Economics Terms A-Z
This subdiscipline of economics studies how decisions made by individuals and institutions are influenced by psychological, cognitive, emotional, cultural, and social factors. It is concerned with understanding how people actually make decisions, rather than assuming that the decision-making process is perfectly rational.
In classical economics, decision making is seen as black and white. People make optimal decisions that always provide them with the best available results in terms of satisfaction and benefit. Additionally, people are assumed to have perfect information. Behavioral economics, however, shows how this often isn’t the case, and that humans also make decisions that are contrary to their self-interest or which don’t maximize benefits. It then tries to explain why this is the case.
Behavioral economics concepts are used extensively by businesses to induce behavior in customers. Product designs, special deals, sales, and advertising campaigns are all ways that businesses try to persuade customers to buy or use a certain product. Much research has gone into understanding what factors can convince people to buy something, or what might alter their decision.
One example of this is the “decoy effect”. Often, a business will want to sell a certain item - let’s consider the example of a large soda. By including a “medium” size soda that is smaller than the large, but only at a slight price discount, more people will purchase the large soda since that seems like a better deal. There are many other examples of how behavioral economics concepts are used by companies, advertising campaigns, product design, and more to try and induce specific choices.
Behavioral economics is closely related to psychology, and as such benefits greatly from collaboration with psychologists or other experts who understand human behavior. In fact, economics itself is built on models of human behavior as participants in markets (which are usually not entirely accurate, as we’ve described above).
Psychology, meanwhile, has a long tradition of understanding human behavior not from mathematical models, but from real-world experiments. Bringing the two fields together and updating economic models with more realistic representations of human behavior is an ongoing process. But, it’s one that will continue to improve economics as a whole.
Good to Know
Since it is concerned with individual decision-making, behavioral economics is mostly a microeconomics concept. However, there are obvious macroeconomic applications, especially when observing events like stock market runs and crashes.
Speaking of the stock market, the term “irrational exuberance” was coined by former U.S. Federal Reserve Chairman Alan Greenspan to describe irrational behavior in the markets. This is a clear application of behavioral economics - why do people continue to invest in a stock well after it has become overvalued? His memoir, The Age of Turbulence, touches on this topic among others and is an interesting read for students of financial economics.
A popular book about behavioral economics concepts is Dan Ariely’s Predictably Irrational. In his book, he describes several experiments and shows how they uncover flaws in human decision-making that are both irrational and systematic.
These include fascinating observations about everyday decision-making that most people probably don’t think about. We tend to overvalue our own belongings, tend to stick with default options, fall victim to the decoy effect, and much more. The book is interesting and digestible even for non-economists, too, so no previous subject knowledge is required to get started.