Behavioural economics is the branch of economics that deals with the psychological aspect of making economic decisions, both in terms of individuals and institutions. It is often related to normative economics. Behavioural economics is mainly concerned with determining whether economists’ assumptions of consumers’ rationality (maximum utility and profit maximization) are good indicators of real behaviour.
Traditional economics does not consider how humans behave but instead assumes the decision-making process and its outcome to simplify the understanding of economic models. However, in reality, people consider many other factors while making decisions such as time, control, and mindset.
Behavioural economics can be used to explain many human actions, thought processes, and tendencies. The most common example can be seen in finance- in the way that people are more saddened by losses than they are happy by profits, even when the amount is the same.
Behavioural economics also challenges some basic economic assumptions upon which all theories and models are based. The most important one is the assumption of monotonic preferences. According to behavioural economics, people tend to stay with their current choices, even if they are not the best ones for them. They are also sometimes constricted by their lack of self-control to act in their best interest.
The concept of behavioural economics has been around for centuries. However, it began to develop and gain traction in the middle of the 20th century. Since then, the progress has been slow but steady.
The first record of behavioural economics can be traced back over 150 years. The subsequent works also include behavioural finance, social psychology, sociology, and history. In 1912, psychology was connected directly to the stock market for the first time in the book Psychology of The Stock Market. It discussed the emotional and psychological forces that surround investors and traders, and the impact they have on the financial markets.
In the field of management and organization, behavioural economics covers marketing, finance, accounting, and technology. Traditional economics believes that the best way consumers and firms do this is by mathematical rules. However, with the rise of behavioural economics, modern economists believe that these rules are devoid of all psychological and social influences, and are thus not a true calculator of real-world choices.
Historically, before these mathematical rules came into place, economists going back to and including Adam Smith gave a lot of thought to how incentives and motivations are impacted by psychological influences. John Keynes, the famous economist, was the first one to analyse the impact of psychological influences in financial markets and their impact on macroeconomics in general.
Richard Thaler, called the father of behavioural economics, for his contribution to behavioural economics and works like his book Nudge, with Cass Sunstein, published in 2008. In this book, they have opined that humans are subject to a number of biases, and often make choices that are not in our best self-interests.
However, in organizations, conventional rules are commonly used to guide and motivate people. These include the hierarchical structures, chain of command, business processes, and much more. The minimal use of behavioural economics by businesses is focussed on external connections- customers, rather than internally on their employees. What most organizations do not realise is that behavioural economics can be used to solve internal issues as well as external issues.
At workplaces, as in personal life, people weigh the pros and cons of every action they do, every decision they take, and behavioural economics helps the management to understand the employees’ rationale and plan their internal policies accordingly. This is because the prediction, understanding, guiding, and changing of someone’s choices can only be done when it is understood why those choices were made in the first place. The choices we make are trade-offs between two or more options. If it can be understood why we choose a particular option in a trade-off, our choices can be influenced and changed in the best interests of the organization. This makes it important for managers and leaders in an organization to understand the implications and impact of behavioural psychology in their leadership, motivation, management, and thus in their internal economies.
The changes introduced in policies with the help of behavioural economics need not always work solely in favour of the organization, they can work well for employees too. In the mid-2000s, General Electric’s management adopted a new trial policy based on behavioural economics to reduce the number of smokers they had, through monetary incentives for a fixed period. Even beyond that period, people did not resume smoking, showing that policies can work well for both employers and employees.
In a similar trial conducted between McDonald’s, a popular fast-food chain, and a Chinese fast-food restaurant, it was found that when asked, people if they want to upsize their order, people in the former often agreed. However, when asked in a Chinese restaurant whether they want to downsize, people said yes quite frequently. This experiment helped the two eateries understand the needs and want of their customers better and also helped increase sales (in McDonald’s) and reduce food wastage (in the Chinese restaurant).
However, it is also not necessary that the company always adopts policies that benefit the employees too, as was seen in the case of Uber. Uber used “nudges” to get its drivers to take on more trips at times and in areas that made these trips less lucrative for the drivers but more for Uber. The drivers were nudged by getting the fare and other essential details for the next trip before completing the current one, which would have been their last one in normal scenarios, and telling them that they are near a milestone whenever their time to end was near. These policies were implemented on the basis of data gathered by behavioural economics and its applications, but they only served the interest of the organization and not its people.
Thus, the decisions which are taken on the basis of information gathered from behavioural economics-evidence-based conclusions and human psychology- are more effective, as there is a clear ‘why’. It can be used by both, big and small organizations, and for any size of decision/change to be made.
The rise of behavioural economics has made it easier for organizations to implement policies that do not require continuous revamping in order to bring the best results, in terms of employees’ productivity and revenue generation or those which are straight-up ineffective. This leads to massive savings in terms of time, money, and effort for the leaders of any organization, the three things which are most important in today’s competitive and fast-moving world.
Though not always easy to keep up with, behavioural economics has now become an essential practice for organizations to survive, grow and earn profits.