What is behavioural economics?

The behavioural economics definition refers to the study of psychology in its relation to the economic decision-making processes of consumers, investors and other economic agents. It is a relatively new field at the intersection of psychology and economics that was created to understand the effects of psychological, emotional, cognitive, social and cultural factors on the decisions of individuals and institutions in a variety of economic contexts.

Where have you heard about behavioural economics?

You may have come across the term back in 2017, when Richard Thaler made headlines by winning the Nobel Prize in Economic Sciences for his work on behavioural economics and policy interventions built around "nudges".

Moreover, you may have heard of a book and podcast known as Freakonomics. The book, which sold more than seven million copies, is known for focusing mostly on behavioural economics. The weekly podcast is also listened to by millions of people every month. The project covers various topics from the regulation of house prices to sports gambling.

Behavioural economics also finds its applications in trading. Known as behavioural finance, the study examines the way psychological and social factors influence decision making particularly in financial markets.

If you are interested in the stock market, like to read financial news or are an active investor yourself, then you are probably familiar with some of the behavioural biases like the fear of missing out or herd following that can negatively impact a trader’s performance. These biases are known to be driven by an individual’s emotions, beliefs, norms and habits, and, therefore, are a subject to behavioural finance studies.

What do you need to know about behavioural economics?

Now that you know the behavioural economics meaning, let’s look at the concept in detail. 

In economics, the rational choice theory suggests that when an individual is presented with a number of options under the conditions of scarcity, they would always pick the one that is the most beneficial for them. The theory argues that humans, given their preferences and limitations, are able to make rational decisions by effectively weighing the benefits and costs of each option available. Thus, the final decision made will always be the best choice for the individual. 

However, as humans are emotional beings, behavioural economics suggests that individuals are often not capable of making rational decisions, and that their end behaviour will be subject to cognitive bias, emotions and social influence. The studies combine psychology and economics in order to explore the reasons behind people’s irrational decisions, with their behaviour not following the predictions of economic models.

As companies begin to understand that their consumers are irrational, they start to increasingly incorporate behavioural economics to increase sales of their products and services. As a matter of fact, we see more behavioural economics examples in our day-to-day lives than we may actually think: when buying a cup of coffee for instance. Starbucks (SBUX) has differentiated itself from Dunkin’ Donuts (DNKN) through its inviting store atmosphere and unique product names. You can always expect a grande Starbucks hot coffee to cost more than a medium one from Dunkin. However, loyal Starbucks consumers are conditioned, and willing, to pay more even though the coffee is pretty much the same.

By creating those distinctive features, the business plants a thought, or an anchor, in a customer’s mind that will later influence their actions going forward. This results in a cognitive bias known as anchoring.