Behavioral Economics

Part
01
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Part
01

Behavioral Economics - Concepts

Although most behavioral economics concepts revolve around the irrational decisions people make, concepts like heuristics, choice overload, and mental accounting are somewhat positive, in that they can be adopted by people who want to save money

Heuristics

  • Also known as "rule of thumb" heuristics are mental shortcuts that help simplify the decisions people make, especially during situations of uncertainty.
  • Heuristics is a process of "substituting a difficult question with an easier one." Although it is said to lead to cognitive biases, there are several advantages of heuristics.
  • The fast and frugal school of thought claims that applying heuristics in an ecologically rational condition leverages the best use of the limited options available to people.
  • Heuristics/rule-of-thumb strategies such as committing to not spending over $20 on a dress or $100 on something that is not a need help simplify daily choices.
  • According to Forbes, positive heuristics can be powerful enough to override bad money behavior. Other examples of heuristics strategies that work include deciding to always take tax returns to the bank or deciding to only buy used cars.
  • Behavioral economists have also asserted that developing positive heuristics can help people adopt good money habits.

Choice Overload

  • This concept asserts that when individuals are presented with too many options, they become overwhelmed and develop decision-making paralysis. Eventually, the individuals opts out of buying that product.
  • While this is sometimes seen as a negative thing, it stops people from making irrational purchase decisions.
  • To persuade consumers, sometimes retailers and marketers may present them with too many choices.
  • Ultimately, decision-making paralysis could stop people from buying products that they want but do not need.

Mental Accounting

  • Richard Thaler, also known as the father of economics, observed that people treat different sources of money that are earmarked for distinct uses, differently.
  • The money-saving bias associated with this concept is that physical cash is worth more than payments made online or digitally.
  • Humans supposedly feel more pain paying with a wad of cash, while a frictionless one-click payment on Amazon is practically guilt-free, in comparison.
  • As a result, most individuals that want to spend less use only cash. This is also a tip for saving money that experts like Ramit Sethi - NYT best-selling author - recommend.
Part
02
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Part
02

Behavioral Economics - Concepts 2

Three additional concepts of behavioral economics are anchoring, choice architecture, and self-control. When applied in the right way, they can positively affect people's relationship with money or their financial wellbeing.

Anchoring

  • Anchoring involves using irrelevant information, like the cost of an asset, as a reference point for analyzing or approximating a financial instrument's unknown price.
  • The process of anchoring usually takes place without our awareness, it can be applied to forecasting and buying decisions.
  • Some anchors are useful in helping market players to deal with inherent complex and uncertain decisions in an environment of excess information.
  • Market players can counter the effect of anchoring bias by recognizing the factors responsible for the anchor and using quantifiable data to replace assumptions.
  • Major financial decisions can be structured to make anchoring bias lead to better outcomes.
  • People can create their own anchors which can empower them to quickly make better financial decisions and have more control over their choices.

Choice Architecture

  • Choice architecture is the practice of influencing people's choices by creating the context through which they make their decisions.
  • Rather than presenting people with too many choices, optimal decisions can be set as the default choice, and people’s tendencies to delay choices can be channeled to benefit them. They can be guided to the best path for them.
  • Choice architecture can prove to be more cost-efficient than conventional financial incentives or sanctions.
  • For example, a company informed its workers that, unless they choose to opt out, 5% of their wages would be deposited automatically into a savings account.
  • Employees who took part in the scheme were more likely to have short-term savings by 40 percentage points than those who did not partake in it. That was far cheaper than offering a 50% matching contribution.

Self-control

  • Self-control is a process that works to prevent some behaviors and emotions in terms of temptations and impulses and it gives self-regulation to enable people to achieve certain goals.
  • Research has shown that self-control positively impacts financial behavior.
  • The use of self-control mechanisms could be a way to solve the challenge of poor financial decisions.




Part
03
of five
Part
03

Behavioral Economics - Case Studies

Companies like Walmart place their products strategically so customers can buy more products than they intended. Similarly, restaurants like Starbucks use normative size statements and anchoring to nudge customers into making purchases.

Placement of Goods in Supermarkets

  • The set-up of grocery stores like Walmart and Target is carefully planned. These supermarkets place the most common and important products like milk at the back end of the store.
  • This forces consumers to pass other items that they previously never intended to buy.
  • As a result, some consumers end up spending more money by buying products they do not need.
  • Another way grocery stores are using space management to nudge customers into spending more is by placing related products or products that are often used together side by side.
  • For example, in a lot of Walmart stores, soft drinks are placed by chips or snacks to nudge customers into buying both products. A consumer who intended to buy just soft drinks might end up picking a snack to go along with it.
  • Walmart and similar grocery stores also place candy and other high-energy items close to the checkout section to nudge people to buy additional products. These nudges contribute to the poor financial decisions people make.

Normative Size Statements by Restaurants

  • Fast food restaurants like McDonald's and cafes like Starbucks use normative statements such as "small," "medium," and "large" labels on products.
  • These statements often trick consumers into buying the products.
  • Normative size statements are often combined with the arrangement of products by appearance to "influence consumer choices through what is called the compromise effect."
  • This nudges consumers to buy more because they have a "tendency to choose the medium by a compromise heuristic."
  • Another form of this strategy involves anchoring. The "“buy two get one free” deal technique has been shown to increase the amount purchased by consumers."
Part
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Part
04

Behavioral Economics - Case Studies 2

Latino Community Credit Union, Commonwealth Bank, and Digit are companies that helped their users/customers save more money. These companies implemented behavioral economics concepts like opportunity cost neglect and present bias to help customers improve their financial well-being.

