Behavioral Economics: A Primer

Lessons that you work out for yourself are much more powerful than rules you memorize parrot-fashion. – Dave Trott, Predatory Thinking

I am working through a personal primer on behavioral economics for my lectures on strategy and the planning process. To force myself to dig deeper, and as a challenge to Trott’s quote, I am going to build it into a brief  that I will then have my students work on. Here we go:

Understanding how humans make decisions and form judgment is central to persuasive communication.

One lens we can use to attempt to understand human decision-making is through behavioral economics. BE integrates psychological, sociological and cognitive effects, as well as, the emotional factors that shape our behavior.

BE challenges classical economic theory by removing the bounded measure of rationality when it comes to making optimal decisions. It incorporates utility, opportunity costs, status and concern for others. In a sense, BE positions itself between economic theory and psychology.

Behavioral economics is not a unified theory. It simply provides a collection of tools used to better understand choice and judgment. BE isn’t a complete rejection of classic economic theory either, but a different lens to view assumptions of decision-making.

In the end, the assumption BE makes, is that we don’t always act rationally. We don’t always make optimal decisions. It is why planner number one will outsell planner number two on college campuses all over the country.

Using the example above, it is easy to see why the unique selling proposition model (a linear, information-based supposition) may not be in perfect concert with our irrational tendencies. The inter-disciplinary approach of BE gives marketers the ability to understand and analyze the influences of consumer behavior. What follows is an examination of the basic concepts of behavioral economics.

System One and System Two

It was Daniel Kahneman who introduced how we form thought in Thinking, Fast and Slow. The instinctual system one describes the part of mind that is responsible for fast, automatic, quick and emotional agency. System two is slower, used to make complex computations and requires attention.

In a 2014 WARC discussion, Rory Sutherland remarked: “we (marketers) are in a system one business”.

System one employs heuristics. Heuristics are short cuts in the decision-making process. Associating new information with pre-existing patterns form these short cuts. They act to simplify decisions.

The pairing of repeated system one actions within a certain context or event can be habit forming. A habit is formed with the association and trigger creates a repeated behavior.

When a pattern deviates, or our information process produces an error in thinking, we experience cognitive bias.

Research into the basic theories of BE, and related concepts, are important for marketers when we want to influence or create an unforeseen value in a product or service.

As we begin to develop a better understanding of how we make decisions, we quickly realize we are not always acting in our own self-interest. As I explored these heuristics and biases, I began to realize our decision-making is often underpinned by a few basic principles:

We are often influenced by salient information found in our immediate environment

We are awful predictors of future behavior

We are influenced by emotions

We are influenced by social norms and social preferences.

Behavioral Economics: Heuristics and Biases

Anchoring

Anchoring has roots in priming. When a person is initially exposed to a number, that number may ultimately  serve as a reference point for future judgement of value. Realtors may employ this technique to influence potential homeowners perceive value of subsequent homes.

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AAA used a similar tactic when I went to renew my membership. They offered three membership levels: silver, gold, and platinum. While there was no consequential differences between gold and platinum, there was a marked difference in price. I was presented options with the hope I would ultimately choose gold level.

Availability

The availability heuristic is a quick assessment on the likelihood of an event, based on the ease with which it can be recalled. For example, the more links or associations that are structured around an event, the more valuable or likely we believe it will occur. Tversky and Kahneman (1974) explored the purchasing of stocks by investors. The perceived value of the stock was greater based on positive coverage in the news. Advertisers can also employ techniques aimed at evoking certain emotions. The more powerful the emotional stimuli, the greater the increase in mental availability (Tversky and Kahneman, 1973).

Representativeness

Representativeness is based on our judgment that the probability of an object (or event) should belong to a category, based on the degree that the object resembles the category. This is often at the expense of the known base. For example, generic brands might try and influence this heuristic by creating packaging that looks nearly identical to a major brand. Kahneman and Tversky (1972) used this popular example to explain this heuristic:

Bob is an opera fan who enjoys touring art museums when on holiday. Growing up, he enjoyed playing chess with family members and friends. Which situation is more likely?

A) Bob plays trumpet for a major symphony orchestra or B) Bob is a farmer

A majority of participants will likely choose “A”, because of the images the description conjures. The answer is much more likely to be “B”. This is because there is a much larger percentage of the population who are farmers.

