In this episode, I’ll be talking a little bit more about the key ideas of behavioral economic theory.
So we already know a couple of differences between logical and behavioral economics. But how did these differences come about?
Well, a major cause of these differences is based on the way we think. Humans make decisions based on a bounded rationality model. This model states that the human brain can only take in so many bytes of information at once, and so it will compress or cache info for a speedier process, very similarly to how a computer works.
There are two systems of thinking within the bounded rationality problems: the intuitive (reflexive) system and the reasoning (reflective) system. For questions that don’t require a lot of cognitive load (e.g. they aren’t time capped or they don’t require vast amounts of complex information), then typically the reflective system is used. On the other hand, if things get too complex, we more often go to reflexive mode.
Within reflexive mode, we use a series of heuristics, or biases, to help us come to a reasonably good decision faster. There’s many, many types of heuristics (some we already went into in the first episode!) but I’ll go into some of the more important ones.
Perhaps the most important heuristic is Prospect Theory, also sometimes called “loss aversion” (though loss aversion only hits at one part of the theory). This theory states that people’s decisions will change depending on whether they view something as a gain or as a loss. For example, if the question is phrased in loss terms, people will pick the option that seems like they are gaining more (even if the answers are exactly the same!). Because of this, it appears our brains automatically default to the idea that losses are more impactful than gains.
Another key piece of behavioral economics is mental accounting. This theory claims that people think of value relatively rather than absolutely. A good example of this is the anchoring bias, in which we are more inclined to “anchor” to the first value we were given for an item, even if that value later becomes invalid. This is how discount sales work!
Then, we have information avoidance. This is where people purposely choose not to gain information about a decision. This could be because they worry about the information making their decision look bad, or they might otherwise not obtain the knowledge out of spite. A related idea is confirmation bias, which is the opposite effect — where people look for information, but only information that supports their decision.
Finally, we have choice effects. This is heuristics that are affected based on the amount and type of choices we are given. For example, if we are unsure about a choice or many different options are given (e.g. our brain is forced in reflexive mode) we will always go with the default, or otherwise easiest, option. Another example is in the decoy effect, when one’s preference for an option over another changes as a result of adding a third option — even if that third option is completely irrelevant!