Mind Blowing Concepts From Behavioral Economics

Behavioral Economics is the study of systematic, irrational decision-making.

To learn Behavioral Economics, you must understand cognitive biases. Below are descriptions of the top biases in Behavioral Economics plus illuminating examples to fuel your curiosity.

Anchoring

“Humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly” (Dan Ariely).

The key to human behavior is understanding that people evaluate things in relative terms. 

The silver medalist on the olympic podium should be happier than the bronze medalist. But look at this picture, do you think that’s reality? 

The bronze medalist on the left smiles brightly because she’s pumped to win anything. The silver medalist on the other hand, barely smirks because she missed out on the gold. 

People compare the value of something (a silver medal in this case) to an anchor, or reference point. 

What do you think the silver medalist’s anchor is?   Ok… I’ll tell you.  It’s the gold medal; hence why she’s upset. If she compared herself to the bronze or the racers who won nothing, she would be happy. 

What does that tell you about human nature and our own emotional state at any given time?  

Restaurants strategically price their most expensive entreé so that the second most expensive option looks rather inexpensive (Dan Ariely)

Mark is happy with an annual salary of $75,000 until he learns Lizzie earns $85,000 doing the same job

From Richard Thaler’s book Misbehaving

“Linnea is shopping for a clock radio. She finds a model she likes at what her research has suggested is a good price, $45. As she is about to buy it, the clerk at the store mentions that the same radio is on sale for $35 at new branch of the store, ten minutes away, that is holding a grand opening sale. Does she drive to the other store to make the purchase?

On a separate shopping trip, Linnea is shopping for a television set and finds one at the good price of $495. Again the clerk informs her that the same model is on sale at another store ten minutes away for $485. Same question . . . but likely different answer.”

Remember, we evaluate things in relative terms. A 22% savings on a clock radio appears more attractive than a 2% savings on a television.

Side note: See also mental accounting bias

Framing

“People don’t choose between things, they choose between descriptions of things” (Daniel Kahneman).

Framing is the ability to influence decisions by altering how something is described.

Yogurt described as 10% fat appears less appealing than the same yogurt described as 90% fat-free

From Michael Lewis’ book The Undoing Project: A Friendship That Changed Our Minds:

“When you told people that they had a 90 percent chance of surviving surgery, 82 percent of patients opted for surgery. But when you told them that they had a 10 percent chance of dying from the surgery—which was of course just a different way of putting the same odds—only 54 percent chose the surgery. People facing a life-and-death decision responded not to the odds but to the way the odds were described to them.” 

Loss Aversion

The “Surgery vs. Death” example demonstrates that people fear loss. In fact, according to Daniel Kahneman and Amos Tversky, the pain of losing is psychologically twice as powerful as the pleasure of gaining. 

Loss Aversion is people’s tendency to give more subjective weight to losses relative to gains. 

From Daniel Kahneman’s book Thinking, Fast and Slow

Investors hold onto stocks in the red because selling them would recognize the “loss.”

Consequently, they sell winning stock even when it’s not in their best interest to do so

From Michael Lewis’ book The Undoing Project: A Friendship That Changed Our Minds:

Bob and Manny are scheduled to leave the airport on different flights, at the same time. They traveled from town in the same limousine, were caught in the same traffic jam, and arrived at the airport thirty minutes after the scheduled departure time of their flights. Bob is told that his flight left on time. Manny is told that his flight was delayed, and just left five minutes ago.

Who is more upset?

Many and Bob should be equally upset because they share the same outcome (missing their flights); however, Manny is more upset because he almost made it.

Dan Ariely set up a stand in the mall selling two kinds of chocolates: Hershey Kisses & Lindt Truffles. When Kisses were priced at one cent and Truffles at fifteen cents, 27% of customers purchased Kisses and 73% Truffles. When both prices were lowered by one cent (Kisses were free and Truffles were fourteen cents) 69% of customers took Kisses and only 31% purchased Truffles.

