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!

Advertisement