Behavioral economics is the study of the effects of psychology on economic decision making. In other words, how people’s emotions and thoughts can affect how they make decisions about money. One of the first supporters of this idea was Adam Smith. Behavioral economics was later disregarded when a more rational approach was taken in the 1800s. By the mid 1900’s, however, there was a clearer understanding of how much psychology plays into economics.
There are three main ideas in behavioral economics. The first is that people generally act on “rules of thumb” as opposed to rational thought. A rule of thumb is a principle that is mostly true in the majority of situations. An economical example of this is the phrase “you get what you pay for.” This phase is mostly true. However, sometimes cheaper products are just as good, if not better, than the brand with the highest price. It would be rational in this case to buy the cheaper, but just as good, product. Most people, however, would buy the more expensive product, thinking that it is superior.
The second idea is that people’s thoughts on a problem are affected by how the problem is presented. This is called framing. Framing can be seen when stores advertise sales. Product A costs $3.99 US dollars (USD), but it isn’t selling very well. So two stores have each devised a way to sell Product A as quickly as they can by advertising the product in their weekly fliers. The first store advertises it as 75% off the original. The second store advertises it as $3.00 USD off the original price. Both stores are now selling Product A for $ .99 USD. The first store will have more buyers than the second because 75% off sounds like a lot more than just $3.00 off, assuming that the consumer doesn't know the original price. How the discount was presented affected which store the consumers shopped at.
The third idea in behavioral economics is market inefficiencies, which explains outcomes when something other than the expected happens. This concept applies to the stock market. Market efficiency is the idea that prices reflect all the known information available about a stock. No investors know what is going to happen before all of the other investors. Market inefficiency is anything that happens to challenge that idea, in a non-rational way. An example of this is selling overvalued stocks, and using that money to buy undervalued stocks. If done correctly, investors can make a lot of money this way, even if it doesn’t seem rational.
Other ideas in behavioral economics are herding and group think. These state that people will follow whatever is popular at the time, thinking as a group of people instead of as individuals. For example, people who sell their stocks, and empty their bank accounts at the hint of a financial decline can start a panic. Others see it, and decide to do the same, which only continues to harm the economy. People may rationally understand that doing these things will make the economy worse, but because everyone else is doing it, they do it, too.
Behavioral economics can explain times of prosperity and times of economic hardship, as well as predict how people will respond to situations during each. People make financial decisions based on psychology all the time. When considering trends in economics, this emotional decision making should be taken into account to give the most authentic view.