Behavioural Economics

The 2017 Nobel Prize for Economics

The 2017 Nobel Prize for economics was awarded to Richard H. Thaler, an American economist at the University of Chicago for his contribution to behavioural economics. Thaler won the award for enhancing the “understanding of the psychology of the economics”, the prize committee said.

People must be wondering what behavioural economics is. Perhaps this article will help you to understand the concept.

What is Behavioural Economics?

Behavioural economics is the subfield of economics that focuses on the psychological, social and emotional factors that influence decision making. It basically is the study of psychology as it relates to the decision making processes of individuals and institutions.

The most important question of this field is:Are the economists assumption of utility or profit maximisations good approximations of real people’s behaviour?

Many generations of economists chose to ignore many irrational elements of decision making since it is makes it harder to predict human behaviour. However, behavioural economics has made a comeback in recent decades and many Nobel prizes have been awarded for blending psychology with economics.

Behavioural economics is being applied to varied fields like marketing, finance, politics and public policy.

Understanding Behavioural Economics

When economists make their model, they generally assume that people are rational and predictable and they weigh the costs and benefits before making a rational decision. But this does not happen always as most of the time people are impulsive, short sighted or to be blunt; they are irrational.

In some specific cases people are rational, for example, when the price of a product falls people tend to buy more of that product, so the law of demand holds true. But, economists also accept that there is bounded rationality. Limits on information, abilities and time might prevent people from seeking out the best possible outcome.

Suppose, if a chicken burger is priced ridiculously low consumers might not buy more or they might not buy at all, because the low prices would imply poor quality and horrible taste. If this happens then the law of demand will not hold true and that there is a serious problem in classical economics.

Classical economics is based on the ideal scenario just like every law in science, but they cannot be applied to real world without making changes. Classical economics assumes that consumers have perfect information while making choices, but this is not the case. This is where behavioural economics comes into play.

Prices do send a lot of signals and there’s science on how prices change perception. Researchers have said that:“Contrary to the basic assumptions of economics…..marketing actions can successfully affect experienced pleasantness by manipulating non intrinsic attributes of goods.”

The idea that perceptions and passions influence our decisions is also applicable to finance. Behavioural economics does not blow up classical economics, it just seeks to understand why and when people behave differently than economic models suggest.

Applications in Real Life

Businesses have known about the psychology of decision making for a long time. For example, a gym will advertise its membership fee as 1$ per day instead of 365$ a year, because the former seems lesser than the latter even though they are the same amount. This is known as psychological pricing.

According to an analysis risk aversion can help incentivise employees.

As an experiment, researchers divided a group of people into three groups:

• Group 1 was the control group which was not promised any bonus.

• Group 2 would be given bonuses only if they met the specified goals after the year.

• Group 3 was given bonuses in the beginning of the year itself with the condition that their bonuses would be taken back is they failed to meet the targets.
  

The workers in the first two groups performed the same whereas the last group was better, because they had their bonuses at stake.

Final Thoughts

So, behavioural economics has a lot to tell us. Accounting for emotions gives us a more realistic view of how people actually behave. It helps us get a better view of how we make decisions.

- Adityaa Srivastava