As a second-year economics bachelor student, I have only managed to absorb some of the most fundamental principles of classical economics, and barely grasped the bigger picture of the subject matter. At our university (and I do believe other universities do it as well), students are introduced to be accustomed to the thesis of neoclassical theories. The core assumption in neoclassical economics, as everyone having studied economics will know, implies the rationality and individual utility-maximization of each economic agent. This framework, depending on the scope of the investigated market, may or may not represent the realistic outlook of the real world. As such, modern economists nowadays tend to be skeptical and more critical about the application of rationality theory in the predictions of future consumption patterns or production behavior, and in researching into the relationships of different markets. Although many people would claim that the relation of behavioral sciences to economics is far-fetched, this article will attempt to show you otherwise. Behavioral economics is much closer to real life than you think.
How is it illustrated theoretically?
Behavioral economics is highly connected to other behavioral science fields, and indeed its approach to the scientific methodology is rooted from concepts of behavioral science.
Heuristics
Heuristics are the by far most investigated aspect of behavioral economics. That makes a lot of sense, since it is probably the reason to answer the question of how individuals tend to act irrationally. Similar to what we understand about heuristics in real life, or in business studies, behavioral scientists define it as the “shortcuts” to the decision-making process. This is a process whereby individuals are less inclined to depict an overall picture when they make a thorough comparison between every possible circumstance before delivering a judgment. Instead, they often rely on their own simplified rationale to come up with the final decision.
In the annual Behavioral Economics Guide that is available online, Alain Samson, the editor of the publication, categorizes heuristics into three typical groups, namely affect, availability and representativeness. These three characteristics uniquely identify distinct aspects of heuristics in real-life scenarios. Affect heuristics occur when we rely on our perceived experiences of a certain set of actions that causes an individual to make a biased judgment on the given issue. A person with an availability heuristic mindset will tend to make their decisions based on what is more easily to be triggered in their memory. To illustrate these two definitions, let’s take an example. Consider a manager who is investing in two projects, one with less financial returns but a positive environmental impact, and one is neutral to the environment but with more significant financial returns. The manager will be more likely to choose the former when he/she has previously suffered from the consequences of a damaging environment (reflecting affect heuristics), and/or has been recently informed about the growing appetite for investment in green projects (reflecting availability heuristics).
Representativeness heuristics are quite different from affect or availability heuristics, when an individual jumps to a hasty conclusion of a problem based on little information that is available. Stereotyping is one outstanding example of this kind of behavior. For example, for Westerners, they usually presume Asians who are wearing glasses and dressing monotonously to school every day (like me for example), to be extremely hard working but extremely unsociable. Although that I cannot completely confirm that this is untrue for every individual, I do believe that we actually fit in very well with the Dutch society.
Loss aversion/Endowment effect – Prospect Theory
Loss aversion is the concept that most of us have (more or less) acknowledged during the first year in the bachelor’s program. It represents the fact that people tend to incur more intensive feelings with losses in comparison to the equivalent amount of gains. In some recent research, findings would suggest that people value losses twice as much as gains.
The endowment effect is the direct inference of loss aversion. The sense of ownership when an individual owns an object makes it more valuable to the owners, hence usually they would overvalue their products. You will see that especially in the second-hand market, sellers usually value their possession much more compared to buyers.
The tendency of humans towards loss aversion might even explain why people would try to do anything to avoid loss. The prospect theory illuminates on the thesis that people are actually loss-averse and actually risk-seeking depending on the probability of predicted loss. Individuals are therefore acting based on their utility level rather than expected outcome. This concept is somewhat incorporated into the economic theory that was introduced (albeit less detailed) in the second-year course.
Reciprocity
Reciprocity is one of the various social norms that connects the distinct elements of behavioral economics. Theoretically, as humans, we are rationally bounded by the surrounding environment, especially in our childhood. These implied ideas categorize the set of behaviors that a community would deem as appropriate when we enter later stages of our life.
