Behavioral Economics: Crash Course Economics #27

Summary

Crash Course Economics explores behavioral economics, a field that integrates psychology into economic models to explain how people actually make decisions. It challenges the traditional rational actor model by highlighting influences like emotions, perceptions, and fairness. The video discusses concepts such as bounded rationality, the framing effect, and loss aversion, using examples like wine tasting, gym pricing, and the ultimatum game to illustrate their impact on decision-making.

Takeaways

• ?\ud83c? Behavioral Economics is a subfield of economics that considers psychological, social, and emotional factors influencing decision-making.
• ?\ud83c? Economists traditionally assume rationality and predictability in human behavior, but behavioral economics acknowledges impulsiveness and irrationality.
• ?\ud83c? Behavioral economics has gained recognition in recent decades, with applications in marketing, finance, political science, and public policy.
• ?\ud83c? Bounded rationality refers to the limits on information, time, and abilities that prevent people from seeking the best possible outcome.
• 📝 Classical economics assumes perfect information, but consumers often make decisions based on limited information.
• 📝 Prices can influence perceptions and decisions, as shown by a study where higher perceived prices increased the enjoyment of wine.
• 📝 Behavioral economics challenges the idea that assets stay at their real value, explaining phenomena like economic bubbles through 'Animal Spirits'.
• 📝 The Ultimatum Game demonstrates that people's decisions are influenced by concepts of fairness and can reject even rational choices.
• 📝 Framing Effect shows that how options are presented can influence decisions, contradicting the classical economic view of rationality.
• 📝 Psychological pricing and nudge theory are practical applications of behavioral economics that influence consumer behavior without limiting choices.
• 📝 Loss aversion, the strong desire to avoid losses, can significantly impact economic decisions and is used to design effective policies.

Q & A

What is Behavioral Economics?

Behavioral Economics is a subfield of economics that focuses on the psychological, social, and emotional factors that influence decision-making.

Why did economists initially ignore irrational elements of decision making?

Economists initially ignored irrational elements of decision making because it made it harder to predict human behavior, which was necessary for creating economic models.

How has Behavioral Economics made a comeback in recent decades?

Behavioral Economics has made a comeback due to the awarding of several Nobel Prizes to researchers blending economics and psychology, and its application in various fields like marketing, finance, political science, and public policy.

What is bounded rationality?

Bounded rationality refers to the limits on information, time, and abilities that might prevent people from seeking out the best possible outcome when making decisions.

How does the law of demand relate to consumer behavior with respect to ice cream prices?

The law of demand suggests that when the price of a product falls, people tend to buy more. However, if consumers perceive a low price for ice cream as a sign of poor quality, they might buy less, which contradicts the law of demand.

What does the California wine tasting study reveal about price and perception?

The California wine tasting study revealed that when participants were given fake higher prices for wines, they reported enjoying the wine more, indicating that price can influence perception of quality and enjoyment.

How do bubbles in finance relate to irrational investor behavior?

Bubbles in finance, such as the Dutch Tulip Mania and the 2008 financial crisis, occur when investors become irrationally exuberant and make decisions not based on logic but on 'Animal Spirits,' leading to overvaluation of assets.

What is the ultimatum game and what does it demonstrate about human behavior?

The ultimatum game is an experiment where two players decide how to share a sum of money, with one proposing a split. If the second player accepts, both keep the money; if not, neither does. It demonstrates that people are influenced by fairness and may reject unequal splits, contradicting classical economic theory.

What is the Framing Effect and how does it influence decision making?

The Framing Effect is a cognitive bias where people's preferences are influenced by how options are presented. For example, people might choose a safer option if it's framed as avoiding loss rather than as a potential gain.

How does nudge theory apply to public policy?

Nudge theory involves encouraging people to act in a certain way without changing the available choices. An example is rearranging school cafeterias to promote healthier food choices by placing healthier options in more convenient locations.

What is loss aversion and how does it affect decision making?

Loss aversion is the idea that people strongly prefer to avoid losses. It affects decision making by making individuals choose safer options to prevent losses, even if those options are not the most logical.

