By Arav Talati. Edited by Arjun Chandrasekar.
According to Investopedia, “Behavioral economics draws from the fields of psychology and economics to explore the study of judgments and choices that people make.” People make thousands of economic decisions throughout their lives: everything from purchasing goods and services to buying and selling stocks. Behavioral economics studies the reasoning behind why people decide to make one choice over another, even if the choice they made wasn’t necessarily the best.
We as humans are emotional, and for that reason, we can sometimes make decisions rashly without thoroughly analyzing if it’s the best decision to make. This is the premise behind behavioral economics. To put it into more relatable terms, imagine a person, let’s call him Joe, who wants to lose more weight. Now, we all know that the best way to do this is by exercising and eating healthier foods, and Joe even has the resources to eat less calorie-rich food. However, behavioral economics states that even if Joe wants to lose weight, his behavior will still be subject to cognitive bias, emotions, and social influences, instead 0f obvious logic.
You’ve probably already heard the long-standing rule for making money in the stock market: buy low and sell high. But believe it or not, most people tend to do the opposite; they invest when stocks are expensive and sell when stocks are cheap. Why does this happen? This is where psychology and economics overlap. Let’s take the example of the 2008 financial crisis and come back to our good friend Joe. What did Joe, the typical investor do throughout the crisis? When stocks were going higher, Joe decided to buy because of the positive atmosphere in the market. When the market started collapsing, Joe probably reassured himself that this wasn’t a big deal. But then came the bankruptcy of a major investment bank, Lehman Brothers, and he sold his stocks sometime in late 2008, the lowest point in the economic crisis. Relative to the market’s high point in October 2007, Joe had lost about 45% of his money. As you can see, Joe bought when the market was at its high and sold when the market was low, despite all the logic pointing against it.
Now, companies are increasingly incorporating behavioral economics to increase the sales of their products. An example, taken from Investopedia, is from 2007 when the price of the 8GB iPhone was introduced for $600 and quickly reduced to $400. If Apple had introduced the phone for $400, some may have thought that the phone was too pricey, and then Apple wouldn’t get as many sales. But by introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal, and sales surged for Apple. There are hundreds of other examples, some companies market the same product but for two different audiences. Examples being Nissan and Infiniti, as Infiniti is the luxury brand for Nissan. However, while some of Infiniti’s cars only have a few changes from Nissan cars, they are priced higher because of their “luxury” status.
As companies begin to understand that their consumers are irrational, behavioral economics is influencing more companies’ decision-making policies. It is a huge part of economics, and it is important to understand behavi