Behavioral Economics – Theories, Key Concepts, and Examples

Ever wondered, “Why do we keep buying things that we don’t really need and still feel like we’re making perfectly rational choices?” 

This is what Behavioral Economics is all about. It combines the science of psychology with traditional economics to explain why people aren’t always able to act rationally. It further evaluates the impact of emotions, biases, and social influences on real-world decisions, for instance, to save, spend, invest, or make policies. 

This blog takes one step further to unravel some interesting theories in Behavioral Economics, such as Prospect Theory, to better understand the “why” behind people’s everyday choices and decisions. It also aims to support these theories with practical examples and ideas from businesses, markets, and daily life.

What is Behavioral Economics?

In simple layman’s terms, Behavioral Economics is a blend of psychology and economics that aims to better understand how and why people behave the way they do in the real world.

In this sense, Behavioral Economics differs from traditional or neoclassical economics, as the latter assumes that people generally have well-defined preferences, enabling them to make well-informed decisions.

Behavioral Economics is an effort to deviate from this understanding and explain the difference between what people “should” do and what they “actually do”. It also determines the possible consequences of these actions.

Evolution of Behavioral Economics

Behavioral Economics emerged in the mid-20th century, challenging traditional economics’ purely rational models. That is when Behavioral Economics incorporated psychological insights to understand real-world human behavior and decision-making better.

Explained below is the evolution cycle of Behavioral Economics over the years:

• 18th-19th century: Even though Behavioral Economics formally emerged in the mid-20th century, its early roots can be traced back to the 18th/19th century when Adam Smith, popularly referred to as the pioneer of Behavioral Economics, asserted that humans aren’t always rational in evaluating limitations and risks, and often tend to overestimate their capabilities.

• 1950s-1960s: The theory of bounded rationality was first introduced by Herbert Simon, a Nobel Laureate, who argued that people are more likely to make “satisfying” decisions owing to limited time and resources, rather than “optimal” ones.

• 1970s – 1980s: The Cognitive Revolution was introduced by psychologists Amos Tversky and Daniel Kahneman, who introduced the Behavioral Economics Prospect theory, which stated that people assign different weights to profits and losses. It also showed that they are generally more averse to the idea of losses than they are encouraged by the concept of profits.

• 1990s – present: The Nudge theory was introduced by Richard Thaler and Cass Sunstein in this era, gently “nudging” or guiding people to make better decisions by changing the environment, not by controlling choice. Behavioral Economics came to be recognized as a standard tool for designing business policies and strategies at this time.       

Core Theories in Behavioral Economics

The whole idea of Behavioral Economics is guided by its various theories, which suggest that human decision-making is less rational than it is often assumed to be. It is selfish too, contrary to what the traditional economic theory opines. To further understand this, let’s take a quick look at some of the most popular theories in Behavioral Economics:

• Behavioral Economics Prospect Theory: Also popularly known as the Loss Aversion theory, this principle asserts that people do not view gains and losses in life the same way. The term “loss aversion” implies that people generally assign a much higher psychological weight to losses than to the corresponding equivalent gains in life.
  
• Bounded Rationality: This means that the rationality of a human being is restricted due to limited time, cognitive limitations, and limited information. This often leads people to be happy with a “good enough” solution rather than trying to maximize potential or achieve the optimum.
  
• Nudge Theory: The guiding principle of this theory is that small and non-forceful changes in the presentation of options/choices to humans can result in a considerable change in their overall behavior. The theory was also popularized by the name “Choice Architecture”.
  
• Social Preferences: This theory holds that people’s decisions aren’t entirely self-interested or selfish. They can be influenced by selflessness, fairness, and reciprocity.
  
• Framing Effect: This theory states that human choices are primarily influenced by how information is presented, rather than by the facts themselves. Positive-worded messages are more persuasive than those with a negative connotation.

Interesting read: How online courses help you to manage studies while working

Key Concepts Explained

Some key concepts of Behavioral Economics can be learned in MA programs in Economics. A Master of Arts (MA) with a concentration in Economics is typically a two-year postgraduate degree program that covers several notions of Behavioral Economics in its course curriculum. 

Some of the key ones include the following:

• Framing: The manner in which something is presented to a person is known as framing. The Framing concept in Behavioral Economics implies that the structure of its presentation determines the outcome of any idea.
  
• Loss Aversion: This is one of the key principles guiding Behavioral Economics. It is based on the premise that people are generally averse to the idea of losses, even more than to the corresponding value of a gain/profit. The latter doesn’t seem to give as much joy as the emotional turmoil an equivalent amount of loss seems to cause in people.
  
• Sunk-Cost Fallacy: This is yet another key concept in Behavioral Economics, which seeks to guide human psychology by recognizing the emotional attachment people have to costs/expenditures incurred in the past. Investors and customers in general tend to have a hard time “letting go” of any failed capital investments or costs.

Real-World Examples of Behavioral Economics

To better understand and relate to the various concepts and theories of Behavioral Economics presented in the earlier sections, we share below a few everyday examples from real-world situations.

Example 1: Advertising to highlight the uniqueness of a product

Behavioral Economics principle used: Framing

The advertising industry primarily uses the Behavioral Economics principle of Framing—the idea that the result of any idea is determined by its presentation. 

Take, for instance, an advertisement for a new car on the market. The car company knows it is competing with numerous other brands selling the same product—the car—to consumers. Hence, they must highlight some unique feature of a standard product to make it stand out from the crowd. Some focus on the silent engine as a unique feature, while some may highlight the excellent shockers as a key selling point. It’s all about Framing—presenting the idea in a certain way to someone to determine its outcome.

Example 2: Losing a Rs. 100 note vs finding a Rs. 100 note that has fallen on the ground   

Behavioral Economics principle used: Loss Aversion

People aren’t averse to the idea of any “specific” loss (emotional/financial/health); they simply do not like the idea of loss in their mind. Here’s a simple example to prove this point.   

The regret of losing a Rs. 100/- note is generally always more than the sheer joy of suddenly finding an equal value of money lying on the ground, unclaimed. This is the loss aversion principle.

Example 3: Social proof drives more business 

Behavioral Economics principle used: Social Proof

Yet another widely used example of Behavioral Economics can be seen in online marketing strategies that primarily use the principle of social proof. This means that people are highly motivated to try something if there is proof that it is popular in their social circles. This is also one of the primary reasons why many people rely on reviews and testimonials before trying a new product/service, particularly on online platforms.

Future of Behavioral Economics   

As the blog suggests, the future of Behavioral Economics largely depends on its growing impact on decision-making in the real world. More and more business sectors, namely Artificial Intelligence, Data Analytics, and Neuroscience, are likely to employ valuable behavioral insights to more accurately design products, policies, and financial systems that reflect how people honestly think and behave. 

The Nudge theory can be used to gently nudge people to make sustainable choices that improve fintech, healthcare, digital marketing, and public policy, among others. In other words, Behavioral Economics is all set to transition from theory to everyday use—making the science of decision-making more personalized, ethical, and human-focused for businesses.

Conclusion

The theory of Behavioral Economics is a conscious reminder that humans are not and should not be expected to be always rational. In fact, their inability to do this is what makes decision-making highly amusing. 

This blog was an attempt to understand how Behavioral Economics integrates psychology into economics, to explain human choices and decisions in the real world—how people think before saving or spending. Finding answers to these questions by digging into the key concepts of Behavioral Economics can enable businesses, individuals, and policymakers to make smarter, more human-oriented decisions.

Take the first step to delving deeper into the world of Behavioral Economics with an Online MA in Economics on the Online Manipal platform, offered by Manipal University Jaipur.