Planning

The 7 things you need to know about behavioral economics

Image: “Genius at work” by patries71

A lot of people in advertising are bound to have heard about behavioral economics by now – the discipline that delivers a groin kick to neo-classical economics and lends some academic backbone to what we’ve known in advertising for a long, long time: that people, for all practical purposes, aren’t rational. Behavioral economics’ ascent to popular fame began with Daniel Kahneman‘s Nobel Prize in economics in 2002, accelerated when Dan Ariely’s book “Predictably Irrational” climbed the charts and recently reached new heights in the form of Richard Thaler’s and Cass Sunsteins’ “Nudge”. In our little advertising business corner of the world, Rory Sutherland has been speaking on the topic here and here.

So much for the history recap (yawn). The question is: What’s it all about? Well, in its simplest form, behavioral economics is about people not behaving like the rational, utility maximizing agents economists often presume they are. But if you find that simple explanation a little too simple, yet have neither the time nor the inclination to read a bunch of scientific papers or even the books mentioned above (confession time: I haven’t read them either), here’s a run-down of some of the major take-outs of behavioral economics for all of us in marketing. No, it’s not a complete list. But hey, at least it’s a list.

1. Loss aversion

A core concept of “prospect theory”, developed by Daniel Kahneman and Amos Tversky. People strongly prefer avoiding losses to acquiring gains. In soccer lingo, people rather play defense. This has powerful implications, since it leads to risk-aversion when people evaluate a possible gain and risk-seeking then they evaluate a possible loss.

2. Ambiguity aversion

Like the old saying goes: “Better the devil you know that the one you don’t”. People prefer a known risk to an unknown risk, even if the known risk is high. This is shown by, for instance, the Ellsberg paradox.

3. The Allais paradox

Named after French economist and 1988 Nobel Prize laureate Marice Allais. It states that in a situation of uncertainty vs uncertainty (=risk) people maximize expected value, whereas in a situation of certainty vs uncertainty the same people prefer certainty and therefore maximize expected utility (=internal satisfaction) rather than value. The fact that people shun risk probably seems self-evident to you, but the inconsistent behavior illustrated by the Allais paradox contradicts any paradigm that holds individuals to be rational beings, such as neo-classical economics – or the paradigm that still seems to prevail in many companies, for that matter.

4. Framing

When people are to choose between different options, their decisions can be altered simply by how the options are expressed. A classic experiment by Tversky and Kahneman found that people made inconsistent choices in disease prevention strategy depending on whether the options involved were framed in a positive or negative manner.

5. Choice architecture

Similar to framing – but whereas framing deals with how choices are expressed, choice architecture has to do with how choices are presented structurally. For instance, organ donor programs could be made more successful simply by employing an opt-out process, where people would have to actively refuse donating their organs (“check the box if you do not want to donate your organs”) instead of an opt-in process.

6. Decoy effect

By introducing a third, assymetrical option in a consideration set of two options you can influence how people choose between the two original options. The important thing to keep in mind here is that the purpose of the added option is to alter people’s choice between the two original options (often to make people choose the more expensive option) and therefore the added option needs to be assymetrical, i.e. appear somewhat “strange” and make people go “hm, who would ever want to choose that?”. As the name implies, it’s a decoy.

7. Hyperbolic discounting

Would you rather be given $80 today or $100 a year from now? Given two similar (but not necessarily identical) rewards people generally prefer one that arrives sooner rather than later. We discount the value of the later reward, by a factor that increases with the length of the delay.

Congratulations, you are now a full-fledged behavioral economist. Or not. But these are interesting ideas that could possibly have – and have been shown to have – very practical implications for marketers. Exactly what to do with them and how to use them to your advantage will, however, have to wait until another post. So that’s all for now. Thanks for reading!

Update: As suspected, it turns out the list of 7 things should actually be the list of 8 things (or possibly 9, 10, 11…). Carl was kind enough to post a comment directing my attention to the concept of “anchoring”, which means when making decisions, people tend to overly rely on a specific piece of information or a specific value and then adjust everything else to that value or information. Thanks, Calle!

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14 thoughts on “The 7 things you need to know about behavioral economics

  1. Dan, thank you for giving some structure to this massive and hugely interesting field. I’m currently trying to read up on Kahneman – and one thing that might make your list is the theory of anchoring, which basically is explains how we tend to lock ourselfs on a few select parameters on which we base our decisions. Very relevant and interesting aswell.

