Let me tell you the story about my boating trip with my family. We were a couple miles away from shore and it's common for the ocean to be very windy. The wind picked up speed and took my hat out away from the boat and into sea. I instantly took my phone out of my pocket, jumped out the water and swam to grab it. This was literally a $20 hat, to many people that seems irrational. Personally, I am a very materialistic person, I hold sentimental value to material things. At this moment I did not consider all the risk factors. For example, many would consider the fact that the pacific ocean is filled with sharks, and all that for a $20 hat? In the book “Naked Economics” by Charles Wheelman, if you were to compare the likelihood of death between riding an airplane or riding a motorcycle, people would assume riding a motorcycle is safer than an riding an airplane even though you are 14 times more likely to die everytime you ride a motorcycle than a plane. What makes humans think like this? Behavioral economics is a subfield of economics that focuses on the psychological, social, and emotional factors that influence decision making: These factors often lead to irrational decision making, which contradicts the majority of classical economic models which adds another level of complexity in economics.
In classical economics, the law of demand implies that if prices go down, people have the incentive to buy more. We also assume that consumers have perfect information when making choices but we all know that isn't always true. In behavioral economics, there's something called bounded rationality, where there's limited information, time and abilities that prevent consumers to make the best rational choice. For example: if an icecream shop lowers its price, according to classical economics, people will have the incentive to buy more. But in behavioral economics, people would assume either it's a great deal or it must be horrible ice cream. This can result a decrease in sales which contradicts the law of demand. This is also called anchoring, where a numeric value may provide a non-conscious reference point that influences subsequent value perceptions according to Alain Samson, PhD. (1) This means that price is often an indicator of quality, but we all knew that right?
Prices can send a lot of signals and perception to each individual which is called price change perception. There was a study in California (Marketing actions can modulate neural representations of experienced pleasantness) that tested the level of pleasantness in the brain with wine tasting. The participants were given fake prices to the exact same wine. Study showed that when the prices were higher, the levels of pleasantness increased and when the price was lower, the participants seemed to enjoy it less. (2) This demonstrates how price change perception is ideal for producers, because they are able to raise prices and demand, if they're able to change the perceptions of their service or products.
Experimental design and behavioral results by the Division of the Humanities and Social Sciences, California Institute of Technology (2)
A- Time course for a typical trial.
B- Reported pleasantness and intensity rating scales.
C- Reported pleasantness for the wines during the cued price trials.
D- Taste intensity ratings for the wines during the cued price trials.
E- Reported pleasantness for the wines obtained during a post-experimental session without price cues.
With that being said, we can now conclude that price change perception can be one of the factors that manipulate our decision making. In a classic economics we assume that human behavior is solely motivated by gain, but it's actually shaped by complex ideas like fairness and injustice. Let's say for example you and your friend got payed $100 in total for a job you both have done. The most common and logical way of splitting it $50 dollars each. Now let's pretend that your friend offered you $20 and they get the rest of $80? Almost no one would not accept because the offer is not fair. But according classical economics, anything is better than $0 is the most rational choice even if it's just $1. Anything better than nothing is a gain. As humans though, we just don't like to lose even if it's irrational.
Sometimes though these complex ideas or preferences can be influenced by the way your options are presented. Just like in our previous example, the $80/$20 split is unfair in the way it was presented. Obviously though right? You both worked the same job, but you only get $20. Would it still seem unfair if you only did 10% of the job? The framing effect are people's decision making can be dependent on how your options are presented. Would you rather buy chicken that is 75% fat free or 25% fat? Would you enter a raffle that says 1 out of 100 people win or they will be 999 losers. According to classical economics, the way your options are framed should have little effect on your decision because we are again assuming people are rational, but in contrary it does. Say for example you see a commercial on TV about this amazing juice blender and places huge bold letters $29.99, but then you look closely and see the smaller text above it that say “three pay easy payments of...” This is psychological pricing, that can make you feel like you're getting a good deal. Once again, according to classical economics, this should have little effect on a consumer's decision making, but it reality this can hugely impact decision making.
In Washington DC, grocery stores wanted to decrease use of disposable bags for environmental reasons. They gave each customer a 5 cent bonus each time they brought their own reusable bags which didn't work at all, people kept using the same amount of plastic bags. Later on, they charged a 5 cent tax per bag to each customer actually reduced the demand for grocery bags by more than half and caused consumers to substitute to reusable bags according to Tatiana Homonoff, phD. (3) This is called loss aversion, the pain of having to pay 5 cents was greater than the 5 cent bonus. Let's say I want to offer you two envelopes, in one envelope I have $100 and the other envelope is empty. You can chose one of the envelope or you can take $50 cash right now. Since there is a 50/50 percent chance of getting $100, the average possible outcome is $50. If you choose the $50 dollars, economists may consider you to be risk neutral. Now, what if I change the price from $50 to $49? If you still pick the $49 dollars you are risk averse. Since $49 is lower than the average possible outcome, then losses are more painful for you than gains, even though $49 dollars still looks more appealing than having the risk of gaining $0.
In general, behavioral economics study why we make decisions that diminish our utility in the long run. According to Wheelman, “...individuals don't always have a refined sense of risk and probability.” This can be either from bounded rationality to price perception to even a congius bias like the framing effect. Behavioral Economics has been essential in economics to have a better understanding of the complexity in human behavior when it comes to decision making. So I'm going to ask again, are we truly rational people?
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