Have you ever wondered why you make certain decisions against your better judgment? Why is it, even when you know what is right, that choosing it is such a challenge? While moral philosophers have debated these questions for centuries, a recent entry into the debate is gaining significant attention: behavioral economics.
First identified in the 1970s, the principles of behavioral economics have come to the forefront of academic and professional research. There are many reasons for this rise, ranging from popular interest to near-universal applications, but one explanation rises above the rest: it makes sense.
A challenge often faced by non-academics with economic theory is the rationality assumption. Simply put, it assumes that in every decision people will weigh the costs and benefits and choose the reasonable course of action to maximize benefits and minimize costs. Behavioral economics challenges this assumption by realizing that biases and perceptions sometimes cause us to choose non-ideal outcomes.
For example, a person trying to lose weight passes a box of doughnuts a co-worker brought in to share and faces a choice: take a doughnut or just walk by. The cost associated with eating the doughnut is increased calories, a feeling of defeat, and a potential workout to burn off the calories. The benefit is short-lived pleasure and a sugar rush. All things held equal, this should be an easy choice: don’t eat the doughnut. But, as you likely have experienced, the situation often does not play out this way. The future cost of the doughnut is underestimated while the immediate benefit is overestimated, and the doughnut is eaten.
What happened? Why weren’t the costs balanced and the benefits weighed? Where is the disconnect? In short, impulse took over; an irrational choice was made. However bleak this may seem, understanding and applying behavioral economics can have real benefits as we are now able to predict when these irrational choices will occur, and plan around them.
One especially common behavioral influence is called loss aversion. Field experiments have shown that it feels more painful to lose something than it does to gain something equal in value. For instance, if I take $50 from you, it will cause more stress than the happiness you would gain if I gave you $50. The dollar amounts are the same, but the emotional responses are different.
This result can be leveraged to prevent overspending, especially with credit cards. A major challenge with credit cards is that we are separated from the actual dollars being spent; just a swipe and we are done. Imagine for a second if all of your card transactions were replaced by physical money. Would it be easier to control spending in this hypothetical scenario? Odds are, yes. While changing spending methods to 100 percent cash is impractical, this thought exercise, or a budgeting program like YNAB or Mint, help make our transactions more tangible and have potential benefit through limiting spending.
Another related behavioral principle is called the endowment effect. Researchers have identified that perceived value increases when we feel a sense of ownership. For example, I may not think your car is worth that much money; but, if I were to own the exact same car, I would feel it was worth more.
When applied to savings plans, this finding helps explain why we often miss our goals. Saving money is acknowledged as important by almost everyone, but the actually practice of saving can be difficult for some, even those who make enough money. Perhaps it is no secret, some people really like to own or consume more than they like to save. This is where defined contribution plans and opt-out programs help. By making contributions before receiving a paycheck, we never “own” or see the money, so we never feel the pain of the withdrawal.
Ben Young and John Hoffmire
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