Managerial Economics

Behavioral Economics
Hazem Mahmoud Hamza Gamaleldin
Abstract
When William Stanley Jevons developed marginal utility theory in the 1860s, he would
have loved to look inside people’s brains and “see” their utility. But he believed that the
human brain was the ultimate black box that could never be observed directly. For Jevons,
and for most economists today, the purpose of marginal utility theory is to explain our
actions, not what goes on inside our brains.

Economists and some psychologists, think that marginal utility theory is based on a view
of how people make choices that attributes too much to reason and rationality. They propose
an alternative approach based on the methods of psychology. Other researchers, some
economists and some neuroscientists, are using new tools to look inside the human brain and
open up Jevons’ “black box”.

Introduction
In an ideal world, people would always make optimal decisions that provide them with
the greatest benefit and satisfaction. In economics, rational choice theory states that when
humans are presented with various options under the conditions of scarcity, they would
choose the option that maximizes their individual satisfaction. This theory assumes that
people, given their preferences and 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 person has self-control
and is unmoved by emotions and external factors and, hence, knows what is best for himself.

During the classical period of economics, microeconomics was closely linked to

psychology. For example, Adam Smith wrote The Theory of Moral Sentiments, which
proposed psychological explanations of individual behavior, including concerns about
fairness and justice. Jeremy Bentham wrote extensively on the psychological underpinnings
of utility. Then, during the development of neo-classical economics, economists sought to
reshape the discipline as a natural science, deducing behavior from assumptions about the
nature of economic agents. They developed the concept of homo economics, whose behavior
was fundamentally rational.

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What is behavioral Economics?
Behavioral economics examines how people
make decisions, taking into account critical insights “The theory that can absorb
from psychology about the social, cognitive and the greatest number of facts,
emotional aspects of people’s choices. It recognizes and persist in doing so,
people’s judgements are systematically biased and generation after generation,
limited. For example, we often forget things or through all changes of opinion
overlook important details, and make decisions and detail, is the one that must
conflicting with our own interests, such as by giving rule all observation”
in to immediate temptations rather than doing the Adam Smith
things which are best for us in the long term.

Behavioral economics studies the ways in which limits on the human brain’s ability to
compute and implement rational decisions influences economic behavior—both the
decisions that people make and the consequences of those decisions for the way markets
work.

Behavioral economics starts with observed behavior. It looks for anomalies—choices

that do not seem to be rational. It then tries to account for the anomalies by using ideas
developed by psychologists that emphasize features of the human brain that limit rational
choice.

Behavioral economics draws on psychology and economics to explore why people

sometimes make irrational decisions, and why and how their behavior does not follow the
predictions of economic models. Decisions such as how much to pay for a cup of coffee,
whether to go to graduate school, whether to pursue a healthy lifestyle, how much to
contribute towards retirement, etc. are the sorts of decisions that most people make at some
point in their lives. Behavioral economics seeks to explain why an individual decided to go
for choice A, instead of choice B.

Because humans are emotional and easily distracted beings, they make decisions that
are not in their self-interest. For example, according to the rational choice theory, if Charles
wants to lose weight and is equipped with information about the number of calories available
in each edible product, he will opt only for the food products with minimal calories.
Behavioral economics states that even if Charles wants to lose weight and sets his mind on
eating healthy food going forward, his end behavior will be subject to cognitive bias,
emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an
attractive price and quotes that all human beings need 2,000 calories a day to function
effectively after all, the mouth-watering ice cream image, price, and seemingly valid

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 statistics may lead Charles to fall into the sweet temptation and fall out of the weight loss
bandwagon, showing his lack of self-control.

Describing the Choices in Behavioral Economics Studies

In behavioral economics, instead of being rational utility maximizers, people are
assumed to have three impediments that prevent rational choice: bounded rationality,
bounded willpower, and bounded self-interest.

