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Behavioural economics: How rational is the human mind?

September 13, 2020
Editor(s): Thomas Sinclair
Writer(s): Aleisha Jiang, Qi Rui Soh, Oliver Soo

Behavioural economics is a subfield of economics which focuses on the social, psychological and emotional factors that influence decision making. This field of economics is useful for examining phenomena that are inconsistent with classical economic theory.

The main reason behavioural economics exists is that we as humans have bounded rationality – where limits on time, information and abilities prevent people from making the most rational decision for themselves.

For example, imagine one day you are late for a university class. You start sprinting and next thing you know you have tripped over a banana peel; your ankle is broken and now you need a surgeon to perform a procedure. In this case, the only difference between the surgeons you are considering is their quoted price. All the surgeons appear equally qualified and experienced. Five of the surgeons offer to do the surgery for $8000, while the sixth surgeon only charges $3500. While the law of demand would state for this case that demand expands as price decreases, therefore, you would pick the cheapest surgeon, in reality this may not happen.

Alarmed at the price difference, you fear the cheaper surgeon charges less because they are inferior and actually learnt how to perform surgery from watching ‘The Good Doctor’ and ‘Grey’s Anatomy’. In your mind, lower price correlates to higher levels of risk. Behavioural economics seeks to explain why situations like this exist where we make economically irrational decisions.

Two important figures in this field are the distinguished Israeli psychologists Amos Tversky and Daniel Kahneman (who received a Nobel prize in Economics for his work on decision making and behavioural economics). Funnily enough, Daniel Kahneman (a research psychologist) never took a single economics course! Everything he learnt about economics came from collaborating with other academics. The awarding of a Nobel prize for the field of behavioural economics helped legitimise behavioural economics and encouraged more research to be conducted in this field.

How is it employed in the real world?

Behavioural economics is now ubiquitously used and employed in nearly all facets of the commerce field. And perhaps the biggest component of behavioural economics that online retailers utilise to their advantage is the fact that the economic optimisations facing their customers are far too complex to be performed to an appreciable extent.

To use a simple economic example, no real human can and/or will compute the infinite alternatives and opportunity costs when making a decision. Rather, most of our decisions probably revolve around economically irrational factors such as sunk costs, utility of transactions or even more simply, which of our favourite online shops is having a sale.

At this point one might start wondering, what could possibly be so bad about a sale? Isn’t a sale an economically rational decision since the consumer can now buy the exact same thing he would have bought at a lower price?

While a sale at its barest is probably economically viable, sales are a way that online retail shops utilise framing to influence the psychology of their consumers. Take for example a bottle of wine costing $8 as compared to a bottle of wine costing $10 but with a 20% discount. While both these scenarios essentially lead to the same outcome, studies have shown that consumers consistently prefer the latter scenario. This is possibly due to the framing effect and the perceived utility that consumers feel they get from a transaction where some sale or discount is involved.

Besides framing the price of the good, retailers can frame the good itself. This phenomenon is often labelled the decoy effect. This is where retailers use other less desirable choices to make the option, they want the consumer to purchase seem more attractive. For example, The Australian newspaper at one period of time had a pricing strategy that seemed irrational to most.

For 50cents a day, you could get either the digital newspaper only or for the exact same price, you could get the digital and the weekend paper delivered. While this left many scratching their heads, it was a brilliant use of decoy pricing where the digital-only option essentially makes the product they wanted you to buy anyway (digital + weekend paper) seem more attractive, even though the price of the actual product hasn’t been affected.

The decoy effect: how you are influenced to choose without really knowing it

Another classic example of the decoy effect is when merchants purposely couple items together to persuade the consumer to choose a more expensive option, or when a less desirable option is presented to divert the consumer’s attention to the other more appealing options. This is best exemplified in the price of Australian McDonald’s soft drinks which range from small to large: $2.50, $3.10 and $3.60 respectively. The difference in price between the medium and large drinks is less than the difference in price between the small and medium drinks, therefore convincing the consumer that there is a higher value in purchasing the large drink, even when they may have initially intended to only purchase the small drink. As with a medium option, the consumer is no longer comparing the price of the large drink directly with the small drink, but the price of the large drink is instead compared to the medium drink.

A way to solve this issue for the consumer is to cognitively remove the middle choice and only compare the price of the small drink with the large one. Another method may be to encourage consumers to compare the unit pricing of goods, often presented on price labels in the supermarket.

This may not only reduce the confusion of pricing for consumers when comparing products for purchase, but also assist the consumer in making the most suitable and beneficial selection for themselves.