How does Behavioral Economics help in understanding economic decisions?

Behavioral Economics helps in understanding economic decisions by accounting for emotions and other non-rational factors, providing a more realistic view of how people actually behave compared to the rational actors assumed by classical economists.

Outlines

00:00

🧠 Behavioral Economics: Understanding Human Decision Making

The paragraph introduces the concept of behavioral economics, a field that studies how psychological, social, and emotional factors influence economic decisions. It contrasts the traditional economic view of humans as rational with the reality that people often act impulsively and irrationally. The video references Adam Smith's early acknowledgment of this in 'The Theory of Moral Sentiments' and discusses the resurgence of interest in behavioral economics, leading to its application in various fields. The paragraph also touches on the law of demand and the concept of bounded rationality, where people's decisions are limited by the information they have, their cognitive abilities, and time constraints.

05:03

🎯 Perceptions, Framing, and Nudges in Behavioral Economics

This section delves into how perceptions can alter economic decisions, using the example of how wine tasting is influenced by the price that is suggested. It explores the concept of framing, where the presentation of options can sway decisions, contrary to classical economic expectations. The paragraph also discusses psychological pricing strategies used by businesses and introduces nudge theory, which is about influencing behavior through subtle environmental changes without eliminating choice. An example of nudge theory in action is provided by a study that aimed to reduce childhood obesity by altering the layout of school cafeterias to promote healthier food choices.

10:07

💰 Risk and Loss Aversion in Economic Decisions

The final paragraph addresses how people perceive risk and loss, using the example of choosing between a guaranteed sum of money and a gamble with a higher potential reward but also the possibility of receiving nothing. It explains the concept of loss aversion, where the pain of losing is felt more intensely than the pleasure of gaining the same amount. The paragraph concludes with examples of how understanding loss aversion can be used by businesses and policymakers to influence behavior, such as reducing the use of disposable plastic bags or incentivizing employee performance.

Keywords

💡Behavioral Economics

Behavioral Economics is a branch of economics that takes into account the psychological, social, and emotional factors influencing economic decisions. It contrasts with traditional economic models that assume humans are rational and predictable. In the video, this concept is central as it explores how people often make decisions that defy traditional economic predictions, such as buying less of a product when its price is too low, suggesting it might be of poor quality.

💡Rationality

Rationality, in economic terms, refers to the idea that individuals make decisions based on reason and logic to maximize their utility or satisfaction. The video discusses how economists traditionally assume people are rational, but Behavioral Economics shows that people can be impulsive and irrational, often making choices that do not align with their best interests.

💡Bounded Rationality

Bounded Rationality is the idea that in the real world, people's rationality is limited by the information they have, the time they can spend making decisions, and their cognitive abilities. The video uses the example of ice cream pricing to illustrate how consumers might not buy more of a product when it's cheap if they suspect the low price indicates poor quality, showing the limits of rational decision-making.

💡Law of Demand

The Law of Demand is a fundamental economic principle stating that as the price of a product decreases, the quantity demanded by consumers increases, assuming other factors remain constant. The video challenges this law by showing that due to factors like perceived quality, consumers might not always follow this pattern, demonstrating the influence of psychology on economic behavior.

💡Ultimatum Game

The Ultimatum Game mentioned in the video is an experiment used in Behavioral Economics to study how people make decisions involving fairness and cooperation. It involves two players dividing a sum of money, where one proposes a split, and the other decides whether to accept or reject it. The video explains how this game shows that people often reject unequal splits, even though accepting any amount is rational, highlighting the importance of fairness in decision-making.

💡Framing Effect

The Framing Effect refers to the psychological phenomenon where people react to a given choice in different ways depending on how it is presented. The video uses examples like describing beef as '75% fat-free' versus '25% fat' to illustrate how the same information can lead to different decisions based on its framing.

💡Psychological Pricing

Psychological Pricing is a marketing strategy that uses price psychology to influence consumer purchasing decisions. The video gives examples such as pricing a gym membership as 'only $1 a day' or a TV at $499.99 instead of $500 to make the prices seem more attractive and affordable.