One of the common values that is shared worldwide, is the value of reciprocity. Formally understood, reciprocity requires that a person is to return the favor to another individual who had offered help to this person. In economics, reciprocity can be actually observed in game theory, in the game of repeated actions. Using the trigger strategy, an individual is anticipated to act accordingly with another player in order to maximize their mutual utility. Otherwise, the second player will impose a punishment on the first player because of the non-cooperative behavior.
Nudging
Although there is no extensive hardcore literature related to this theory, the application of nudging is much more common (example below). It is, as a matter of fact, widely applied in business management. A research by Thaler and Sunstein defined this concept as “any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives.” As such, nudging will work best on individuals who are uncertain when they make a decision since it is usually much easier to alter their ideas.
However, the problem here also lies within the definition: “without,” ”forbidding,” or “significantly changing” human behavior. And as much as perfect as it may sound, critics have questioned the ability of users to correctly understand on how to use nudging appropriately that captures the complete meaning of this definition.
More than just theories
Nudging: Organ donation
The prominent example of nudging has been involved in the use of organ donation. The application for nudging in this case, is to involve more people being active with their registration for organ donations, therefore expanding the number of organs that are collected and facilitating a more efficient market mechanism. In the organ donation market, it is critical that a donated organ must be complied to stringent requirements to fit the medical conditions of the potential recipient. By enlarging the number of organs being exchanged, there will be more options to choose and hence more demand will be met.
There are multiple ways to persuade more people to partake in the program, but every successful story of it carries some shared fundamental principles that have been researched extensively into the topic. Sunstein identifies that some of the types of nudges, for example, social norms or precommitments, are detrimental to the success of the program. In the National Health Service (NHS) campaign that encourages people to do donations, more than 100,000 people registered on the donor list. By using nudges of social norm that encourage people to do the good deed, the campaign wanted to transfer its messages by highlighting that “If you needed an organ transplant, would you have one? If so, please help others.” Obviously, it was extremely successful in engaging more potential donors by the use of precommitments, which successfully attaches a person’s (potential) future state to the present. Although the donor might not need a transplant in the future, he/she actually “precommits” to make a donation anyway.
Reciprocity: Giving out samples
By giving out samples, a company has implicitly attached to the customers the feeling of reciprocity to whom that offers the product. As such, the customer will feel more indebted and more likely to be obligated to make a real purchase on the product afterward. Statistics show that free samples increased sales as much as 20 times.
Behavioral economics at UvA
Behavioral economics is considered to be one of the most important research areas at the University of Amsterdam; and with an influential contribution to economics, the department was granted the status of “Research Priority Area.” Maybe as a student in our faculty, you might have visited CREED Lab inside the E-building of our campus as well. And yes, as you might have guessed by now, this small facility was established as one of the four sub-organizations that have been so detrimental in providing invaluable research data and analysis to the entire department through the public-held experiments that occur every now and then. Although the research area requires a comprehensive understanding of interdisciplinary fields, stretching from economics to other social fields such as psychology, the university also wants to inspire our generation of future economists an opportunity to capture the essence of this field of growing interest. Indeed, for students, the university also offers the selection of behavioral economics as an elective course for the final year, which focuses on the fundamental construction of (behavioral modes of) game theory models and its relevant experimental methods. In Master’s level studies, the course of behavioral economics takes a different approach, in which it attempts to critically evaluate the conventional proposition (i.e. thesis of neoclassical theories) in evaluating more complex economic problems.
Academic institutes are diving into this subject as well. Behavioral economics has established their presence not only around Europe, but also the United States and multiple Asian countries. The prospect does indeed look as promising as ever, and there should be no doubt that the subject matter would be in the same cohort with mainstream economics.
Myriads of social scientists and economists have worked together for decades on studying the decision-making process of individuals, and significant progress has been greatly recognized by the scientific community. Unfortunately, it seems that the world of behavioral economics is either too uncommon or too sophisticated to the society (even to economists themselves!). Therefore, as a suggestion to other academic communities as well, such important scientific contributions to real life should not be alienated, but rather to be communicated more effectively to the broader audience.