5 Behavioral Economics Concepts Essential for Business Success
Behavioral Economics, along with food-truck tacos and local craft beer, had a strong and recurring presence at SXSW 2018. This is only a few months after Richard Thaler won the 2017 Nobel Peace Prize for his advances in the field and it feels like the world is finally excited to start talking about BE.
A relatively young academic field, Behavioral Economics was founded in the early 1970s by Nobel-Prize winner Daniel Kahneman and his research partner, Amos Tversky. It is the study of decision-making through a behavioral psychology lens. With a focus on understanding cognitive biases and inconsistencies, Behavioral Economics has profound insight into creating businesses and designing products for the real world humans, rather than for the homo economicus, the perfectly rational but entirely unlikely model of humanity on which traditional economics and, often much business study, is based. (Designing for homo economicus might be relevant decades from now if we’ll be designing for our potentially more rational AI friends; another strong and recurring presence at SXSW panels).
The field of Behavioral Economics is ever-growing, providing deepening awareness of our daily decision making experiences, big and small. In this article, I will focus on 5 key concepts that can help everyone better understand their own biases, as well as everyone else’s. Each of the below concepts has been demonstrated empirically and as you will soon see, applied to promote business success and personal wellbeing.
1- Anchoring
You click on a facebook ad to buy a new pair of jeans. The landing page says “premium raw denim: $400/pair,” but when you click on the style you like to select the size, it says “originally $400, marked down to $285.” You feel great about this 30% discount and buy two pairs.
In their 1974 paper on heuristics and biases, Amos Tversky and Daniel Kahneman explained why consumers respond this way by highlighting the importance of setting an “anchor.” The anchoring bias describes our over-reliance on the first piece of information we are given. In the above example, the clothing store is anchoring the price at $400, so, in relation to that price, $285 is cheap, irrespective of the intrinsic value of the jeans. One master of the anchoring bias was the great roman emperor, Marcus Aurelius. In his Meditations, he advises, “Begin each day by telling yourself: Today I shall be meeting with interference, ingratitude, insolence, disloyalty, ill-will, and selfishness.” By anchoring his day in misery, he ensured that every other experience would seem relatively pleasant.
2-Default Bias
Since you don’t actually know the exact percentage you should be directing towards your savings, chances are, rather than raise or lower it, you will keep the 7% rate.
One of the most salient examples of this behavioral bias is demonstrated in Eric Johnson and Daniel Goldstein’s study of organ donations across the world. In researching the large discrepancy in the percentage of populations that were organ donors, even between countries that are otherwise similar in terms of values, religion, and culture (for example, Denmark and Sweden: Denmark has only 4% organ donors while Sweden boasts 86% donors), they realized that the difference was largely based on the wording of the organ donation form in each country. Some countries’ forms read, “check this box if you want to be an organ donor” while others said, “check this box if you do not want to be an organ donor.” The countries that presented that second formulation had a much higher organic donation rate. When faced with tough decisions like these, most people choose to not choose. The default option, therefore has significant repercussions. Opt-out vs opt-in.
3- Loss Aversion (and Endowment Effect)
Even though you don’t necessarily need these sunglasses by Friday, you feel that you don’t want to miss this opportunity and you click ‘order’.
Kahneman and Tversky discovered that we tend to. As part of Kahneman and Tversky’s explanation for loss aversion, they identified the “endowment effect,” which states that we place an unreasonably great value on things we own. Ironically, the endowment effect was the cause for increased devastation in the US housing crisis; individuals over-valued their homes simply because they owned them, ultimately leading to a large decrease in their value. Home-owners didn’t want to recognize that their homes had lost value and therefore held on to them for too long until it was too late.
4- Choice Architecture
You’re on Skyscanner, booking a flight from NYC to LA and the airline presents the following options.
Option 1: $200, direct flight
Option 2: $175, with a stopover, lunch included
Now, because options 2 and 3 are easily comparable, option 2 looks like a relatively better
option and results would likely be split between option 1 and 2–even though, logically, if you prefer 1 to 2 and 2 to 3, you should still always choose option 1.
Karen Horgan, founder and CEO of VAL Health, described the way in which choice architecture has been used for the collective good. In studies conducted to lower calorie consumption (over-consumption is a big problem in the USA), behavioral scientists realized that by simply listing the low-calorie items on the top of a menu, and listing the higher calorie foods further down, individuals consumed 25% fewer calories. Kaiser Pharmaceutical was recently successful in reducing opioid consumption by listing opioids lower down on a list of optional post-surgery medication. As Horgan reminded her audience, “information doesn’t make change, the order in which you present information makes change.”
5- Confirmation Bias
Throughout these weeks, you obviously saw many pictures of cool and un-cool people getting in and out of many cars of many colors (as Instagram was target-marketing cars to you based on your google searches), but you subconsciously paid special attention to the yellow sports cars and their cool owners.
Confirmation bias is the term that pinpoints our overvaluation of information that confirms or supports our prior beliefs and ignores contradictory information. Just think back to the last time you had a hypothesis and Google-searched it to see if you were right. If you’re being
honest with yourself right now, you’ll realize that you subtly ignored any contradictory information and only clicked on the headlines that supports your hypothesis.
The exciting thing about studying Behavioral Economics and applying its insights to life and work is that it is a relatively new and ever-changing field of study; there is always a new concept to explore and apply. The more that we can increase our understanding of the human experience, the better we can build products and services that our humanity as opposed to exploit it. If you’ve enjoyed the insights from this article, please take a look at the book recommendation below. Collectively, they provide a wonderful foundation for the field of Behavioral Economics.
How can these principles and other behavioral economics concepts apply to innovating your new products and services? Email to learn more.
Bonus Bias: Recency (and the importance of endings)
The recency bias is exactly what it sounds like: whatever we have experienced most recently
leaves the most lasting impression. Due to its ease of recollection (and our otherwise poor memory), we’re inclined to over-value recent experiences and then in turn use them as a baseline for future decision making. Therefore when making decisions based on things that happened in the past, we should make sure that our data set goes back far enough. Additionally, if we know that the most recent memories color our view of the experience, we should pay extra attention to the endings of experiences.
***Note: I am deliberately ending this article with a bonus insight as I understand the effect of the recency bias***
Behavioral Economics Reading List:
Judgement in Managerial Decision Making by Max Bazerman
Predictably Irrational by Dan Ariely
