BE101x: Behavioural Economics in Action

Unit 1.2.1 What is Behavioural Economics?

DILIP SOMAN: What is behavioral economics? Perhaps the best way to illustrate the
difference between traditional economics and behavioral economics is to borrow a
phrase from Dick Thaler and Cass Sunstein book, Nudge. In that book, the authors
talk about two kinds of species-- humans and Econs.

What are Econs, you ask? Econs are mythical creatures that live on the pages of
economics textbooks. They're very smart, they can look forward infinitely, they can
compute something called utility of objects, and they make perfectly rational choices.
Econs don't care about emotions because they don't have any. Econs have the ability
of a supercomputer to make fairly complex computations in the snap of a finger.

Human beings are people like you and me-- very different. We're different because
we're emotional. We fall in love, we sometimes do silly things, regret our choices, and
sometimes we choose things just because, which is a concept that Econs would never
understand. Human beings are impulsive.

Human beings tend to make decisions on the spur of the moment. Human beings
sometimes do things because other people would like them to do things. Human
beings donate to charity. Human beings are also very forward-looking at some points
in time, but often care only about the present. Human beings typically form judgments
or make choices based on the context around them, as opposed to Econs, who don't
care about context.

Perhaps the best way to illustrate this point is to talk about a product category that's
one of my favorites-- coffee. Most coffee shops all over the world will sell you coffee
in one of three sizes-- small, medium, or large. That's probably going to come as no
surprise to you if I tell you that the most popular size of coffee anywhere in the world
is the medium size of coffee.

But here's where it gets interesting. It doesn't matter how much coffee is in that
medium cup of coffee. For example, in this scenario, this is probably going to be the
most popular cup of coffee. What happens if I remove the largest size, and replaced
that with an even smaller size? It turns out now the new medium cup of coffee will be
the most popular cup of coffee.

A number of years back when I lived in Hong Kong, I and a bunch of my students did
a study in a coffee shop which was in an office building. We asked people why they
picked the medium cup of coffee, and you typically heard something like, the larger
one has too much, the little one has too little, the one in the middle has the right
amount of coffee. What we then did was we actually increased the size of every cup
of coffee by two ounces-- just what I showed you before-- and we found that the new
medium now became the most popular size. Again, we asked people why they picked
the new medium, and they would say that the little one had too little, the large one had
too much, and the one in the middle was just right.

This is a classic example of what we call a context effect. This effect was first made
popular by Itamar Simonson, who is a professor at Stanford. And the argument he
was making is that in situations where people do not have a good idea of how to value
objects, they use information from the context to help them make that judgment.

Now it turns out that this works not just for coffee, but for a whole number of other
product categories. Here's another example. I took this picture a few years back at a
gas station that I've been buying petrol for the past several years. And I took it
because for years and years, this gas station has been selling gasoline in three grades--
87, 89, and 91. And all of a sudden, they introduced a fourth-- 94.

And I wondered why they did that. And I'm still not sure why they did do that, but
one of the interesting consequences of that introduction was that now the 91 grade
gasoline, which used to be the extreme gasoline in terms of quality, was in the middle.
And my speculation was that the sale of 91 would go up as a result of the introduction
of 94.

It turns out that that was indeed the case. So here, we have situations where the
context now informs consumers about what the right choice is. And so, as we said
before, humans are extremely prone to the role of context in decision-making.

A second example of the role of context in decision-making comes from a completely

different domain-- the domain of organ donations. Simple question-- why are organ
donation consent rates really low in countries like Canada and the United States? Why
are they extremely high in other countries, like France and Austria?

It turns out there are a number of differences between countries like Canada on the
one hand, and Austria on the other hand, but they don't seem to explain the
differences in organ donation rates. In Canada, organ donation rates are about 2.5%.
In Austria, they're close to 99%, and that's a big difference.

The answer as to why there is a big difference in donation rates comes from the
process that people need to engage in order to donate their organs. In Canada, for
example, if you want to donate organs, you have to go to the Department of Motor
Vehicles, ask for a form, fill it out, send it in. You then get a web code that you go
online, access, and register, and then you are an organ donor.

In Austria, it is assumed you will donate your organs. But if you want to not donate
your organs, you would go to the same Department of Motor Vehicles, ask for a form,
fill it out, send it in, get a web code, and then de-register from being an organ donor.
Essentially, the default assumption is different in Canada versus Austria, and defaults
play a huge role in shaping decision-making.

Defaults work because of two reasons. Reason number one-- people are extremely
lazy. If you put obstructions in their approach to a certain outcome, those obstructions
are enough to prevent them from reaching that outcome. So the simple principle that
comes out is if you want to engage people in a certain outcome, make that outcome
easy. Conversely, if you were to prohibit people from engaging in that outcome,
impose a simple transaction cost or simple obstacle, and they will not do that outcome.

Second reason that defaults work is that defaults signal something about everybody
else. For example, if everybody else is donating organs-- if that's the default-- perhaps
I should donate organs, as well, because that's the right thing to do. So what we've
seen across these two examples of the compromise effect-- Itamar Simonson's work--
and the default effect is the role that context plays in shaping human behavior.

The other big challenge in human decision-making is our inability to follow through
on intentions that are our own. For example, all of us want to lose weight, all of us
want to work hard, all of us want to save for the future, and all of us want to exercise
but we don't get down to doing it. And the reason we don't get down to doing it is that
life gets in the way.

So there's often a huge-- what we call-- action implementation gap, or a planning

implementation gap, where all of us plan to do the right thing, but we just don't get
down to doing that. And this gap, in conjunction with the idea that context plays a
huge role in decision-making, is the perfect recipe for all kinds of model decision-
making. This is the reality of human decision-making.