Behavioral Economics: Crash Course Economics #27 Video Lecture - World Knowledge

Adriene: Hi, this is Crash Course Economics,
I’m Adriene Hill.
Jacob: And I’m Jacob Clifford. So, when
economists make their models, they generally
assume that people are rational and predictable.
Adriene: But when we look at actual human
beings, it turns out that people are impulsive,
shortsighted, and, a lot of times, just plain
irrational. Look! Balloons!
Jacob: Today we’re talking about Behavioral
Economics and how people actually make decisions.
[Theme Music]
Behavioral economics is a subfield of economics
that focuses on the psychological, social,
and emotional factors that influence decision-making.
That's not necessarily new. In fact, our old
buddy Adam Smith, discussed it in The Theory
of Moral Sentiments in 1759.
But generations of economists chose to ignore
many irrational elements of decision making
since it makes it harder to predict human
behavior.
But in the last few decades, behavioral economics
has made a comeback. Several Nobel Prizes
have been awarded to researchers that blend
economics and psychology and behavioral economics
is being applied to more and more fields like
marketing, finance, political science, and public policy.
Now it’s important to mention that irrational
human behavior doesn’t negate everything
you’ve learned here at Crash Course Economics.
It just adds another layer of complexity,
which is exactly what we love at Crash Course
Now in most cases, people are rational. When
the price falls for a product, people have a tendancy
to buy more of that product, so the law of
demand holds true. But economists also accept
that there is bounded rationality. Limits
on information, time, and abilities might
prevent people from seeking out the best possible
outcome.
For example, if the price for ice cream is
really low consumers might not buy more.
In fact, they might buy less if they think that that
low price means that ice cream tastes horrible.
Now if that happens, then the law of demand doesn’t hold true, which creates a serious problem in classical economics.
I mean it is the LAW of demand. You can’t
have a situation that breaks the law and still
call it a law. That doesn’t happen in other
disciplines like physics…except it does.
The Newtonian laws of physics, like gravity,
hold true most of the time but they break
down at the quantum level. They explain the
orbits of planets, but they have a harder
time explaining the orbits of electrons
And It’s the same in economics. Classical
economic theories explain the big picture
stuff pretty well, but there are still a lot
of things about individual decision-making
that we just don’t fully understand.
Adriene: In our ice cream example one of the
problems is lack of information. Classical
economics assumes that consumers have perfect
information when making choices. That is,
they know or at least can quickly access information
about prices and quality, but, in reality, they often don’t.
Sure, the consumer could ask around or call
their friends to see if they’ve tried that
type of ice cream but they're probably not
gonna do that. In this situation, consumers
may act on the limited information they have,
a suspiciously low price, which means either
the ice cream is a great deal or it tastes
like mayonnaise. They just don’t know.
Prices do send a lot of signals, and there’s
even science on how prices change perception.
A study in California analyzed the brains
of people taste testing a variety of red wines.
The researchers gave participants fake prices and scanned their brains to determine the level of enjoyment.
The results were surprising. When they thought the price was higher, they actually liked the wine more.
This held true even when the subjects were
given the exact same type of wine but were
told it was a different higher-priced wine.
The researchers said "Contrary to the basic
assumptions of economics…marketing actions
can successfully affect experienced pleasantness
by manipulating non-intrinsic attributes of
goods.”
So, once you’ve got a palatable Pinot Noir,
you might be able to raise the price, and
actually raise the demand. All you have to
do is change perceptions.
The idea that perceptions and passions
influence our actions also applies in finance.
Many economists used to believe that assets, like
stocks and real estate, would stay at or near
their real value because cold, calculating
investors would buy undervalued assets and
sell overvalued assets. But that doesn’t
explain bubbles:
In real life, investors aren’t always cold and calculating. They can get worked up and irrational sometimes.
This helps explain bubbles. From the Dutch Tulip Mania
of the 17th century, to the 2008 financial crisis.
Investors became irrationally exuberant,
and were driven not by logic, but by what
economist John Maynard Keynes
once called, “Animal Spirits.”
So behavioral economics doesn’t blow up traditional economic theory, it just seeks to understand
when and why people behave differently than economic models suggest. Let’s go the Thought Bubble:
Jacob: One of the most popular experiments in
behavioral economics is called the ultimatum game.
In this experiment, two players decide how to
share a specific sum of money, let’s say $100.
The first player is given all the money and then is asked to propose a way of splitting it with the second player.
Now if the second player accepts the deal
both players get to keep the money.
But, if the second player refuses,
nobody gets to keep the money.
When the first player offers to split the money
50/50 the second player almost always accepts.
But what happens when the first player
offers an unequal split, like 80/20?
Would you accept that offer? Well, It turns out
that less equal offers are often rejected.
Now that doesn’t seem surprising, but it directly contradicts classical economic theory. It’s irrational.
