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What is Behavioral Economics?

When existing Mercedes car owners go back to buy another Mercedes, they pay $7,000 more for the same car as first-time buyers. Why is this? Read the explanation of "confirmation bias" below to understand the phenomenon.

Recent research shows we aren't nearly as rational as we think. Behavioral economics is a relatively new science that studies how and why people make money-related choices. Here are some of the things the studies have shown thus far.

Mental Accounting

If you bought tickets to the opera for $100, and you lose them on the way there, would you buy another set for another $100 if you had the money? Most people say no when asked this. Second scenario: You're on your way to the opera, planning to buy the tickets there, and you lose $100 in the street on the way. You still have enough money for the tickets, though, so do you continue with your evening's plan and go to the opera? Most people answer yes to this scenario.

Scientists in the field of behavioral economics call this "mental accounting." In the first scenario, you already spent $100 from the mental category "opera," so it seems too expensive to spend another $100. In the second scenario, you lost $100 cash - a separate category. It's easier to buy the tickets still, even though in both cases the financial situation is absolutely the same. This kind of "mental accounting" has its consequences, and you'll see it at work in some of the other tendencies explained below.

Sunk-Cost Fallacy

We are more likely to attend an event if we pay for the ticket than if we get it free, even if the information and interest are the same. Money, once spent, logically has no relevance to the decision, yet the tendency persists even when pointed out. Most of us would feel worse throwing away a ticket we paid for, right?

Applications are obvious, if you look. For example, rather than giving away tickets to "get rich" seminars, organizers would get better attendance by selling their "$100" tickets for $3. Simply paying something makes people more likely to attend.

Confirmation Bias

People act economically in a way that confirms their current beliefs. For example, when negotiating to buy the exact same model of Mercedes, current owners, who presumably believe in the value of a Mercedes, pay $7,000 more, on average, than new Mercedes customers. You can imagine the value of this knowledge to companies that sell high-priced items.

Decision Paralysis

A study showed that customers bought twice as often when given four samples of jam to taste than when they had twenty to choose from. It seems that having too many choices leads to an inability to decide. Offering limited options may be a useful sales technique, according to this research finding.

Extremeness Aversion

We instinctively avoid extremes, according to the research. With a choice of televisions costing $300, $500, and $700, for example, not many buy the $700 one. But add a $1200 television to the choices, and more will then buy the $700 one, because it is no longer the most expensive one.

Weber's Law

The law: A change of stimulus is more emotional and motivational, according to the base: Subjects tested would drive across town to save $10 on a $20 item, for example, but not to save $10 on a $500 item. For sales people, this means you probably won't lose a sale on a thousand-dollar couch over $10, so forget dropping the price and sell the other benefits.

Note: Some who study behavioral economics go beyond just looking at what people do. On my personal blog I have an interesting post on monkey prostitution (yes, you read that right).

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Behavioral Economics