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Behavioral Economics Guide 2. By Alain Samson, Ph. DThink about the last time you purchased a customizable product. Perhaps it was a laptop computer. You may have decided to simplify your decision making by opting for a popular brand or the one you already owned in the past.
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You may then have visited the manufacturer’s website to place your order. But the decision making process did not stop there, as you now had to customize your model by choosing from different product attributes (processing speed, hard drive capacity, screen size, etc.) and you were still uncertain which features you really needed.
At this stage, most technology manufacturers will show a base model with options that can be changed according to the buyer’s preferences. The way in which these product choices are presented to buyers will influence the final purchases made and illustrates a number of concepts from behavioral economic (BE) theories.
First, the base model shown in the customization engine represents a default choice. The more uncertain customers are about their decision, the more likely it is that they will go with the default, especially if it is explicitly presented as a recommended configuration. Second, the manufacturer can frame options differently by employing either an . In an add mode, customers start with a base model and then add more or better options.
In a delete frame, the opposite process occurs, whereby customers have to deselect options or downgrade from a fully- loaded model. Past research suggests that consumers end up choosing a greater number of features when they are in a delete rather than an add frame (Biswas, 2. Finally, the option framing strategy will be associated with different price anchors prior to customization, which may influence the perceived value of the product. If the final configured product ends up with a . Sellers will engage in a process of careful experimentation to find a sweet spot—an option framing strategy that maximizes sales, but set at a default price that deters a minimum of potential buyers from considering a purchase in the first place.
Rational Choice. In an ideal world, defaults, frames, and price anchors would not have any bearing on consumer choices. Our decisions would be the result of a careful weighing of costs and benefits and informed by existing preferences. We would always make optimal decisions. In the 1. 97. 6 book The Economic Approach to Human Behavior, the economist Gary S.
Becker famously outlined a number of ideas known as the pillars of so- called . The theory assumes that human actors have stable preferences and engage in maximizing behavior.
The decade of the 1. Prospect Theory. While economic rationality influenced other fields in the social sciences from the inside out, through Becker and the Chicago School, psychologists offered an outside- in reality check to prevailing economic thinking. Most notably, Amos Tversky and Daniel Kahneman published a number of papers that appeared to undermine ideas about human nature held by mainstream economics. They are perhaps best known for the development of prospect theory (Kahneman & Tversky, 1. Our willingness to take risks is influenced by the way in which choices are framed, i. Have a look at the following classic decision problem: Which of the following would you prefer: A) A certain win of $2.
B) A 2. 5% chance to win $1. How about: C) A certain loss of $7. D) A 7. 5% chance to lose $1. Tversky and Kahneman’s work shows that responses are different if choices are framed as a gain (1) or a loss (2). When faced with the first type of decision, a greater proportion of people will opt for the riskless alternative A), while for the second problem people are more likely to choose the riskier D).
This happens because we dislike losses more than we like an equivalent gain: Giving something up is more painful than the pleasure we derive from receiving it. Bounded Rationality.
Long before Tversky and Kahneman’s work, 1. Scholars during the neoclassical revolution at the turn of the 2. Camerer, Loewenstein and Rabin, 2. The importance of psychologically informed economics was later reflected in the concept of . According to this view, our minds must be understood relative to the environment in which they evolved. Decisions are not always optimal. There are restrictions to human information processing, due to limits in knowledge (or information) and computational capacities (Simon, 1.
Kahneman, 2. 00. 3). Gerd Gigerenzer’s work on “fast and frugal” heuristics later built on Simon’s ideas and proposed that the rationality of a decision depends on structures found in the environment. People are “ecologically rational” when they make the best possible use of limited information- processing abilities, by applying simple and intelligent algorithms that can lead to near- optimal inferences (Gigerenzer & Goldstein, 1. While the idea of human limits to rationality was not a radically new thought in economics, Tversky and Kahneman’s . About 3. 0 years later, their thinking entered the mainstream, resulting in a growing appreciation in scholarly, public, and commercial spheres. Mental Accounting. The economist Richard Thaler, a keen observer of human behavior and founder of behavioral economics, was inspired by Kahneman & Tversky’s work (see Thaler, 2.
Thaler coined the concept of mental accounting. The overarching notion behind this theory is that people think of value in relative rather than absolute terms. For example, they derive pleasure not just from an object’s value, but also the quality of the deal—its transaction utility (Thaler, 1.
In addition, humans often fail to consider fully opportunity costs (tradeoffs) and are susceptible to the sunk cost fallacy (Thaler, 1. A core idea behind mental accounting is that people treat money differently, depending on factors such as the money’s origin and intended use, rather than thinking of it in terms of formal accounting.
An important term underlying the theory is fungibility, the fact that all money is the same and has no labels. In mental accounting, people treat assets as less fungible than they really are; they frame assets as belonging to current wealth, current income, or future income. Consider unexpected gains: Small windfalls (e. Another example from mental accounting is credit card payments, which are treated differently than cash. Mental accounting theory suggests that credit cards decouple the purchase from the payment by separating and delaying the payment. Credit card spending is also attractive because on credit card bills individual items (e. In the book, Thaler and Sunstein point to experience, good information, and prompt feedback as key factors that enable people to make good decisions.
Consider climate change, for example, which has been cited as a particularly challenging problem in relation to experience and feedback. Climate change is invisible, diffuse, and a long- term process. Pro- environmental behavior by an individual, such as reducing carbon emissions, does not lead to a noticeable change.
The same is true in the domain of health. Feedback in this area is often poor, and we are more likely to get feedback on previously chosen options than rejected ones.
The impact of smoking, for example, is at best noticeable over the course of years, while its effect on cells and internal organs is usually not evident to the individual. Traditionally, generic feedback aimed at inducing behavioral change has been limited to information ranging from the economic costs of the unhealthy behavior to its potential health consequences (Diclemente et al., 2.
More recent behavior change programs, such as those employing smartphone apps to stop smoking, now usually provide positive and personalized behavioral feedback, which may include the number of cigarettes not smoked and money saved, along with information about health improvement and disease avoidance.“Irrational” Decision Making: The Example of the Psychology of Price. Boundedly rational choices, made due to limits in our thinking processes, especially those we make as consumers, are illustrated well in Dan Ariely’s popular science book Predictably Irrational. One study asked participants whether they would buy a product (e. They were then asked about the maximum they would be willing to pay.
In the case of cordless keyboards, people in the top 2. The experiment demonstrates anchoring, a process whereby a numeric value provides a non- conscious reference point that influences subsequent value perceptions (Ariely, Loewenstein, & Prelec, 2. Ariely also introduces the concept of the zero price effect, namely when a product is advertised as . A free chocolate is disproportionately more attractive relative to a $0.
Finally, price is often taken as an indicator of quality, and it can even serve as a cue with physical consequences, just like a placebo in medical studies. One experiment, for instance, gave participants a drink that purportedly helped mental acuity. When people received a discounted drink their performance in solving puzzles was significantly lower compared to regular- priced and control conditions (Shiv, Carmon, & Ariely, 2. Predictably Irrational and Nudge alerted the public to a new breed of economists influenced by the study of behavioral decision making that was pioneered by Kahneman and Tversky’s work (sometimes referred to as . The psychology of homo economicus—a rational and selfish individual with relatively stable preferences—has been challenged, and the traditional view that behavior change should be achieved by informing, convincing, incentivizing or penalizing people has been questioned (Thaler & Sunstein, 2.