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Lesson 1: What Is Behavioral Economics?

November 15, 2011

Do you recognize this image?  If not, take a guess about where it could be from.

ECVP doesn’t offer too many clues.  The figures in the picture appear Greco-Roman, however, so maybe it was from an event in Southwestern Europe?  Or possibly an advertisement for a festival from 2005?

Any ideas?

Alright. While you were thinking, did you realize that the writing, figures and numbers in both sides of the image are the exact same color?

Not convinced?

I re-framed the ‘E’ from the original image to help to convince you that the details in both of the images are identical (If you’re still not convinced, you can do this yourself in Paint). Isn’t this example amazing? Go back to the original image and look at how distinct the two ‘E’s look. Yet they are, in fact, exactly the same.

As you can see from both examples, our perception of these details is extremely mutated by the way in which they were presented to us. The left image appears to have a black background with white details, while the right image appears to have a white background with black details. But this isn’t exactly the case.

Now try this exercise from one of my favorite books, Nudge.  Answer the questions as quickly as possible:

  1. A bat and a ball cost $1.1o in total. The bat costs $1.oo more than the ball. How much does the ball cost? ______ cents
  2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? ______ minutes
  3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half the lake? ______ days

What were your answers?

If you said 10 cents, 100 minutes and 24 days, congratulations, you are human. But those are not the correct answers. They are: 5 cents, 5 minutes and 47 days.

So What?

The point of these exercises is to show that as humans we can be very easily swayed, misled, and even negligent, all while being blissfully ignorant of these missteps.

In the image example, your perception depended on a seemingly arbitrary detail (the background). This concept, presenting the same object in different formats, is known as framing, and is one of the most well-known biases used by Behavioral Economists. For example, if I asked you to give my friend a ride, and told you nothing about him other than that he is a Reed College dropout, you might hesitate. But what if I had instead only mentioned that he is the founder of Apple? Then your reaction might be a little different. (Yep, that’s Steve Jobs!)

Or more commonly, think of a standard donation form.  They usually provide about four possibilities, and an open option, something like this:

[]$15  []$25  []$50  []$100  _____ Other

When presented with options in this way, most people tend to choose one of the middle two, not wanting to give too little, but also resisting to spend $100. But what if the options were instead changed to this:

[]$15  []$30  []$60  []$100  _____ Other

The total amount donated would most likely rise.

And Behavioral Economics Is…?

Behavioral Economics is a sub-genre of economics that borrows insight from psychology to further inform economic theory. The traditional, neo-classical subject in an economic model is assumed to: (1) be a rational decision-maker (2) have perfect information regarding their economic decision (3) be self-interested with stable preferences. But I think most anyone would agree, that as humans, our rationality can be somewhat limited. In a 2003 paper by Nobel laureate Daniel Kahneman, regarding his first encounter with the psychological assumptions made in an economics book:

Its first or second sentence states that the agent of economic theory is rational and selfish, and that his tastes do not change.  I found this list quite startling, because I had been professionally trained as a psychologist not to believe a word of it.

So this is exactly where the fledgling field of Behavioral Economics begins. Many in the field, including one of my favorites, Duke Professor Dan Ariely, frequently label humans as irrational decision-makers.  I, however, prefer the description of us as having “bounded rationality,” that is, we are actually quite limited by our lack of information, our cognitive ability, and our availability of time. We don’t continuously make bad decisions, rather we tend to stumble into the occasional trap or make a hasty, ill-advised choice.

But that is the caveat; our ability as humans to make split second decisions is overwhelmingly a positive, evolutionary one. And as is evidenced by Professor Ariely’s latest book, The Upside of Irrationality, Behavioral Economists are not only concerned with the negative.

But at this stage, the field is still an infant, and its boundaries are unclear and ever-expanding. Though the sharpest criticism regarding this sub-genre is that its insights tend to focus on individuals, and not markets or the broader allocation of resources, it has provided us with a profound amount of insight with respect to the quirkiness of human decision-making.

Why, for example, even though we fully intended to cancel the free trial once it expires, we fail to, and end up paying money. Or why, more generally, get-rich-quick schemes and faulty products continue to exist, even if they have been on the market for years. Or even how you can guilt people into recycling.

Pretty exciting stuff, if you ask me.

* The optical illusion was taken from ECVP (European Conference on Visual Perception, 2005)

  1. Dave Malloy permalink

    Excellent overview of behavioral econ. You touched on an interesting distinction between labeling humans as irrational or simply calling their rationality “bounded.” I might lean towards the “irrational” label myself, but that’s probably just the pessimist in me talking!

    Looking forward to more.

  2. Steve Willard permalink

    Wow – had no idea that economics could be so fun. Ha I did not do well on those speed questions, and definitely would have turned down that college dropout.

  3. I think it is great that you guys made a group for Behavioral Economics first of all. I do think however, that when considering topics like irrationality, the acknowledgment of the “Behavioral” side is lacking. The field of Applied Behavior Analysis would tackle some of these questions quite differently.

    For instance, why do we do free trials, intending to cancel them, and then not cancel them. Well a more behavioral standpoint would see because we discount (we take smaller sooner rewards versus larger later rewards which is based on the theories of reinforcement). Getting the free trial is easy to do (effort) and is immediately reinforcing. Stopping the trial afterwards takes a lot of effort and is maintained through negative reinforcement (avoiding the fee) which can be ineffective.

    Essentially we do what is most reinforcing to us in the short term. This is human nature and provides a more predictable and reliable way of observing and predicting behavior than going on assumptions of people’s thoughts and emotions.

    There’s no doubt there are emotions and feelings that impact why we make choices and decisions, but typically the consequences of our actions and our behavioral histories play a large role in our daily decision making.

  4. Isn’t the image modified from Matisse?

  5. Great read! I just discovered the blog, and look forward to future posts and discussions.

    The traditional economic view of rational behavior does seem very misguided, even from a macro-economic perspective. Hopefully behavioral economics will be able to provide insight to actual behavior.

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