknowledges how humans often perceive discounts as percentages rather than in absolute terms. In this light, it is not irrational for a consumer to prefer the buy one, get one free burger deal, as it represents a 50% discount, compared to the 10% discount on the steak.

In a nutshell, this is the difference between behavioral and traditional economics. Traditional economists model economic transactions according to certain rules around rational behavior and self-interest. Behavioral economists try to build models of economic transactions that are rooted in how humans actually behave — which, as you probably know, can often be far from rational.

Behavioral economics is an interdisciplinary field that combines insights from psychology and economics to better understand human decision making. It seeks to explain why people make the economic choices they do, taking into account factors that traditional economics might overlook.

One of the key tenets of behavioral economics is that it challenges the traditional economic theory that humans are rational actors. It recognizes that a variety of factors influence human behavior, and that people do not always act in their own best economic interests.

Behavioral economics strives to provide a more realistic and nuanced understanding of human economic behavior. It does this by studying how people behave in real-world situations rather than relying solely on theoretical models.

At the heart of traditional economics is the concept of Homo Economicus, a hypothetical individual who is always rational and self-interested. This framework simplifies complex economic behaviors in order to create models that predict how people will act in certain situations.

According to this model, Homo Economicus is a cold and calculating decision maker, always seeking to maximize utility. This means making choices that provide the greatest benefit or satisfaction given the resources at hand.

Another assumption of the Homo Economicus model is that individuals have perfect information. This means they are aware of all the options available to them, understand the consequences of their choices, and can make the best decision based on this information.

Unfortunately, the assumptions of traditional economics, such as rationality, self-interest, and perfect information, are often unrealistic. In the real world, people do not always behave rationally, nor do they act exclusively in their own self-interest, or have access to perfect information.

History has shown that traditional economic models often fail to predict or explain human behavior accurately. This is because they do not take into account the complexity of human decision making, which is influenced by a variety of factors, including emotions, biases, and social context.

For example, traditional economics suggests that a person would make the same choice consistently given the same set of options. In fact, one individual won’t necessarily order the same food at their favorite restaurant each time they visit, even if the menu remains the same. They might have a craving for clam chowder today even though they normally order the mushroom soup. This is where behavioral economics comes in – as a response to the limitations of Homo Economicus.

Behavioral economics calls into question the dominance of traditional economics by providing a more realistic model of human behavior. By acknowledging the quirks of human behavior, it paints a picture of a decision maker that hits closer to home – a real, live human and not a calculating machine run on algorithms.

While traditional economics tends to be prescriptive, telling people how they should behave, behavioral economics is descriptive. It seeks to explain how people actually behave, taking into account the complexity of human decision making.

Traditional economics often relies on models like the efficient market theory, which assumes that markets are always rational and efficient. In contrast, behavioral economics acknowledges that humans sometimes make decision-making shortcuts, which may sometimes lead to inefficient outcomes.

Is there more to life than money? Camerer, Babcock, Loewenstein, and Thaler’s 1997 study of New York City taxi drivers illustrates how humans do not equate utility solely with monetary gain. The study found that taxi drivers often set a daily earnings goal and would stop working once they reached it, even if they could have earned more by working longer.

The study brings into light some interesting questions. Why wouldn’t a person strive to make as much money as he can if all it takes is clocking more time at work? This behavior suggests that utility can come in many forms, not just monetary gain. For example, taxi drivers may value their leisure time, the convenience of not having to work longer hours, or the satisfaction of reaching their earnings goal.

Traditional economic models often fail to account for these other forms of utility. They tend to focus disproportionately on the monetary aspects of decision making, ignoring other factors that can influence people's choices.

Traditional economics often relies on monetary indicators to measure economic performance. For example, GDP or gross domestic product refers to the total value of all goods and services produced by a country in a given period.

However, Simon Kuznets, the inventor of GDP himself, warned against using it as an indicator of a nation’s wellbeing. He recognized that GDP does not take into account factors such as income inequality, environmental degradation, or the quality of life of a country's citizens.

Unfortunate events, like natural disasters, may lead to an increase in GDP, or income inequality might worsen despite improvements in GDP. This is because GDP measures economic activity, not economic wellbeing. Natural disasters, for instance, lead to increased economic activity due to reconstruction efforts, even though they are obviously not healthy for any society.

Traditional economics often overlooks aspects that are not easily measured and quantified, such as happiness and wellbeing. However, some countries are starting to recognize the limitations of a purely monetary approach and are developing new measures that reflect a broader range of priorities.

For example, Bhutan has developed an index called Gross National Happiness, which measures the nation’s collective happiness and wellbeing. This index takes into account factors such as psychological wellbeing, health, education, and environmental diversity in addition to economic indicators.

Similarly, New Zealand has introduced a Wellbeing Budget, which prioritizes the wellbeing of its citizens over economic growth. This approach reflects a growing recognition that traditional economic measures do not capture all aspects of a nation's wellbeing.

Behavioral economics began as a distinct field of study in the 1970s and '80s, but its roots can be traced back to 18th-century economists. As early as then, Adam Smith recognized that human behavior is influenced by a variety of factors, not just economic incentives.

More recently, the work of Israeli psychologists Amos Tversky and Daniel Kahneman on uncertainty and risk has pushed behavioral economics forward. Their research has shown that people often make decisions based on heuristics and biases rather than pure rationality as traditional economics suggests.

While it was once a niche and somewhat controversial field, behavioral economics has gained the respect of many traditional economists, especially as prominent figures like Daniel Kahneman and Richard Thaler have won the Nobel Prize in Economics in 2002 and 2017, respectively. Their work has highlighted the importance of understanding human behavior in order to make accurate economic predictions and to design effective policies.

Behavioral economics has had a significant impact on various fields, including marketing, policy-making, and finance. By providing a more realistic understanding of human behavior, it has helped to improve the effectiveness of policies and interventions.

By understanding how people respond to incentives, governments can design policies that encourage desirable behaviors, such as saving for retirement or reducing energy consumption. At the forefront of such initiatives is the United Kingdom, which established its Behavioural Insights Team, also referred to as the Nudge Unit, in 2010.

Concepts from behavioral economics are also widely used by organizations to influence consumer behavior. For example, ‘nudges’ have been used to help consumers make healthier food choices, invest more into their future, or to reduce plastic waste. These strategies recognize that people do not always act rationally, and that their decisions may be swayed by a change in their decision-making environment.