Status Quo Bias

Humans would rather stick with a previous decision, or continue to have things stay the same. Even in situations that are not beneficial, if the cost is perceived as minimal, we often seek the status quo. Similarly, the more important a decision is, and if we believe that the transitional cost is low, we will continue the behavior. I continue to pay my ridiculuous Verizon phone bill. I do this with the knowledge that Sprint has unlimited data options. I continue to tell myself that the transitional cost is not worth the amount saved per year. To overcome this bias, Sprint creates promotions that make the switch much easier (pay for the contract to break, waive initial fees).

Present Bias

Present bias describes our tendency to prescribe more value, or weight, to present events than future events. Monetary gain is a good example of this bias. Most people would rather have $50 than $60 in a month. Many promotions offer a gift card with purchase or a free product with purchase. Under this tactic, the consumer’s present gains are amplified.

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Forecasting

This concept describes our effort to predict how we will feel in the future. We often overestimate the amount of pleasure we will derive from an experience, or the intensity of our future emotions. As consumers, we often believe our next purchase will evoke much stronger emotions than the previous purchase (see also: Hedonic adaptation). Brands can influence this bias in two primary ways. First, brands can create powerful memory structures around purchases to inform future habits. Any future evaluation is often informed by the most pleasurable part of consumption.

Second, marketers can find ways the current consumers can signal consumption-related cues to potential consumers. Often our frame of reference for consumption-related feelings are informed by market-oriented cues.

Endowment Effect

The endowment effect is often referred to as the IKEA Effect. We often overvalue objects that we own. Once ownership has been established, we often place symbolic, experiential or emotional significance with the product. This increases the value of the object. Furniture purchased from IKEA must be put together by the consumer. The time invested in the building of the furniture, leads to an overvaluing of the product by the consumer. (See also: McCracken’s work on meaning transfer)

Related Concepts:

Fairness

We have a strong desire to practice reciprocity. In relation to fairness, our decisions are often shaped in different social contexts. Thus, when an individual takes action in a positive way toward us, we want to return the favor with an equal action. By simply asking someone if they have time to fill out a survey, has been shown to increase survey participation. Falk (2004) found that sending a fancy gift with a opportunity to donate, increased donation frequency by 75 percent, compared to not sending a gift.

Arguably, the early advent of the web, and now social media today, has been partially built by reciprocity.  In The Virtual Community, Rheingold argued that reciprocity created the architecture for many online communities. Lewis Hyde related this idea to consumer behavior. Hyde argued that a monetary transaction does not inspire connectedness, and that it is often status, prestige or esteem that acts as a proxy for money. This concept was then extended by Henry Jenkins as the behaviors that underline social media culture.

Social norm/Social Proof

Social norm describes the spoken or unspoken rules, or appropriate behavior, within a group. We often make consumption choices based on the signaling of an identity that aligns with a particular norm. Fundraising may announce donors, and their donations, as a way to signal a group norm (the norm as an amount). Similarly, blood drives may provide stickers for blood donors. On college campuses this can be a particularly powerful tactic to create a norm.

We often seek behavioral cues when deciding to adopt an action or behavior. In the context of consumption, we are often influence by consumption related cues, signaled by others (consumer socialization theory).

Mumbia employed a tactic using social proof to reduce residents electricity consumption. Using a simple rubber stamp, city officials were able to curb cost.

Chevy found an interesting way to present a majority behavior in their 2015 commercial. They created a fictitious focus group and used the “testimony” as a way to flesh out majority opinions of truck drivers.

Framing

Framing is an effect that influences the reactions of people to a particular choice based on how it is presented. Tversky and Kahneman (1981) specifically attributed this effect to how we react to perceived gains and losses. Framing can be used on price, product attributes and brand building.

Food waste is a major issue from the farm and households. For example, approximately 20 to 40 precent of food is discarded for cosmetic reasons before they even reach the store. Intermarche, a French supermarket, created a campaign called Inglorious Fruits and Vegetables to frame our perception of ugly fruits.

Priming

This technique involves exposing people to a very specific stimuli or engaging activity. The hope is to influence behavior by using stimuli that sparks certain associations. Whole Foods places a fresh flower display at the entrance. The smell and colors are supposed to spark associations with freshness and wholesomeness.

Malcolm Gladwell gives a brief description of how priming affects behavior.

Clay Shirky wrote: “Behavior is motivation filtered through opportunity”. The opportunity or choice that the consumer is presented with can have a major impact on an outcome. Thaler and Sunstein call this choice architecture. Choice architecture is the designing of an environment to encourage certain behaviors. Understanding heuristics and related concepts helps us to better understand how to design for optimal outcomes.

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