Enough Coffee For Ya? — An Introduction to Behavioural Economics
The last time you learned about economics, did you learn why many people drink more coffee than they need, or why they often end up leaving money on the table? If your answer is no, you might be thinking, “that doesn’t even sound like economics”; but that’s likely because you’ve only been introduced to the traditional economic approach.
The Traditional Economic Approach
Under this approach, when humans are presented with multiple options with various costs and benefits, they always choose the option that maximizes their individual satisfaction. Based on this approach, people are entirely rational, and emotions and other external factors have absolutely no effect on their ability to make the best choice.
Now, keeping that in mind, let’s look into something called behavioral economics.
Behavioural Economics
Behavioural economics uses insights into human psychology, and attempts to make traditional economic models more accurate in order to help us understand why consumers and investors make certain decisions which may seem irrational. It also explains why people often don’t make the choice which would maximize their satisfaction.
Behavioural economics is applied in many areas such as politics, public policy, education and marketing.
Let’s explore some basic concepts and examples.
The Power of Defaults
We’ll start by diving in to an interesting example presented in a book called The Last Mile, written by Rotman School of Management professor, Dilip Soman. In the book, he noted the organ donation rates for multiple countries: on one hand, countries such as Denmark, Germany and the United Kingdom had very low rates of 4.35%, 12% and 17% respectively. However, on the other hand, countries such as Austria, France, and Hungary had rates of 99.98%, 99.91% and 99.97% respectively.
These countries are “not very far away from each other [geographically]”, so why did one set of countries have extremely different organ donation rates from the other? The advertising programs between both sets of countries were not different. “The only difference [between the two] was what was called the default option.”
For example, in Canada, “a person who [may] want to consent to donate organs, needs to go to the Department of Motor Vehicles [to] obtain a form.” This form is usually given to you after you’ve completed the task for which you came, such as renewing a driver’s license. This process is called the explicit consent (or an opt-in) process, because you need to “actively take steps to say that you want to be an organ donor”, and if that form is never handed in, “the implicit assumption is that you will not be an organ donor.”
In a country like Austria, the process is basically the exact opposite, and is called a presumed consent (or opt-out) process. “The assumption is that unless you fill out and hand in a form, you do want to donate organs.”
One reason why defaults are extremely powerful is because “they tend to signal some sort of a social norm. If the default is that everybody is a donor, people might think that perhaps they should be donors as well”, and vice-versa. However, the main reason why defaults work well is that human beings are known for being very lazy, and will not make an effort to exercise their right of choice to move away from the default, unless they are particularly averse to it.
The Compromise Effect
Another example that Soman wrote about in The Last Mile, is the compromise effect. He conducted research in six different countries and noticed that in each one of them, the most popular size of coffee was the medium size. He also noticed that “the amount of coffee in the medium-sized coffee cup was different in different countries.”
Soman then did a small experiment in a Hong Kong coffee shop. Before customers left the shop, he would ask them why they picked the size they chose. The answers of those who chose medium were something like: “the small coffee had too little, the large size had too much, and the middle one was just right.” At that point, “the three sizes of coffee were eight ounces, ten ounces, and twelve ounces.” Then, he eventually increased the size of each cup by two ounces. He found that even though the new medium size was the same amount as the old large one, it still became the most popular! In the end, this all proved that “as long as there was a bigger and more expensive option and a smaller and cheaper option, the one in the middle was likely to get selected.”
Nudging — A Way to Prevent People from Leaving Money on the Table
In behavioural economics, a nudge is known as something that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. In an example provided in The Last Mile, it actually stopped many people from turning away from money.
He described a case in which a company was offering an in-house clinic to give annual flu shots to their employees, along with a $50 incentive for those who got one. Even with the incentive, there were too many people who were not getting a flu shot. That’s why Darthmouth University’s Professor Keller and her colleagues decided to do an “experiment with three different ways of asking people whether they wanted to get a flu shot.”
In the usual approach, the company would send out emails to their employees with all the basic information, such as when the clinic would be set up. While the employees were given all the required information, it was still up to them to actually “make an active choice to go and get the flu shot.”
In another version of procedure, a second group of employees received a short questionnaire, along with the basic information, which asked them about whether they planned on getting a flu shot. They had to check one of two boxed: one read, “Yes, I want to get a flu shot this fall”, and the other read, “No, I do not want to get a flu shot.”
In the third version of this procedure, the two options were phrased slightly differently. One read, “Yes, I will get the flu shot to reduce my risk of getting the flu, and because I like the $50 incentive.” The other option read, “No, I will not get a flu shot this fall because I don’t care about my risk of getting the flu and I don’t care for $50.”
This is an excellent example of a simple nudge. Those who did the experiment found that in the standard approach, only 42% of employees were considering getting a flu shot. In the second version, with the simple yes or no choice, 62% planned on getting a flu shot. In the third version, with the “enhanced active choice, the number of people saying they wanted to get a flu shot went up to 75%.”
All of this goes to show that the traditional economic approach may be a great place for people to start learning about economics, but isn’t quite accurate at predicting what choices humans will make…
If it was, would people really say “no” to $50? Think about that over a medium-sized cup of coffee.
Written by Sineen Madni, Director of the Junior Economist
