Behavioral Economics and Decision-Making

Behavioral economics explores the idea that consumers sometimes do not make rational decisions that maximize their utility, due to the influence of emotional, social, and psychological factors.

Cognitive Biases

Behavioral economists identify several cognitive biases that influence decision-making:

Price Anchoring

• Definition: A reference point or 'anchor' is created in our minds to compare prices.
• Example: Retail prices labeled as recommended create an anchor, making the actual lower price seem like a good deal.

Social Norms

• Definition: Decisions are influenced by societal rules.
• Example: Tipping in restaurants is a social norm while tipping at a friend’s dinner party is not.

Availability Bias

• Definition: Decisions are based on how easily examples come to mind, often inflating the perceived probability of events.
• Example: The perceived high risk of shark attacks in Australian seas due to frequent news coverage, despite the low actual risk.

Framing

• Definition: Decisions are influenced by how information is presented.
• Example: Products advertised as 'low fat' may be more likely to be bought due to the positive framing of information.

Loss Aversion

• Definition: Preference to avoid losing things over acquiring gains.
• Example: Reluctance to invest money due to fear of losing it, despite low risk and high potential gain.

Endowment Effect

• Definition: Overvaluing what one already owns compared to potential gains.

Herd Behavior

• Definition: Making decisions based on the actions of others.
• Example: Investors buying stocks because others are doing the same, potentially leading to market bubbles.

Choice Architecture

• Definition: Decisions influenced by the way choices are presented or their location.
• Example: Placement of salad bars or hand sanitizers affects consumption behaviors.

Applications in Behavioral Economics

Behavioral economics can provide insights where traditional economics might fail:

Altruism

• Definition: Acts of kindness or selflessness without expecting a return.
• Example: Charitable donations might not be explained by utility maximization alone but by moral values or emotional feelings.

Employment Decisions by Firms

• Traditional economics suggests firms hire only when needed for profit maximization.
• Behavioral economics suggests firms might hire for reasons beyond profit, such as improving societal well-being or reducing unemployment.

Conclusion

• Behavioral economics provides a broader understanding of consumer and firm behavior by considering cognitive biases and emotional, social, and psychological factors.

Stay tuned for the next discussion on applying behavioral economics to policymaking to address market failures.