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Behavioral economics studies how psychology affects economic decision making. It suggests that people often act on “rules of thumb” instead of rational thought, are influenced by how a problem is presented, and can be affected by market inefficiencies, herding, and groupthink. Understanding emotional decision making is important for predicting economic trends.
Behavioral economics is the study of the effects of psychology on economic decision making. In other words, how people’s emotions and thoughts can influence the way they make decisions about money. One of the first proponents of this idea was Adam Smith. Behavioral economics was later ignored when a more rational approach was adopted in the 1800s. By the mid-1900s, however, there was a clearer understanding of how much psychology plays into economics.
There are three main ideas in behavioral economics. The first is that people generally act on “rules of thumb” as opposed to rational thought. A rule of thumb is a principle that is mostly true in most situations. An economic example of this is the phrase “you get what you pay for”. This stage is mostly true. However, sometimes the cheaper products are just as good, if not better, than the higher priced brand. In this case it would be rational to buy the cheapest, but equally good product. Most people, however, would buy the more expensive product, thinking it is superior.
The second idea is that people’s thoughts about a problem are influenced by how the problem is presented. This is called framing. The framing can be seen when stores advertise sales. Product A costs $3.99 USD (USD), but it’s not selling very well. So two shops figured out a way to sell Product A as quickly as possible by advertising the product in their weekly flyers. The first store advertises it as 75% off the original. The second store advertises it at $3.00 USD off the original price. Both stores are selling product A for $0.99 USD. The first store will have more shoppers than the second because a 75% discount sounds a lot more than just $3.00 off, assuming the consumer doesn’t know the original price. How the discount was presented affected which store consumers shopped at.
The third idea in behavioral economics is market inefficiencies, which explain outcomes when something other than expected occurs. This concept applies to the stock market. Market efficiency is the idea that prices reflect all known information available about a security. No investor knows what will happen before all other investors. Market inefficiency is anything that happens to challenge that idea, non-rationally. An example of this is selling overvalued stocks and using those funds to buy undervalued stocks. If done correctly, investors can make a lot of money this way, even if it doesn’t seem rational.
Other ideas in behavioral economics are herding and groupthink. These state that people will follow whatever is popular at the time, thinking as a group of people instead of individuals. For example, people who sell their stocks and empty their bank accounts due to a financial decline can start a panic. Others see this and decide to do the same, which only continues to hurt the economy. People may rationally understand that doing these things will make the economy worse, but because everyone else is doing it too.
Behavioral economics can explain good times and bad economic times, as well as predict how people will respond to situations during each. People always make financial decisions based on psychology. When considering trends in the economy, this emotional decision making should be taken into account to give the most authentic view.
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