The rational choice would be for the second
player to accept any offer, even if it's only a dollar.
After all, a dollar is better than nothing.
But human behavior is not motivated solely by gain;
it’s also shaped by complex ideas like
fairness, injustice, and even revenge.
The ultimatum game shows that people aren’t always as predictable as many economists like to suggest.
If people were entirely rational then they
would consistently make the same decision
given identical options, but sometimes people's
preferences are dependent on how the options
are presented. Psychologists call this type
of cognitive bias the Framing Effect.
I mean, would you rather eat beef that's 75%
fat free or 25% fat? Would you rather enter
a raffle that claims that 1 out of every 1000
players is a winner or a raffle that points
out that there will be 999 losers. Would you
support a law named the “Improve our Schools Act”
or one named the “Raise our Taxes
Act”?
Each of these scenarios can be framed in ways
that influence your decision. Classical economics
argues that framing should have relatively
little effect on decision making because most
people are rational and intelligent, but in
the real world, people can be pretty irrational.
Adriene: Thanks Thought Bubble. So, Businesses
have known about the psychology of decision
making for a long time. For example, a gym
might break down its membership fee and advertise
it only costs only $1 a day, which seems
way more affordable than $365 a year.
And a TV priced at $499.99 seems like a
better deal than one priced at $500.
This is called psychological pricing. It can
make people feel like they’re getting a good deal.
Interestingly, high-end retailers sometimes
do the opposite. They set their prices at whole
dollars, basically signalling their goods are of a higher quality than you might see at a discount store.
Behavioral economists also like to talk about
nudge theory. Nudges encourage people to act
a certain way, without actually changing the
choices that are available to them.
Fighting childhood obesity is a priority in
many countries and policy makers have suggested
a whole range of solutions. Everything from
banning soda in schools to running media campaigns
promoting healthy eating. Behavioral economists
approached the problem a little differently.
They wanted to see if they could get children
to eat healthier by rearranging school cafeterias.
They put healthier food like fruits and vegetables
on eye-level shelves and less healthy foods,
like desserts, in less convenient places.
Classical economic theory suggests that this
idea wouldn’t work since rational people
would pick the brownie.
But it turns out, students choose the healthier foods.
Nudge theory works and it’s changing how we
implement public policy. There are some issues that
can be addressed best with the right type of nudge.
Jacob: Let’s talk about something else behavioral
economists look at: risk. Let’s say someone
offered you two sealed envelopes. One has
a hundred dollars, and one has no dollars.
You can choose an envelope, or you can
take $50 cash right now.
So do you take the fifty bucks?
Or what about $49?
Now, this is unlikely to happen to you in
real life, but the exercise is about your
attitude towards risk. Since there’s a 50/50
chance of getting $100 or nothing, the expected
return, or the average of the possible outcomes
is $50.
If you’re willing to accept $50 cash to
abandon the envelopes, then you’re risk neutral.
But If you accept less than $50, just to avoid walking away with nothing, then you’re risk-averse.
Behavioral economists have done lots of studies
about risk and in particular loss aversion,
the idea that people strongly want to avoid
losing. Studies show that, in general, losses
are more painful than gains are pleasurable.
So people might choose a safe course of action
even if it’s not the most logical choice.
Let’s say we flip a coin and if it’s heads I give you $100 but if it’s tails, you have to give me $50.
Now, mathematically you should go for it. But many people won’t because they want to avoid losing.
Adriene: Understanding of loss aversion can help businesses and policymakers influence decisions.
For example, some grocery stores
in the Washington DC tried to decrease the
use of disposable plastic bags by offering five cent bonuses if customers brought reusable bags.
The policy didn’t do that much. Later they
tried a five-cent tax on plastic bags, and,
this time, people used fewer disposable bags.
This is loss aversion at work. The pain of
having to pay 5 cents per bag was greater
than the benefit of receiving 5 cents per bag.
Another study analyzed how loss aversion can
help incentivise employees. Researchers divided
workers into three groups. The first was a
control group that wasn’t given a bonus.
The second group was promised a bonus at the
end of the year based on meeting specific goals.
Participants in third group were given the
bonus at the beginning of the year and were
told that they would have to pay it back if
they didn’t meet specific goals.
The workers in the first and second groups
performed about the same.
But those in the third group performed
significantly better. We just hate losing.
Jacob: So, behavioral economics has a lot
to tell us. Accounting for emotion gives
us a realistic view of how people actually
behave.
Adriene: We might not always be the rational
actors classical economists believe us to be.
For years, economics has had a blind spot.
But behavioral economics helps us get a better
look at how we make decisions.
Thanks for watching. We’ll see you next
week.
Jacob: Thanks for watching Crash Course Economics.
It's made with the help of all these awesome people.
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Thanks for watching. DFTBA.