A lot of times, when I am having conversations with my friends about the work I do, the word behavioral economics comes up quite often and eventually the question is asked – “what is behavioural economics?”
Now there are two ways to answer this question, the fun way and the ‘other’ way. And I am going to answer in both ways!
Imagine that one fine day you get a very strong urge to eat an apple but you happen to have any apples at home. So, you go to the nearest daily needs store to get an apple and see that apples have been stacked up very nicely in the middle of the store with a sign that says “Price: Rupees 50 a piece”. As you are about to pick an apple you run into a friend. He tells you that he saw a similar apple being sold in a store five shops down for 10 rupees less. In most cases, you will put down the apple and walk five stores down to buy an apple from the other store for 10 rupees less.
Now imagine, in a parallel world on the same day, you had a sudden urge to buy a fancy T-shirt! You go to the nearest shop and find a T-shirt that you like. The price of the T-shirt is 2,000 Rupees. As you are about to buy the T-shirt, the same friend walks up to you and tells you that he saw the same T-shirt for 10 rupees less in a store five stops down. i.e. a T-shirt that was available here for 2,000 here is 1,990 in the other shop. In this case, it is very likely that most people will not take the effort to save 10 rupees!
In both cases, the amount to be saved was 10 rupees and so was the effort that needed to be taken. Then why in the second case are you less likely to do it? It’s because your brain doesn’t see the saving in absolute terms – 10 rupees, it uses the total amount as a reference point to see how big the saving is! In the first case, your brain sees that you are saving around 20% (10 rupees on 50) which is huge, whereas in the second case, the saving is only 0.005% (10 rupees on 2000) which is not worth taking the extra effort! This phenomenon is called reference dependence.
It is the study of such phenomenons that is behavioral economics. It is, basically, the study of how human beings make systematic mistakes in judgement.
To talk about the ‘other’ (technical) definition of behavioral economics we must start with the word economics ‘Economics’ itself. Economics is the study of how human beings and institutions use the resources that they have to meet their needs, demands, and desires.
One of the fundamental principles of Economics is that human beings always make profit-maximizing or satisfaction maximizing decisions. However, as we saw in the example above, that is not always true! Many external and internal factors like motivation, experience, memory, environment and other stimuli play a major role in influencing the decision-making process. These factors may be something as obvious as social influences from friends, family, and peers while ordering food to something as subliminal as a number you happened to read on a completely unrelated source just before making an investment decision.
How do these factors influence and change the way we make decisions?
Well, that is something that will see in articles going forward, on this blog. Some interesting phenomena that I will be covering in articles going forward are decoy pricing, anchoring, reference dependence, loss aversion, social proof and so on. I will also talk and write about current research, case studies and possible application areas for behavioral economics.
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