    Thanks again // Carl

  2. Mission accomplished! And it only took an hour or so. You see, I was hoping to get exactly that kind of reaction to this post, since I’ve been struggling with this subject for some time now and had the feeling I would miss something. So why not put it out there and trust the wisdom of the crowd?

    So thank you, Carl! Anchoring, of course. Very, very interesting.

    I have a feeling I’m going to have to update this post with an expanded list soon…

  3. Janne says:

    Toppen, tack!
    Nu kanske jag kan låta bli att läsa ut Nudge. Drygt halvvägs igenom svär jag i konsensuskyrkan genom att tycka att den är rätt trist och känns ganska kraftigt överreklamerad. Visst, exemplet med pensionssparande baserat på framtida löneökningar är väldigt, väldigt snyggt (om än naturligtvis i första hand applicerbart på en amerikansk marknad med tydligare lönesteg än vad de flesta svenskar har) men jag tycker det är mycket makadam mellan guldkornen.
    Finns det verkligen någon som på allvar tror att människor är rakt igenom rationella (eller är det en ”härskarteknik” som ni reklammän använder för att få oss i er omvärld att framstå som än mer korkade, inskränkta och trångsynta än vi faktiskt är)?

  4. Janne, jag älskar folk som svär i konsensuskyrkan! Dels av princip, dels lite extra mycket i det här fallet eftersom det betyder att jag inte behöver lägga Nudge på min bok-/ångesthög.

    Härskarteknik? Inte medvetet i alla fall. Jag tror mer det är ett uttryck för frustration än för von oben-perspektiv. Enligt min egen erfarenhet är kruxet att nej, på en direkt fråga finns ingen idag som säger att de tror att människor är rakt igenom rationella, men samma personer glömmer snabbt bort precis det så fort de ska arbeta i praktiken, t ex med att göra reklam. Det här är dock inte ett problem bara på marknadsavdelningar och i företag generellt utan även på reklambyråer, där alltför många diskussioner fortfarande handlar om “budskap” och huruvida folk “förstår” reklamen eller inte.

    Jag säger helt enkelt som Dan Pink (som jag tidigare skrev om här: https://danlandin.wordpress.com/2009/10/07/can-you-sell-the-truth/ ): “There’s a mismatch between what science knows and what business does”. Och lägger till: “And between what business says it knows and actually does”.

  5. Behavioral marketing is getting way huge – building on the idea of behavioral economics. However, while I’d argue that a lot of economics is based on human behavior, behavioral marketing seems to be an evolution of ad targeting. Take ReTargeter for example – they offer better ROI than normal online advertising at a very cheap price.

  6. GREAD POST! I’ve read Ariely’s book, and I like it a lot. As most of us know: the heart makes the decision and the head rationalize it.

    Here are a few other »things« that makes us truly human:

    1. The mind gets what it expects. (Duh!) Really fun chapter in Ariely’s book. I’ve also written about in http://www.minegoestoeleven.com/2008/11/29/du-ar-irrationell/.

    From another book, »True enough«, by Farhad Manjoo:

    2. We tend to sympathize with people that resembles us. People rather listen to the other side’s flimsy attacks on our side than our side’s flimsy attack on theirs. (It’s called the weak dissonance.) Furthermore we tend to select our reality according to our biases. We like to think we’re are objective – truth is we are extremely biased.

    3. We also accept obvious lies provided that they are delivered in a) a funny way, or b) by a star of some sort, or c) by an authority. (Read the hilarious story about dr. Fox in my book »F*ck logic 2«, page 135.)

    Cheers.

  7. Thanks, Per Robert! Lots of cool stuff in behavioral economics and psychology.

    Your point about confirmation bias is very interesting. The brain wants things neatly organized and hates disorder and dissonance and hence rationalizes everything into a seemingly coherent whole. I read a thoughtful point in an article recently about cognition being an output rather than an input, i.e. we use “thinking” not to make decisions but to post-rationalize decisions already made by non-concious processes in our brain (or “the adaptive unconciousness” as Timothy Wilson puts it). Of course, we’re not aware of this, so the myth of cognition-based decision making lives on. No matter what science says, people still live in a Cartesian world: “I think, therefore I am”.

  8. Pingback: Brand strategy vs creative strategy | SegerJohansson

  9. Jag tror att man ska börja läsa om en del marknadsföringsbloggar, eller så är det så att man börjar bli glömsk på gamla dar… Tack för en utmärkt sammanställning!

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