Behavioural Economics is a subfield of Economics that weaves psychology into decision making by a customer. It attempts to explain human behaviour through the lens of social preferences, beliefs and societal norms. It borrows findings from neighbouring disciples of social sciences like psychology, sociology, neuroscience and cognitive science to provide a more reliable and precise explanation of human behaviour under economics parameters. Although it may seem to be a new branch of the youngest of social sciences, Adam Smith has discussed the subject in The Theory of Moral Sentiments in 1759. But economists chose to ignore it because it just made their jobs harder.
Economics, simply put, is common sense made uncommon. All laws and principles are based on a rigid assumption that consumers behave rationally and are bound to choose the alternative which maximises their satisfaction and gives them maximum utility. The “ceteris paribus” of every law of economics essentially restrict its validity in the actual world. There is no market structure in the world which abides by this supposition and no consumer changes in the market that may seem even remotely significant. What classical economics lacks, behavioural economics makes up for it. Classical economics plays with a perfectly rational consumer. The rational choice theory states that when consumers are presented with various alternatives of similar goods in times of scarcity, they would choose the alternative that maximizes their individual satisfaction. This theory assumes that the consumers, given their preferences and budget constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational consumer has self-control and is able to distance himself from external emotions and make a rational economic choice. This essentially tells us that all choices made in the world are the economically best that could have been made. How many times have we realised that it is not the case? Well, almost always.
Classical economics shies away from deviations because it makes it harder for economists to predict consumer behaviour. Behavioural economics is more to the truth than anything simply because it attempts to dismiss any assumptions in the theory of economics by studying the errors in decision making by the design of the human mind. A consumer may not always want long term, gradual benefits of a product but rather choose a competitor that gives him instant pleasure. Economics in its original sense fails to relate to present day consumers because consumers are irrational, impulsive and erratic. Take an example. According to traditional economics if Jai wants to lose weight and is equipped with the calorie count of every food item he will opt for the food which has the least amount of calories. On the contrary, Jai may be persuaded by an attractive offer that compels him to buy an ice cream at a cheaper rate. He may, in turn, forget his priorities and opt for a less favourable alternative, in the economics sense. He gives into his temptation and shows lack of self-control. That’s not any less practical than a normal consumer. Another ideal example would be Brexit. Economists suggest that the decision to leave the EU by the majority was most likely taken as a consequence of social and emotional influence rather than a well calculated, rational choice.
What seem to be decisions that lack a basic sense of rationality are just out of what the psychologists call humans’ sense of bounded rationality that prevent them from seeking the best possible outcome. Take the Patanjali soaps. Their prices are way below the prevailing market prices. Yet their demand isn’t correspondingly very high. Consumers might misconstrue the low price and relate it to low quality. The problem here is lack of information. Classical economics assumes that consumers have perfect knowledge of the product that they are buying, thereby ignoring a very compelling determinant in decision making.
The idea that perceptions and passions affect our decision making process is also applicable in finance. Investors aren’t always cold and calculating. They tend to get worked up and make impractical decisions. They might get irrationally exuberant and not employ any logic in their investment choices. A prime example of such behaviour is the 2008 financial crisis. Another industry where behavioural economics helps is marketing. Companies often employ a popular theory known as the nudge theory to sell a product. Carrying the soap example forward, if a seller labels one of his products as ‘For Sensitive Skin’ he attracts another customer base that wouldn’t have bought his soap if it weren’t for the added benefit that he advertised, regardless of the fact that his soap was not much superior to his competitors. He nudged the customers to choose his product by understanding the behaviour of the customers when they are making economic decisions regarding soap. Another example would be when in 2007, prices if the iPhone were quickly reduced from $600 to $400, the consumers though they were getting a great deal as opposed to their previous reactions that the smartphone was too expensive.
With US academic Richard Thaler winning the Nobel prize in economics, this field has become all the more interesting. And as companies begin to understand that traditional economics does not govern their consumers’ decision making abilities, attempts are being made to embed behavioural economics in the company’s decision-making policies that concern its internal and external stakeholders, which may prove to be worthwhile if done properly. Meanwhile behavioural economics continues to be an unknown branch of economics that houses huge potential and numerous untapped opportunities for our generation with its applications presents in almost every industry of commerce.