Behavioral Economics (Part 1)

 

When economists make their models, they generally assume that people are rational and predictable. But when we look at actual human beings, it turns out that people are impulsive, shortsighted, and, a lot of times, just plain irrational. Look! Balloons!

Today we’re talking about Behavioral Economics and how people actually make decisions.

Behavioral economics is a subfield of economics that focuses on the psychological, social, and emotional factors that influence decision-making. That's not necessarily new. In fact, our old buddy Adam Smith, discussed it in The Theory of Moral Sentiments in 1759. But generations of economists chose to ignore many irrational elements of decision making since it makes it harder to predict human behavior. But in the last few decades, behavioral economics has made a comeback. Several Nobel Prizes have been awarded to researchers that blend economics and psychology and behavioral economics is being applied to more and more fields like marketing, finance, political science, and public policy. Now it’s important to mention that irrational human behavior doesn’t negate everything you’ve learned here at Crash Course Economics. It just adds another layer of complexity, which is exactly what we love at Crash Course

Now in most cases, people are rational. When the price falls for a product, people have a tendency 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, time, and abilities might prevent people from seeking out the best possible outcome.

For example, if the price for ice cream is really low consumers might not buy more.

In fact, they might buy less if they think that that low price means that ice cream tastes horrible.

Now if that happens, then the law of demand doesn’t hold true, which creates a serious problem in classical economics. I mean it is the LAW of demand. You can’t have a situation that breaks the law and still call it a law. That doesn’t happen in other disciplines like physics…except it does.

 

The Newtonian laws of physics, like gravity, hold true most of the time but they breakdown at the quantum level. They explain the orbits of planets, but they have a harder time explaining the orbits of electrons And It’s the same in economics. Classical economic theories explain the big picture stuff pretty well, but there are still a lot of things about individual decision-making that we just don’t fully understand. In ice cream example one of the problems is lack of information. Classical economics assumes that consumers have perfect information when making choices. That is, they know or at least can quickly access information about prices and quality, but, in reality, they often don’t. Sure, the consumer could ask around or call their friends to see if they’ve tried that type of ice cream but they're probably not going to do that. In this situation, consumers may act on the limited information they have, a suspiciously low price, which means either the ice cream is a great deal or it tastes like mayonnaise. They just don’t know.

Prices do send a lot of signals, and there’s even science on how prices change perception.

A study in California analyzed the brains of people taste testing a variety of red wines.

The researchers gave participants fake prices and scanned their brains to determine the level of enjoyment.

The results were surprising. When they thought the price was higher, they actually liked the wine more. This held true even when the subjects were given the exact same type of wine but were told it was a different higher-priced wine. The researchers said "Contrary to the basic assumptions of economics…marketing actions can successfully affect experienced pleasantness by manipulating non-intrinsic attributes of goods.” So, once you’ve got a palatable Pinot Noir, you might be able to raise the price, and actually raise the demand. All you have to do is change perceptions.

 The idea that perceptions and passions influence our actions also applies in finance.