Behavioral Economics 101

Numerous long-standing economic theories employ a fundamental assumption that we are Homo Economicus: the rational, self-interested human being who makes choices based on thoughtful reason, free from personal bias, in order to maximize utility. According to this assumption, the Economic Man considers all possible outcomes given current information, then makes choices that are in his or her own best interests.

However, recent psychological research has given rise to a new brand of economics, based on the assumption that humans often act irrationally, which lets bias or social pressures creep into our decision making. The field of behavioral economics draws on the work of psychology and other social sciences to identify anomalies in rational human behavior. As it turns out, these anomalies often result in decisions that yield outcomes less-than-ideal for the individual.

What follows is a list of some of the most interesting cognitive biases and processes that humans exhibit, often subtly influencing the way we make decisions (usually without our being aware of it):

Heuristics – People use a range of problem-solving techniques and mental processes, the most familiar of which include processes of elimination, rules of thumb and educated guesses. In other words, instead of always using strict logic to make decisions, people reach many outcomes through a more efficient (though perhaps not optimal) manner based on experience. 

It is often the case that decisions are too complex or would take too much time to fully think through. Example: which toothpaste to buy at the grocery store. Not only are there multiple brands, but each comes in different sizes and with some unique plaque-fighting or cavity-preventing claim. It would be overwhelming for someone to analyze the costs and benefits of each option in order to verify the utility-optimizing one, so instead we use bounded rationality – based on our experience – to settle for the toothpaste that meets the most criteria. The result doesn’t have to be optimal, just satisfactory.

Loss aversion – People hate losing things more than they like gaining things. For instance, the dissatisfaction of losing $50 outweighs the satisfaction of winning $50.

Try this thought experiment: Would you take a bet in which you had a 50.01% chance of winning $1,000,000 and a 49.99% chance of losing $1,000,000? Homo Economicus would always take the bet since there is a positive expected return, but we’re guessing there are many people who would not.

Hyperbolic discounting – People are very inconsistent in the way they discount the value of future payouts. A rational person would discount future payouts by the same rate for each day they had to forego its consumption; but many people exaggerate (that’s what hyperbolic means in this context) value, by discounting payouts very heavily in the immediate future – while hardly at all in the distant future.

For example: If I were to offer you $20 today or $21 tomorrow, which would you choose? Many would choose the $20 today because it is not worth it to wait an extra day for one dollar. But if I ask you if you would prefer $20 one year from now or $21 in one year and one day from now, you would probably take the $21. After all, what’s another day after you’ve been waiting an entire year?

Anchoring – People tend to start with a reference point that influences their assessment of value or probability. In a classic experiment by Amos Tversky and Daniel Kahneman, subjects were asked to estimate what percentage of Africa’s nations were members of the United Nations. Members of one group were first asked if they thought it is more or less than 10%, then asked for an estimate (their average response was 25%). The second group was asked if it is more or less than 65%, and their average response was 45% (much higher, since they had been given a higher anchor).*

This bias is particularly applicable in bartering situations when one party does not know much about the value of the item (think of The Old Man on Pawn Stars low-balling a prospective customer – he’s setting a low anchor value when beginning a negotiation).

*Currently, 54 of 55 African nations are members of the U.N., or 98%. Western Sahara has sovereignty issues.

Confirmation bias – People tend to seek out, interpret, retain or recall information that confirms their preconceptions. This is a relatively familiar cognitive bias that explains why people tend to engage in media sources that support their values, or remember the great plays of their favorite team’s shortstop while forgetting his numerous errors.  When it leads to ignoring evidence that would refute someone’s beliefs, confirmation bias can result in poor decision-making.

Overconfidence effect – People tend to rate themselves as more capable than others, and to overestimate their own ability to perform tasks and predict outcomes. A somewhat amusing finding from Ola Svenson in 1981 was that 93% of American drivers rated themselves better than the average driver. It’s not a far stretch to imagine this fallacy extending to someone’s ability to pick winning stocks or make strategic business decisions.

Money illusion – people tend to assess the value of money in nominal terms, instead of in real terms. Since the genuine value of money is in the ability to trade it for goods and services (purchasing power), it is irrational to be concerned only with its nominal value.

So, people should be more or less indifferent between a 3% increase in nominal income while inflation is at 1%, and a 4% increase in nominal income while inflation is at 2%; both represent nearly the same increase in real income. During times of high inflation employers can take advantage of this irrationality, because employees who buy into the money illusion would be satisfied with an increase in nominal income even it did not keep pace with inflation.

Now that you probably have a better understanding of some frequent human biases, you might get the impression that you’re better armed against falling into these traps. We’ve included just one more, so you don’t get too full of yourself:

Bias blind spot – people tend to see themselves as less susceptible to cognitive biases than others, and resultantly fail to compensate for them.

At least it’s good to know there’s not much you can do about it.

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