BEHAVIORAL ECONOMICS FOR DECISION MAKING (MANOJ KUMAR)

SESSION 1 & 2: DECISION MAKING UNDER CERTAINTY

▪ Standard Economics is Normative; Behavioral Economics is Descriptive: Standard Economics tells

you how you should behave to maximize your interests (Econs) while Behavioral Economics describes
how people actually behave (Humans). Nudge is about getting people to do what is best for them.

▪ People do not behave “rationally” to maximize their benefits. They often act “irrationally”:

▪ Ignore Opportunity Cost: If profit from option A is Rs 100, and profit from option B is 60, then
opportunity cost of A is 60 while opportunity cost of B is 100. In standard economics, one should
choose the lowest opportunity cost option i.e. in this case option A. In real life, people do not
calculate opportunity cost of their decisions, and even if they want to do this, it is often difficult
to calculate. For example, New York City cab drivers ignore opportunity cost when they operate
on achieving a daily target amount, and end up working lesser number of hours on more
profitable days e.g. when it rains.

▪ Take into account Sunk Costs (Sunk cost fallacy): In Standard Economics, one should ignore
“sunk costs” while making decisions. For example, if you have invested $9 million in a factory and
you are evaluating an additional investment if $1million, then your decision of investing $1m
should be based on the best Return on your investment of $1m, and not on the basis of $9m
sunk cost. In Behavioral Economics it is found that people often forget this principle, which leads
to compounding of bad choices, and this is called as sunk cost fallacy.

▪ Exhibit Menu dependence (Decoy effect): If you prefer A over B, then you should be consistent
in your preference between A and B in all situations. This is what Standard Economics teaches
us. However, in real life, if we introduce a choice C, then it is possible to influence preference
and for people to chose B over A. In this context, C is called a “decoy” and this principle is called
“Menu dependence or Decoy Effect” in Behavioral Economics. Examples of this can been seen in
Starbucks coffee, where people would prefer small size when given a choice of Small and
Medium, but shift their preference to Medium size when a Large size is introduced.

▪ Overweight losses relative to gains (Endowment effect and Loss Aversion): Standard Economics
assumes that your tastes should remain fixed and not change because of history. Your
Willingness to Pay (WTP) should be equal to your Willingness to Accept (WTA). For example, if
you bought a mug for $3, you should be willing to sell it for $3 if someone offered it and say, you
needed the money. But in real life, people “overvalue” what they own and this is called the
Endowment effect in Behavioral Economics. Studies show that for things which one owns, WTA
is around 2 times WTP. This also means that losing something makes you twice as miserable as
gaining the same thing makes you happy (loss aversion).

▪ Permit arbitrary anchors : Anchoring leads to creation of reference points for calculating loss
and gains.
▪ Prospect theory explains loss aversion not captured in standard economics

gain x

2x loss