Rationality is the backbone to classical economics. People will act rationally and will make decisions based on their needs in a logical manner. Recently, behavioral economics sought to explain the behavior of consumers while taking into account irrational behavior. Basically…people should act logical and make rational decisions and this should form an economy. Instead people tend to act irrationally. This is the basis behind our website, but this idea is far from new. In fact, nudge economics already made you make a decision this week, although you may not know it.
What is Behavioral Economics and Where Did it Come From?
Amos Tversky, and Daniel Kahneman truly began to explore the use of cognitive psychology to explain various divergences of economic decision making from neo-classical theory. During their decades of work together, they sought to explain why consumers act irrationally and how psychology interacts with basic rational human thought. I would highly recommend reading about their work either by combing through their research or books like “Prospect Theory” or by taking the lazier way out and reading Michael Lewis’s book “The Undoing Project.” Freakonomics had an awesome podcast episode with Michael Lewis that explores these who economic pioneers and is actually the basis behind this article.
Prospect Theory was the result of one of the first research projects seeking to combing cognitive psychology and economic decision making. Based on the research by these two individuals, the average consumer makes choices that are irrational and clearly against interest. Their book and subsequent journal articles sought to quantify the mechanisms behind the irrationality and they succeeded.
If all of this sounds complicated or confusing, don’t worry. These individuals are very smart and the concepts are far beyond this simple website. Instead, I’m going to give some examples of behavioral economics aka nudge theory and how it already is changing your life. FYI, nudge theory just won the Nobel Prize in Economics.
Supermarkets
Nudge theory suggests changes can be made to an individual’s “choice environment” to influence their decision making. If grocery stores places items at your eye level, you are more likely to purchase those items. Likewise, the healthier items will usually be on the edges of the store so you are immediately greeted by unhealthy junk food.
Organ donation
Theresa May is considering a system of presumed consent in the U.K. – which would mean individuals are presumed to agree to the use of body parts after death unless they opt out.
E-cigarettes
The behavioural insights team worked with Department of Health on the regulatory framework for e-cigarettes, viewing the devices as potentially beneficial in helping smokers to quit. It advised the government that it is much easier to substitute a similar behaviour than to eliminate an entrenched one. More than 2.3 million people are now vaping in the U.K.
Federal Employee Retirement Plan
Are you invested in your employee’s 401k? If so, you probably filled out a form or several forms and opted in to the program. The federal government also has a 401k type program called the Federal Employee Retirement. program. Unfortunately, people weren’t investing in his program. Most were counting on social security to cover their retirement. If you’ve ever looked at social security, you know this is not a rational way to save for retirement. The federal government actually automatically opted a group of employees into the program and allowed them to opt out. This led to a 15-20 percent increase in the number of people who signed up for the program.
These are just a few examples of the positive and negative effects of behavioral economics on our society. The government is also experimenting with automatic opt in programs for pensions for soldiers to encourage greater savings. Remember, the median savings for Americans under age sixty (60) is around $5000. Maybe forced savings isn’t a bad idea. If you ever feel like a store or company is pointing you in a certain direction, they probably are. Nudge Economics can work for you in your company and might be the reason you acted irrationally in the past. Did you need that new bag of chips that was staring you in the eye at Whole Foods? Probably not . . . But Richard Thaler would be proud.
-B&T