Behavioural economics measures the proportion of sense and sensibility in the choices made by consumers. The cognitive bias associated with behavioural economics is a component of many people’s daily lives when decisions are made, whether they are conscious of it or not.

The scarcity principle, a fundamental principle in behavioural economics, depicts how consumers place more value on rarer items or products that are more difficult to obtain. A ‘Hermès Birkin’ or ‘Kelly’ has a higher resale value than any other handbag in the world due to their scarcity and the high level of difficulty required to obtain one. Similarly, a ‘1929 Domaine de la Romanee-Conti Les Gaudichots’ is a greatly prized and sought-after wine due to the same reasons – rare and difficult to obtain. This not only creates a sense of competition, but also plays on the consumers’ fear of missing out, which can be effective in inducing people to find justifiable reasons for making impulse or sometimes irrational purchases.

London / UK, August 21st 2019 - Hermes Shop Front In The Royal Exchange, In  Bank. Hermes Is A High-end Retailer Editorial Stock Photo - Image of  commerce, highend: 156921183

In physical stores, where stock is visible, scarcity of products was far more apparent to customers. For example, during the early stages of the coronavirus pandemic, Australians witnessed a ‘toilet paper rush’, where consumers were seen piling stacks of toilet paper rolls onto their trolley for fear of a toilet paper shortage in lockdown. The more stores were stripped bare of toilet paper, the more people panicked and as demand overtook supply, the price of each roll of toilet paper flew higher. As supply recovered, and reality set in, many people were left with years’ worth of toilet paper rolls and an empty wallet.

Similarly, online stores have also been successful in portraying scarcity with real time numbers, such as limited quantities or a narrow window of time. For example, airline websites show the number of tickets remaining during the consumer’s preferred travel window at a certain price and often leave a narrow time window for the consumer to finish their payment in order to finalise their selection.

‘Afterpay’ is also a dominant presence on many websites, including David Jones and Myer. Their “buy now, pay later” ideology and “there’s nothing to pay” slogan has appealed to hundreds of thousands of millennials. This not only encourages impulse buying and irrational behaviour, but also convinces consumers that purchasing the product today is more important than having the means to do so, as a product with limited quantity may not be available for a long time.

While behavioural economics can help marketers to create offers that meet consumers’ needs better, there are some concerns. What constitutes manipulation or deception? Does behavioural economics actually benefit the consumer? Ultimately, the answer may depend on whether you believe consumers are responsible for their own decisions and being able to detect when an entity is trying to manipulate them, or if you believe businesses are responsible for having clear guidelines about what in behavioural economics is ethical and what isn’t.

References:

https://www.youtube.com/watch?v=dqxQ3E1bubI

https://impactually.se/what-is-behavioral-economics-and-why-does-it-matter/

https://www.news.com.au/national/crazy-video-shows-shoppers-mad-grab-for-toilet-paper-at-aldi-store/video/50364fdee16fec649fbe5bc8853ee61a

https://en.wikipedia.org/wiki/Daniel_Kahneman

https://drivinginnovation.ie.edu/the-importance-of-behavioral-economics-for-marketers/

https://www.klarna.com/knowledge/articles/how-to-use-power-of-behavioural-economics-in-e-commerce/.

https://theconversation.com/the-decoy-effect-how-you-are-influenced-to-choose-without-really-knowing-it-111259.

https://www.dreamstime.com/london-uk-august-st-hermes-shop-front-royal-exchange-bank-high-end-retailer-carrying-luxury-brand-s-apparel-handbags-image156921183

https://www.imd.org/research-knowledge/articles/behavior-economics-in-the-digital-world/.

https://www.imd.org/research-knowledge/articles/behavior-economics-in-the-digital-world/

https://theconversation.com/the-decoy-effect-how-you-are-influenced-to-choose-without-really-knowing-it-111259

https://www.smh.com.au/money/borrowing/why-afterpay-broke-af-ad-campaign-is-so-very-wrong-20180403-p4z7h1.html#:~:text=The%20company’s%20slogan%20%E2%80%93%20%22There’s%20nothing,hundreds%20of%20thousands%20of%20Millennials.

https://www.frugalfeeds.com.au/mcdonalds-prices-menu/

http://www.theexponential.agency/2016/09/the-psychology-of-popcorn-pricing/

https://www.accc.gov.au/consumers/groceries/grocery-unit-prices



The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Thomas Sinclair
Editor
Aleisha Jiang
Writer
Qi Rui Soh
Writer
Oliver Soo
Writer