Behavioral Economics and Marketing, Part I

An Introduction to Behavioral Economics

How many economic decisions have you made today? As I write this during a mid-afternoon break, I can count a handful of choices I’ve already made, ranging from where to get coffee (Starbucks lost out this morning – I drank the free coffee at the office), to buying gas (I drove around the block to a place that was five cents per gallon less, to lunch (I ate out, having saved on coffee and fuel). Individually, these are trivial everyday events. Collectively, when combined with other consumers’ choices, their effect is large: on the local service stations, on Starbucks, on the national economy.

How many of your decisions have been rational and considered, arrived at by carefully weighing the alternatives and evaluating the benefits? If you are like me, probably few of your choices are made entirely rationally. Even on larger decisions, such as buying a car or a home, it seems that the way we make our decisions is often not some orderly, linear process, but an amalgam of prior experiences, emotions, and selective use of information.

Classical economics from the time of Adam Smith and Daniel Bernoulli up to more recent economists like Milton Friedman argued that markets are the product of rational human beings. Bernoulli, for example, formulated an explanation for why insurance makes sense for both the underwriter and the insured. The wealthy underwriter needs to have a mechanism to grow assets in a meaningful way that also minimizes the risk of losses. Conversely, the merchant with less capital needs a way to protect against loss, even if the risk of loss is low. Each side assigns a utility to the insurance, and these relative utilities govern the price and terms of the insurance. If, for instance, the underwriter wants to charge too much for the insurance, then the merchant can compete by self-insuring or seek out another underwriter. In any event, the phenomena of risk aversion and utility were seen as the product of rational processes.

Because of the many inconsistencies between this theory of rationality and real-world outcomes, economists devised many devices to explain the divergence. For example, “bounded rationality” was introduced as a concept to allow markets to be generally rational, while allowing that in some cases some actors might not behave in their own best interests. Disparity in information among parties was another way to explain some things, still with the assumption that if information were equal, all parties would act rationally.

About thirty years ago, a new school began to arise, one that used not only classical economics, but also human psychology, to model human decision-making. These researchers found interesting phenomena, such as multiple mechanisms for how people make economic choices. For example, they noticed that even when presented with complete information, people tended to rely on selective information that matched their assumptions. We seem to have a menu of “heuristics” that we rely on: for example, we may draw on what appears to be an analogous situation to solve a current problem, even though the situations are fundamentally different.

These researchers also found that how problems are framed strongly influences the outcome. Take for example, two potential headlines: State Beats Union; Union Loses to State. Both describe the same fact, but provide access to different thoughts. Experienced physicians, some of whom are presented with a poor prognosis while others are presented with a more optimistic prognosis, will prescribe different courses of treatments, even when their experience and expertise in their specialty is comparable. Moreover, such concepts as fairness, competition, and experience play important roles in shaping decisions.

In other words, economic decision-making is highly complex and rarely the purely rational process that was promoted by mainstream economics for two centuries.

Marketers, of course, have long understood and used many of these decision-making processes in the service of advertising and marketing. A good copywriter knows that the right headline can frame the discussion in such a way that the consumer is primed to make a positive selection. The imagery and design of advertising likewise are intended to evoke certain thoughts and emotions. Databases and models let us identify which consumers are most likely to be receptive, and testing permits us to validate the relative effectiveness of different combinations of targeting, offers, and creative.

After thirty years, the field of behavioral economics encompasses more than I can describe here. In the next installment, I’ll provide more concrete applications to data-driven marketing. In the meantime, if you want to read more, I suggest the following;

Daniel Kahneman’s Nobel Prize Lecture. Kahneman and Amos Tversky were leading pioneers in the field, and Kahneman was awarded the 2002 Nobel Prize in Economics.

Hugh Schwartz’s book, A Guide to Behavioral Economics (2008), is a good general primer; it is also easy to digest, as it contains fewer than 100 pages.

If you want to dig deeper, then I recommend Advances in Behavioral Economics (2004), edited by Colin Camerer, George Loewenstein, and Matthew Rabin.

And finally, a book said to have been read by President Obama: Nudge: Improving Decisions About Health, Wealth, and Happiness (2009), by Richard Thaler and Cass Sunstein. Their thesis, in part, is that government can use behavioral economics to “nudge” the population to behave in positive ways. It is much more a political book than an economics treatise, but demonstrates how this field is growing in influence.