💡Nudge Theory

Nudge Theory, as discussed in the video, is the concept of influencing people's behavior through subtle changes in their environment rather than imposing rules. An example given is rearranging school cafeterias to encourage healthier food choices by placing fruits and vegetables at eye level, demonstrating how small changes can have significant impacts on decision-making.

💡Loss Aversion

Loss Aversion is the principle that people's tendency to avoid losses is stronger than their desire to achieve equivalent gains. The video explains this with a coin flip example where people might prefer a guaranteed gain of $50 over a 50/50 chance of winning $100 or losing $50, showing the strong emotional impact of potential losses.

💡Animal Spirits

Animal Spirits, a term coined by economist John Maynard Keynes, refers to the spontaneous, irrational, and unpredictable urges that drive human behavior in the market. The video uses this term to explain economic bubbles, such as the Dutch Tulip Mania and the 2008 financial crisis, where investors acted not out of rational calculation but out of emotional exuberance.

💡Perception and Pricing

Perception and Pricing relate to how the way a product is perceived can influence its price and demand. The video describes a study where people enjoyed wine more when they thought it was expensive, even though it was the same wine. This shows how perceptions, influenced by pricing, can alter the experience and value of a product.

Highlights

Behavioral economics focuses on psychological, social, and emotional factors that influence decision-making.

Adam Smith discussed behavioral economics in 'The Theory of Moral Sentiments' in 1759.

Behavioral economics has been applied to fields like marketing, finance, political science, and public policy.

Irrational human behavior adds complexity to economic models but doesn't negate them.

Bounded rationality refers to limits on information, time, and abilities that affect decision-making.

The law of demand can be affected by perceptions of quality based on price.

Prices can influence perception, as shown in a study where higher prices led to increased enjoyment of wine.

Behavioral economics seeks to understand when and why people behave differently than economic models suggest.

The ultimatum game demonstrates that people are influenced by fairness and are not purely rational actors.

The framing effect shows that the presentation of options can influence decision-making.

Psychological pricing strategies, like presenting prices in a more attractive way, can affect consumer behavior.

Nudge theory encourages certain behaviors without restricting choices, as seen in school cafeteria arrangements.

Loss aversion, the strong desire to avoid losses, influences decision-making more than equivalent gains.

Behavioral economics provides a realistic view of human behavior by accounting for emotions.

Behavioral economics helps address issues like childhood obesity by implementing effective nudges.

Loss aversion can be used to incentivize employees, as shown in studies where potential loss improved performance.

Behavioral economics offers insights into how emotions and perceptions affect economic decisions.

Transcripts

Adriene: Hi, this is Crash Course Economics, I’m Adriene Hill.

Jacob: And I’m Jacob Clifford. So, when economists make their models, they generally

assume that people are rational and predictable.

Adriene: But when we look at actual human beings, it turns out that people are impulsive,

shortsighted, and, a lot of times, just plain irrational. Look! Balloons!

Jacob: Today we’re talking about Behavioral Economics and how people actually make decisions.

[Theme Music]

Behavioral economics is a subfield of economics that focuses on the psychological, social,

and emotional factors that influence decision-making. That's not necessarily new. In fact, our old

buddy Adam Smith, discussed it in The Theory of Moral Sentiments in 1759.

But generations of economists chose to ignore many irrational elements of decision making

since it makes it harder to predict human behavior.

But in the last few decades, behavioral economics has made a comeback. Several Nobel Prizes

have been awarded to researchers that blend economics and psychology and behavioral economics

is being applied to more and more fields like marketing, finance, political science, and public policy.

Now it’s important to mention that irrational human behavior doesn’t negate everything

you’ve learned here at Crash Course Economics. It just adds another layer of complexity,

which is exactly what we love at Crash Course

Now in most cases, people are rational. When the price falls for a product, people have a tendancy

to buy more of that product, so the law of demand holds true. But economists also accept

that there is bounded rationality. Limits on information, time, and abilities might

prevent people from seeking out the best possible outcome.