Latino Community Credit Union: Opportunity Cost Neglect

  • Latino Community Credit Union learned that because money can be spent on anything and the number of things money can be spent on is infinite, consumers find it difficult to think about trade-offs and save money.
  • The company partnered with Common Cents Lab to highlight how much their customers would be giving up soon by failing to think about trade-offs and save.
  • Latino Community Credit Union hoped its borrowers would be willing to round up their loan payments and pay their debts off sooner, while also saving money.
  • The company's first step involved defaulting its borrowers to a larger, rounded payment, after they were informed. Next, the company explained the amount of savings these borrowers could accumulate and the money they could waste if they failed to save.
  • With the help of Common Cents Lab, Latino Community Credit Union ended up increasing its round-up rates by 12%, thus helping customers save more. So rather than a repayment of $138 for example, they would round up each loan payment to $150.
  • Latino Community Credit Union was able to help its members painlessly and seamlessly build regular savings. It was easy to get consumers to do this because in general, behavioral economists assert that people don't think a lot about precise numbers in their budget.

Commonwealth Bank: Using Behavioral Insights to Help Users

  • In April 2019, Commonwealth Bank of Australia announced that it gathered behavioral insights to launch a new tool on its app.
  • The bank found that the main reasons people do not save include a lack of self-control, forgetting to put money in a savings account, and/or not having any set-out plan in place.
  • It also found that 25% of Australians do not find life enjoyable due to how their poor management of money.
  • It created a new tool called Goal Tracker to help customers set a personalized savings goal and segment the total amount into different stages, thus allowing more achievable milestones.
  • Goal Tracker was created to help customers curate better financial habits and improve their financial well-being through its combination of "the latest in digital banking innovation as well as behavioral science."
  • Behavioral economics experts hypothesize that people are more willing to save up for something when they have a planned goal, whether that be a trip or shopping. On Goal Tracker, customers set a savings goal and the tool helps them break it down into weekly targets so it is not overwhelming. Customers also have the ability to set up automatic payments to meet these weekly targets.
  • Since GoalTracker was launched, over 250,000 saving goals were created on the platform. Almost 30% are savings towards a holiday, while 19% are savings towards properties, and 15% are savings towards a significant purchase.

Digit: Present Bias

  • Digit, a fintech company, found that people are more motivated or influenced by immediate wants than by future needs. This distracts them from saving for long term goals like retirement.
  • The company set out to increase savings by automatically "withdrawing small amounts from users’ checking accounts, to test whether pre-committing to saving could counter present bias."
  • Digit hoped to make its users save for future needs as opposed to spending for immediate wants. In order to do this, Digit asked a group of users to commit to saving a specific portion of their tax refund prior to getting it. It asked a different group how much of their tax refund they wanted to save and automatically saved this amount after it was deposited into their accounts.
  • Among those who decided to save out of their tax refunds, Digit was able to increase savings rates by 10%. It helped thousands of users save part of their tax refund. In total, $1 million in savings was accumulated.
Part
05
of five
Part
05

Behavioral Economics - Company Concepts

Social proof, decision paralysis, the decoy effect, and attribute pricing are some behavioral economics concepts that companies capitalize on to sell more products or reach more consumers.

Decision Paralysis

  • Behavioral economists hypothesize that consumers are more likely to buy a product when fewer options of that product are introduced.
  • In one study, researchers displayed bottles of jam in a supermarket. One group of Jam had six different varieties, while another had 24 varieties on display.
  • These researchers found that although more consumers stopped by the 24-jar display section, only 3% bought items from this section compared to 30% who purchased from the 6-jar section.
  • This proves that when faced with a lot of options, individuals find it difficult to evaluate this plethora of options and end up not buying at all.
  • BBVA is one company that leverages this concept. Rather than presenting customers with different credit cards and their features in a list or chart, the company offers descriptions of what these credit cards are used for. BBVA goes as far as shortlisting the list of cards they offer based on what each consumer will most likely prefer.

Social Proof

  • This is a principle of behavioral economics that asserts that when people receive information about how others behave, they tend to conform or comply.
  • It is also known as the nudge theory and social norms. In general, people like to do what others do or what most people think it is right to do.
  • Companies embrace nudging as a method of getting more people to buy their products. Companies like Spotify, Netflix, and Apple Music do this by offering free trials on their platform for a few days to a month.
  • Another method of social proof that companies leverage involves letting them know how many other people are using the product. Terms like "70% of Americans Use this Product" are used to nudge people into using the same product.
  • Arizona Credit Union uses social proof. It shows customers that similar individuals are spending less on eating out than they might expect. This swaps "motivation for saving money with the motivation to be like their peers."

Decoy Effect

  • Economists coined the term "decoy effect" in 1982. They intellectualized that consumers tend to change their preference between two options when they are offered a third option that is asymmetrically dominated - inferior to one of the options and superior to the other.
  • In simpler terms, when a third strategically important choice is offered, - known as the decoy - consumers are more likely to buy the more expensive/superior option from the other two.
  • For example, if an online subscription service was offered for $59 for Standard, Premium was offered for $125 and included both online & print subscriptions, while a "print only" option was also offered for $125, consumers are more likely to go with the second option. This is because the second option appears to be a bargain.
  • Companies like NutriBullet use this to entice customers. They offer three different options of the same product online.

Attribute Pricing

  • Researchers have shown that talking to customers about a specific quality or advantage of a product affects "their decision in favor of that attribute."
  • In one study, researchers talked to customers who wanted to buy a laptop at an electronics store. About 50% of these consumers were asked about the memory they want, while the other 50% were asked about the processor-speed they need.
  • They found that those who were asked about memory eventually purchased laptops with higher memory, while those asked about processor speeds purchased laptops with higher speeds.
  • This is a strategy that companies like Best Buy use. The company's representatives ask consumers about certain attributes in a device they want to encourage them to buy devices that have more of that attribute.
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