By Uygar Kilic, Behavioural Economist
Behavioural economics incorporates human psychology, decision science and economics in an attempt to understand how people make decisions. From a simple perspective, it explains why we make irrational decisions and try to find rational reasons to justify them. This is a relatively new concept to the business world, however it has been known to academics for a very long time – more precisely, since Adam Smith released a book called ‘The Theory of Moral Sentiments’ in 1795.
Understanding the human decision-making process is crucial for businesses. Humans make more than 3,000 decisions per day through both biases and heuristics, but unfortunately, our brains are not designed to make precise economical decisions. We make heuristic decisions about our finances, which is why people take out personal loans with really high interest rates or why they don’t save for retirement. Behavioural economics, however, explains how all these decisions are made.
I would like to cover five key points that you need to know about behavioural economics.
1. History of Behavioural Economics
While the concept of behavioural economics is relatively new to business life, it was actually founded in 1795 by a Scottish economist named Adam Smith. He covered the basics of behavioural economics in his book, ‘The Theory of Moral Sentiments’, and explained human behaviours very precisely.
Nonetheless, psychology was not considered to be a science in the 18th century, and it was only in the early 20th century that the Australian School of Economics suggested that economics should be considered a form of psychology, as economic decisions are derived from basic human principles. They were not supporting the ‘neoclassical economic’ theory that every human is rational.
“Understanding the human decision-making process is crucial for businesses”
In the following years, John Maynard Keynes highlighted the importance of human psychology on economics decisions. Thinking of more recent times, you might remember the books ‘Thinking Fast and Slow’, ‘Nudge’ and ‘Predictably Irrational’, written by Daniel Kahneman and Dan Ariely respectively. It was then that behavioural economics was introduced by academics to daily life. Many companies started to encourage their behavioural economics teams to implement its principles in human resources advertisement, health and safety and many more. Believe it or not, you are often exposed to nudges during your daily life.
2. Irrational Behaviour
According to the ‘neoclassical economics’ theory, when the price of a product increases, the demand decreases. When a product’s price increases, sometimes their demand increases too; they call this an exception. However, this exception can be seen in many industries. When a product’s price increases, more people are looking to buy it, because unfortunately our brains are not designed to make precise financial decisions. According to the book ‘Enigma of Reasoning’, we make a decision and defend it, with our brains acting similarly to a defence barrister rather than a scientific professor. We make a decision through biases and heuristics, and then we justify our decision later. Paying three pounds for a cup of coffee, spending more than £1000 on a smartphone, taking a huge risk to have a credit card with 57.6% APR; none of these decisions are rational, but we all make them.
3. Behavioural Economics Has No End
While it feels good thinking you know everything, unfortunately this does not apply to behavioural economics. As Daniel Ariely recently mentioned, things are changing all the time. For example, we now have social media channels. First it was Facebook posts, then Instagram photos and now Stories. The way we communicate with each other fundamentally changed with messaging apps such as WhatsApp. Our world is constantly changing, as is the way we behave. It used to be impossible to send a document via text message, but now we can send documents on WhatsApp. While our behaviours are ever-changing, there is no end for behavioural economics.
4. Behavioural Economics Can be Applied to Everything
Behavioural economics principles can be applied to many different fields. As this concept is heavily used in the marketing and advertising industries, many people believe that applications are therefore limited to marketing and advertising only; these principles cannot be applied to the fields of human resources, finance or health and safety.
Conversely, the behavioural economics principles such as loss aversion, framing, scarcity effect and herding effect can be applied to any field that involves direct interaction with humans. Our brains do not have switches for marketing, human resources, driving or eating; we use our existing decision-making processes for everything. Therefore, these principles can easily be implanted in various, diverse business operations.
5. Behavioural Economics Shows What Data Cannot
Data is a vital part of every business, as well as our daily lives. It is traceable, trustworthy, and we can’t argue with numbers! However, market research or data cannot show one thing, and that is human psychology. It cannot show why people are getting a particular mortgage, or why people pay the minimum amount for their credit cards when they can afford to pay it all. Data shows what has happened but cannot explain the herding effect or loss aversion, and so it is behavioural economics that explains the rational or irrational reasons behind those numbers.