Bounded Rationality Bounded rationality is rationality that is limited by the computing

power of the human brain. We can’t always work out the rational choice. For Lisa, choosing
between movies and soda, it seems unlikely that she would have much trouble figuring out
what to buy. But toss Lisa some uncertainty and the task becomes harder. She’s read the
reviews of “Ironman 2” on Fandango, but does she really want to see that movie? How much
marginal utility will it give her? Faced with uncertainty, people might use rules of thumb,
listen to the views of others, and make decisions based on gut instinct rather than on rational
calculation.

Bounded Willpower Bounded willpower is the less than-perfect willpower that prevents
us from making a decision that we know, at the time of implementing the decision, we will
later regret. Lisa might be feeling particularly thirsty when she passes a soda vending
machine. Under Lisa’s rational utility-maximizing plan, she buys her soda at the discount
store, where she gets it for the lowest possible price. Lisa has already bought her soda for
this month, but it is at home. Spending $1 on a can now means giving up a movie later this
month. Lisa’s rational choice is to ignore the temporary thirst and stick to her plan. But she
might not possess the willpower to do so—sometimes she will and sometimes she won’t.

Bounded Self-Interest Bounded self-interest is the limited self-interest that results in

sometimes suppressing our own interests to help others. A hurricane hits the Florida coast
and Lisa, feeling sorry for the victims, donates $10 to a fund-raiser. She now has only $30
to spend on movies and soda this month. The quantities that she buys are not, according to
her utility schedule, the ones that maximize her utility.

The main applications of behavioral economics are in two areas: finance, where
uncertainty is a key factor in decision making, and savings, where the future is a key factor.
But one behavior observed by behavioral economists is more general and might affect your
choices. It is called the endowment effect.

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 The endowment effect is the tendency for people to value something more highly simply
because they own it. If you have allocated your income to maximize utility, then the price
you would be willing to accept to give up something that you own (for example, your coffee
mug) should be the same as the price you are willing to pay for an identical one.

In experiments, students seem to display the endowment effect: The price they are
willing to pay for a coffee mug that is identical to the one they own is less than the price they
would be willing to accept to give up the coffee mug that they own. Behavioral economists
say that this behavior contradicts marginal utility theory.

Applications
Heuristics One application of behavioral economics is heuristics, which is the use of
rules of thumb or mental shortcuts to make a quick decision. However, when the decision
made leads to error, heuristics can lead to cognitive bias. Behavioral game theory, an
emergent class of game theory, can also be applied to behavioral economics as game theory
runs experiments and analyzes people’s decisions to make irrational choices. Another field
in which behavioral economics can be applied to is behavioral finance, which seeks to
explain why investors make rash decisions when trading in the capital markets.

Companies are increasingly incorporating behavioral economics to increase sales of

their products. In 2007, the price of the 8GB iPhone was introduced for $600 and quickly
reduced to $400. What if the intrinsic value of the phone was $400 anyway? If Apple
introduced the phone for $400, the initial reaction to the price in the smartphone market
might have been negative as the phone might be thought to be too pricey. 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. Also, consider a soap manufacturer
who produces the same soap but markets them in two different packages to appeal to multiple
target groups. One package advertises the soap for all soap users, the other for consumers
with sensitive skin. The latter target would not have purchased the product if the package did
not specify that the soap was for sensitive skin. They opt for the soap with the sensitive skin
label even though it’s the exact same product in the general package.

As companies begin to understand that their consumers are irrational, an effective way
to embed behavioral economics in the company’s decision-making policies that concern its
internal and external stakeholders may prove to be worthwhile if done properly.

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 Nudge Nudge is a concept in behavioral science, political theory and economics which
proposes positive reinforcement and indirect suggestions as ways to influence the behavior
and decision making of groups or individuals. Nudging contrasts with other ways to achieve
compliance, such as education, legislation or enforcement. The concept has influenced
British and American politicians and economists . Several nudge units exist around the world
at the national level (UK, Germany, Japan and others) as well as at the international level
(OECD, World Bank, UN).