For example, if the price for ice cream is really low consumers might not buy more.

In fact, they might buy less if they think that that low price means that ice cream tastes horrible.

Now if that happens, then the law of demand doesn’t hold true, which creates a serious problem in classical economics.

I mean it is the LAW of demand. You can’t have a situation that breaks the law and still

call it a law. That doesn’t happen in other disciplines like physics…except it does.

The Newtonian laws of physics, like gravity, hold true most of the time but they break

down at the quantum level. They explain the orbits of planets, but they have a harder

time explaining the orbits of electrons

And It’s the same in economics. Classical economic theories explain the big picture

stuff pretty well, but there are still a lot of things about individual decision-making

that we just don’t fully understand.

Adriene: In our ice cream example one of the problems is lack of information. Classical

economics assumes that consumers have perfect information when making choices. That is,

they know or at least can quickly access information about prices and quality, but, in reality, they often don’t.

Sure, the consumer could ask around or call their friends to see if they’ve tried that

type of ice cream but they're probably not gonna do that. In this situation, consumers

may act on the limited information they have, a suspiciously low price, which means either

the ice cream is a great deal or it tastes like mayonnaise. They just don’t know.

Prices do send a lot of signals, and there’s even science on how prices change perception.

A study in California analyzed the brains of people taste testing a variety of red wines.

The researchers gave participants fake prices and scanned their brains to determine the level of enjoyment.

The results were surprising. When they thought the price was higher, they actually liked the wine more.

This held true even when the subjects were given the exact same type of wine but were

told it was a different higher-priced wine. The researchers said "Contrary to the basic

assumptions of economics…marketing actions can successfully affect experienced pleasantness

by manipulating non-intrinsic attributes of goods.”

So, once you’ve got a palatable Pinot Noir, you might be able to raise the price, and

actually raise the demand. All you have to do is change perceptions.

The idea that perceptions and passions influence our actions also applies in finance.

Many economists used to believe that assets, like stocks and real estate, would stay at or near

their real value because cold, calculating investors would buy undervalued assets and

sell overvalued assets. But that doesn’t explain bubbles:

In real life, investors aren’t always cold and calculating. They can get worked up and irrational sometimes.

This helps explain bubbles. From the Dutch Tulip Mania of the 17th century, to the 2008 financial crisis.

Investors became irrationally exuberant, and were driven not by logic, but by what

economist John Maynard Keynes once called, “Animal Spirits.”

So behavioral economics doesn’t blow up traditional economic theory, it just seeks to understand

when and why people behave differently than economic models suggest. Let’s go the Thought Bubble:

Jacob: One of the most popular experiments in behavioral economics is called the ultimatum game.

In this experiment, two players decide how to share a specific sum of money, let’s say $100.

The first player is given all the money and then is asked to propose a way of splitting it with the second player.

Now if the second player accepts the deal both players get to keep the money.

But, if the second player refuses, nobody gets to keep the money.

When the first player offers to split the money 50/50 the second player almost always accepts.

But what happens when the first player offers an unequal split, like 80/20?

Would you accept that offer? Well, It turns out that less equal offers are often rejected.

Now that doesn’t seem surprising, but it directly contradicts classical economic theory. It’s irrational.

The rational choice would be for the second player to accept any offer, even if it's only a dollar.

After all, a dollar is better than nothing. But human behavior is not motivated solely by gain;

it’s also shaped by complex ideas like fairness, injustice, and even revenge.

The ultimatum game shows that people aren’t always as predictable as many economists like to suggest.

If people were entirely rational then they would consistently make the same decision

given identical options, but sometimes people's preferences are dependent on how the options

are presented. Psychologists call this type of cognitive bias the Framing Effect.

I mean, would you rather eat beef that's 75% fat free or 25% fat? Would you rather enter

a raffle that claims that 1 out of every 1000 players is a winner or a raffle that points

out that there will be 999 losers. Would you support a law named the “Improve our Schools Act”

or one named the “Raise our Taxes Act”?

