Either a human behaves rationally or irrationally. We always prefer taking logical decisions but sometimes, unknowingly we get trapped into schemes. Rational behaviour refers to a decision-making process that is based on making choices that result in the optimal level of benefit or utility for an individual i.e. that individuals always make prudent and logical decisions. Most conventional economic theories are based on the assumption that all individuals taking part in an action or activity are behaving rationally and this leads to unrealistic economic analysis and policy-making.
Behavioural economics counterfeits the same and studies the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions of individuals and institutions and how those decisions vary from those implied by classical theory.
But why is Behavioural Economics so important on a micro and a macro level?
Let me give you an example. You run a successful Smartphone company named ”Orange” which is considered to be one of the best and you just launched an upgraded version of the previous model which was sold successfully throughout the country. The price of the new model is Rs. 70,000. Some people were eagerly waiting for this launch and side by side comparing it with “One Fuss” brand whose phone sells at Rs. 50,000. In two weeks, the “Orange” phone price drops to Rs.57,000 and the same people who were at first unable to make a decision, go and buy the one which is still more expensive. Now, what if the intrinsic value (true value) of the “Orange” Phone was Rs. 57,000 anyway? If Orange introduced the phone for 57k, the initial reaction to the price in the smartphone market might have been negative as the phone might be thought to be too pricey. By introducing the phone at a higher price and bringing it down to Rs. 57,000, consumers believed they were getting a pretty good deal and sales surged for Orange. In an ideal world, frames and price anchors would not have any bearing on consumer choices if everything was rationally done. We would always make optimal decisions.
Let’s look at some more such examples and important concepts of Behavioural Economics:
1. Decoy Effect: The decoy effect is technically known as an ‘asymmetrically dominated choice’ and occurs when people’s preference for one option over other changes as a result of adding a third (similar but less attractive) option and you’re influenced to choose without even knowing it.
National Geographic ran an experiment to test how the decoy effect influences consumers to buy a large popcorn rather than a small or medium one.
To begin with, they offered the first group of consumers a small bucket of popcorn for $3 or a large one for $7. The result revealed that most of the consumers chose to buy the small bucket, due to their personal needs at that time.
As for the second group, they decided to offer three options: a small bucket for $3, a medium bucket (the decoy) for $6.5 and a large one for $7.
2. Halo effect: Halo effect is a cognitive bias that influences our perception about a person/product/company by focussing on just one personality trait or characteristic of the person/product. It is the tendency for an impression created in one area to influence opinion in another area. Eg. We make assumptions about someone’s whole personality when we get to know 1-2 characteristics of theirs. A strong opening to Rajnikant or Salman khan movies is a typical example of Halo effect. People making mile-long queues for every new Apple product is another example. This is a bias which can lead to the biggest investment mistakes. We have seen stocks jumping on news containing adjectives like "CAPEX", "expansion" "forward integration", "backward integration" etc appear. Investors tend to latch on the stocks without digging deeper and then lose money. Likeability of the CEO makes a huge factor in the eyes of even seasoned investors. Big M&A deals get influenced by the likeability factor. We tend to make judgements about a company based on just one report, factor, news on the company.
3. Choice Overload/Overchoice: The phenomenon of choice overload occurs as a result of too many choices being available to consumers. It is especially prevalent when an individual has to consider multiple options that only slightly differ from one another and don't contain a superior option. Studies have shown that too many options even lead to the customer not buying anything at all.
4. Herd Behaviour: This effect is evident when people do what others are doing instead of using their own information or making independent decisions. We have seen numerous examples of stocks jumping to new highs when the news that a top Investor like Mr Jhunjhunwala or Mr Damani has invested in it. Not all of Mr Jhunjhunwala's picks have made money. Many investors lost big time when he sold Hawkins at low valuations and when he held on to stocks like Bilcare and Delta Corp.
5. Loss aversion: Loss aversion is a tendency in behavioural finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. Research on loss aversion shows that investors feel the pain of a loss more than twice as strong as they feel the enjoyment of making a profit. Many investors don’t acknowledge a loss as being such until it is realized. Therefore, to avoid experiencing the pain of a “real” loss, they will continue to hold onto an investment even as their losses from it increase. This is because they can avoid psychologically or emotionally facing the fact of their loss as long as they haven’t yet closed out the trade.
6. Inequity aversion: Human resistance to inequitable outcomes is known as ‘inequity aversion’, which occurs when people prefer fairness and resist inequalities. In some instances, inequity aversion is disadvantageous, as people are willing to forego a gain to prevent another person from receiving a superior reward.
7. Sunk cost fallacy: Individuals commit the sunk cost fallacy when they continue a behaviour or endeavour as a result of previously invested resources (time, money or effort). For example, individuals sometimes order too much food and then over-eat ‘just to get their money's worth’. If the costs outweigh the benefits, the extra costs incurred (inconvenience, time or even money) are held in a different mental account. Investors fall into the sunk cost trap when they base their decisions on past behaviours and a desire to not lose the time or money they have already invested, instead of cutting their losses and making the decision that would give them the best outcome going forward.
Write-up by: Mudra Desai
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