Behavioral Economics (Part 2)

 

Many economists used to believe that assets, like stocks and real estate, would stay at or near their real value because cold, calculating investors would buy undervalued assets and sell overvalued assets. But that doesn’t explain bubbles:

In real life, investors aren’t always cold and calculating. They can get worked up and irrational sometimes.

This helps explain bubbles. From the Dutch Tulip Mania of the 17th century, to the 2008 financial crisis.

Investors became irrationally exuberant, and were driven not by logic, but by what economist John Maynard Keynes once called, “Animal Spirits.”

So behavioral economics doesn’t blow up traditional economic theory, it just seeks to understand when and why people behave differently than economic models suggest. Let’s go the Thought Bubble:

One of the most popular experiments in behavioral economics is called the ultimatum game.

In this experiment, two players decide how to share a specific sum of money, let’s say $100.

The first player is given all the money and then is asked to propose a way of splitting it with the second player.

Now if the second player accepts the deal both players get to keep the money.

But, if the second player refuses, nobody gets to keep the money.

When the first player offers to split the money 50/50 the second player almost always accepts.

But what happens when the first player offers an unequal split, like 80/20?

Would you accept that offer? Well, It turns out that less equal offers are often rejected.

Now that doesn’t seem surprising, but it directly contradicts classical economic theory. It’s irrational.

The rational choice would be for the second player to accept any offer, even if it's only a dollar.

After all, a dollar is better than nothing. But human behavior is not motivated solely by gain; it’s also shaped by complex ideas like fairness, injustice, and even revenge.

The ultimatum game shows that people aren’t always as predictable as many economists like to suggest. If people were entirely rational then they would consistently make the same decision given identical options, but sometimes people's preferences are dependent on how the options are presented. Psychologists call this type of cognitive bias the Framing Effect.

I mean, would you rather eat beef that's 75% fat free or 25% fat? Would you rather enter a raffle that claims that 1 out of every 1000 players is a winner or a raffle that points out that there will be 999 losers. Would you support a law named the “Improve our Schools Act” or one named the “Raise our Taxes Act”?

Each of these scenarios can be framed in ways that influence your decision. Classical economics argues that framing should have relatively little effect on decision making because most people are rational and intelligent, but in the real world, people can be pretty irrational. So, Businesses have known about the psychology of decision making for a long time. For example, a gym might break down its membership fee and advertise it only costs only $1 a day, which seems way more affordable than $365 a year.

And a TV priced at $499.99 seems like a better deal than one priced at $500.

This is called psychological pricing. It can make people feel like they’re getting a good deal.

Interestingly, high-end retailers sometimes do the opposite. They set their prices at whole dollars, basically signaling their goods are of a higher quality than you might see at a discount store. Behavioral economists also like to talk about nudge theory. Nudges encourage people to act a certain way, without actually changing the choices that are available to them.