Humans are intrinsically afraid of loss. The real allure of FREE ! is tied to this fear. There’s no visible possibility of loss when we choose a FREE ! item (it’s free). But suppose we choose the item that’s not free. Uh-oh, now there’s a risk of having made a poor decision—the possibility of a loss. The positive emotional response to FREE ! is called the zero price effect

Mental Accounting & Placebo Effect

Our minds play tricks on us…

“Players who were ahead in the game did not seem to treat their winnings as “real money.” This behavior is so pervasive that casino gamblers have a term for it: “gambling with the house’s money” (Ricard Thaler).

Mental Accounting is the human tendency to treat money differently depending on how it was earned.

“There is nothing “just” about the power of a placebo, and in reality it represents the amazing way our mind controls our body” (Dan Ariely).

The Placebo effect is the human ability to absorb a product’s benefits because we believe it to be true, not because the product helped.  

Side note: Dr. Alia Crum demonstrates how hotel maids lost more weight when they believed their job was exercise. Full Ted Talk here.

 

$1 spent using a credit card is the same as $1 spent using cash; however, we spend 30% more when using credit cards

In our minds, credit cards are further removed from our checking account, so we do not feel the same “loss” when using them” (Richard Thaler).

Investors tend to take more risks with capital gains. They treat it as “house money.”

Money is fungible (Richard Thaler). A dollar from profits has the same value as a dollar from weekly wages. 

Why treat them differently? 

Which of the following two options do you prefer? 

  • $100 now
  • $110 a week from now

Most prefer $100 now, but what about with this?

  • $100 in 51 weeks 
  • $110 in 52 weeks

Here, most prefer waiting the extra week. Nothing changed except for the length of time. 

This phenomenon has been termed hyperbolic discounting by the psychologist Richard Herrnstein.

Cambridge University studied over six thousand blind tastings and people only preferred more expensive wine when they knew the price

Availability Bias

“Because of the coincidence of two planes crashing last month, she now prefers to take the train. That’s silly. The risk hasn’t really changed; it is an availability bias” (Daniel Kahneman).

Availability bias is the tendency to overestimate the validity of topics that spring to mind quickly. This is why the media is so powerful. 

Test your bias, did you know the below statistics?

From Yuval Noah Harari’s book, Sapiens: A Brief History of Humankind:

 
“In the year 2000, wars caused the deaths of 310,000 individuals, and violent crime killed another 520,000. Each and every victim is a world destroyed, a family ruined, friends and relatives scarred for life. Yet from a macro perspective these 830,000 victims comprised only 1.5 per cent of the 56 million people who died in 2000. That year 1.26 million people died in car accidents (2.25 per cent of total mortality) and 815,000 people committed suicide (1.45 per cent). The figures for 2002 are even more surprising. Out of 57 million dead, only 172,000 people died in war and 569,000 died of violent crime (a total of 741,000 victims of human violence). In contrast, 873,000 people committed suicide. It turns out that in the year following the 9/11 attacks, despite all the talk of terrorism and war, the average person was more likely to kill himself than to be killed by a terrorist, a soldier or a drug dealer.”
 
Compared to terrorism, people are
  • 18% more likely to die from suicide
  • 50% more likely to die in a car accident

Ask yourself — is it rational for society to fear terrorism more than suicide or car accidents? 

From Yuval Noah Harari’s book Homo Deus: A History of Tomorrow:

“In 2012 about 56 million people died throughout the world; 620,000 of them died due to human violence. In contrast, 800,000 committed suicide, and 1.5 million died of diabetes. Sugar is now more dangerous than gunpowder.”

Sources: 

  • Ariely, Dan. Predictably Irrational, Revised and Expanded Edition 
  • Thaler, Richard H.. Misbehaving: The Making of Behavioral Economics
  • Lewis, Michael. The Undoing Project: A Friendship That Changed Our Minds
  • Kahneman, Daniel. Thinking, Fast and Slow 
  • Harari, Yuval Noah. Sapiens (A Brief History) 
  • Harari, Yuval Noah. Homo Deus: A History of Tomorrow
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