The first formulation of the term and associated principles was developed in cybernetics
by James Wilk before 1995 and described by Brunel University academic D. J. Stewart as
"the art of the nudge" (sometimes referred to as micronudges. It also drew on methodological
influences from clinical psychotherapy tracing back to Gregory Bateson, including
contributions from Milton Erickson, Watzlawick, Weakland and Fisch, and Bill O'Hanlon.
In this variant, the nudge is a microtargetted design geared towards a specific group of
people, irrespective of the scale of intended intervention.

In 2008, Richard Thaler and Cass Sunstein's book Nudge: Improving Decisions About
Health, Wealth, and Happiness brought nudge theory to prominence. It also gained a
following among US and UK politicians, in the private sector and in public health. The
authors refer to influencing behavior without coercion as libertarian paternalism and the
influencers as choice architects. Thaler and Sunstein defined their concept as:

“A nudge, as we will use the term, is any aspect of the choice architecture that alters people's
behavior in a predictable way without forbidding any options or significantly changing their
economic incentives. To count as a mere nudge, the intervention must be easy and cheap to
avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk
food does not. “

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 Enforced Change Nudge Techniques
Instructing a small child to tidy his/her Playing a 'room-tidying' game with the
room. child.
Erecting signs saying 'no littering' and Improving the availability and visibility of
warning of fines. litter bins.
Joining a gym. Using the stairs.
Counting calories. Smaller plate.
Weekly food shop budgeting. Use a basket instead of a trolley.

Thaler and Sunstein give many examples of nudges in their academic and popular work ,
but there are several well known examples they emphasize throughout . in one , a manager
of a cafeteria in an office building is tasked with arranging the food items . to promote healthy
eating among the workers in the building without foreclosing any opinions , the manager
chooses to put healthier options at the front of the shelf and in the best light , to take
advantage of people’s prosperity toward laziness and the illusion of well- lit items as being
tastier . While consumers are free to take the poorly lit and hard-to-reach puddings, the
manager takes advantage of their behavioral quircks to guide them toward healthier choices.

In another example, employers are concerned that employees are not saving enough for
retirement –in particular, they are not taking advantage of 401(k) plans, contribution to which
are not only tax exempt but are often matched by employers. The forms that new employees
fill out at human resources typically require active choice to enroll in such a program; in
other words , the default choice is nonenrollment (also known as “Opt-in”).because studies
show that people often defer to the default choice on a form (either through active or passive
choice).employers who want to promote savings can switch the default choice to enrollment
(also known as “Opt-out”). In doing so, they leverage people’s unthinking acceptance of the
default choice by switching the default to the option that they believe is in people’s best
interest.

Nudging techniques aim to use judgmental heuristics to our advantage. In other words,
a nudge alters the environment so that when heuristic, or System 1, decision-making is used,
the resulting choice will be the most positive or desired outcome.

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Conventional methods of changing
people use direction and enforcement, often with the
threat of punishment, Whereas Nudge
theory entails changing people's environment and
choices so they are more likely to make decisions that
are helpful and positive (for themselves).

In terms of style and emphasis we can equate these

two different approaches to Douglas McGregor's
Theory X and Theory Y, where:

X-Theory equates to conventional enforcement, and

Y-Theory equates to 'Nudge'.

Nudge theory has also been applied to business management and corporate culture, such
as in relation to health, safety and environment (HSE) and human resources. Regarding its
application to HSE, one of the primary goals of nudge is to achieve a "zero accident culture".

Conclusion
Economics has developed over the past 150 years with little help from and paying little
attention to advances being made in psychology. Both economics and psychology seek to
explain human behavior, but they have developed different ways of attacking the challenge.

Since Economics has traditionally assumed people always make decisions in their best
interests. Behavioral economics challenges this view by providing a more realistic model of
human behavior through explaining that humans are not rational and are incapable of making
good decisions. It recognizes we are systematically biased (for example, we tend to satisfy
our present self rather than planning for the future) and can make decisions that conflict with
our own interests.