Each of these scenarios can be framed in ways that influence your decision. Classical economics

argues that framing should have relatively little effect on decision making because most

people are rational and intelligent, but in the real world, people can be pretty irrational.

Adriene: Thanks Thought Bubble. So, Businesses have known about the psychology of decision

making for a long time. For example, a gym might break down its membership fee and advertise

it only costs only $1 a day, which seems way more affordable than $365 a year.

And a TV priced at $499.99 seems like a better deal than one priced at $500.

This is called psychological pricing. It can make people feel like they’re getting a good deal.

Interestingly, high-end retailers sometimes do the opposite. They set their prices at whole

dollars, basically signalling their goods are of a higher quality than you might see at a discount store.

Behavioral economists also like to talk about nudge theory. Nudges encourage people to act

a certain way, without actually changing the choices that are available to them.

Fighting childhood obesity is a priority in many countries and policy makers have suggested

a whole range of solutions. Everything from banning soda in schools to running media campaigns

promoting healthy eating. Behavioral economists approached the problem a little differently.

They wanted to see if they could get children to eat healthier by rearranging school cafeterias.

They put healthier food like fruits and vegetables on eye-level shelves and less healthy foods,

like desserts, in less convenient places. Classical economic theory suggests that this

idea wouldn’t work since rational people would pick the brownie.

But it turns out, students choose the healthier foods. Nudge theory works and it’s changing how we

implement public policy. There are some issues that can be addressed best with the right type of nudge.

Jacob: Let’s talk about something else behavioral economists look at: risk. Let’s say someone

offered you two sealed envelopes. One has a hundred dollars, and one has no dollars.

You can choose an envelope, or you can take $50 cash right now.

So do you take the fifty bucks? Or what about $49?

Now, this is unlikely to happen to you in real life, but the exercise is about your

attitude towards risk. Since there’s a 50/50 chance of getting $100 or nothing, the expected

return, or the average of the possible outcomes is $50.

If you’re willing to accept $50 cash to abandon the envelopes, then you’re risk neutral.

But If you accept less than $50, just to avoid walking away with nothing, then you’re risk-averse.

Behavioral economists have done lots of studies about risk and in particular loss aversion,

the idea that people strongly want to avoid losing. Studies show that, in general, losses

are more painful than gains are pleasurable. So people might choose a safe course of action

even if it’s not the most logical choice.

Let’s say we flip a coin and if it’s heads I give you $100 but if it’s tails, you have to give me $50.

Now, mathematically you should go for it. But many people won’t because they want to avoid losing.

Adriene: Understanding of loss aversion can help businesses and policymakers influence decisions.

For example, some grocery stores in the Washington DC tried to decrease the

use of disposable plastic bags by offering five cent bonuses if customers brought reusable bags.

The policy didn’t do that much. Later they tried a five-cent tax on plastic bags, and,

this time, people used fewer disposable bags. This is loss aversion at work. The pain of

having to pay 5 cents per bag was greater than the benefit of receiving 5 cents per bag.

Another study analyzed how loss aversion can help incentivise employees. Researchers divided

workers into three groups. The first was a control group that wasn’t given a bonus.

The second group was promised a bonus at the end of the year based on meeting specific goals.

Participants in third group were given the bonus at the beginning of the year and were

told that they would have to pay it back if they didn’t meet specific goals.

The workers in the first and second groups performed about the same.

But those in the third group performed significantly better. We just hate losing.

Jacob: So, behavioral economics has a lot to tell us. Accounting for emotion gives

us a realistic view of how people actually behave.

Adriene: We might not always be the rational actors classical economists believe us to be.

For years, economics has had a blind spot. But behavioral economics helps us get a better

look at how we make decisions.

Thanks for watching. We’ll see you next week.

Jacob: Thanks for watching Crash Course Economics. It's made with the help of all these awesome people.

You could help keep Crash Course free, for everyone, forever, by supporting it at Patreon.

Thanks for watching. DFTBA.