Behavioral Economics

Behavioral Economics

Behavioral economics studies the effects of the human psyche on economic decision making. To put it simply: how emotions and thoughts can affect how people make decisions about money. This theory is nothing new. One of the first supporters of this idea was Adam Smith. Behavioral economics was later disregarded when a more rational approach was taken in the 1800s. By the mid-1900s, however, behavioral economics made a comeback as there was a clearer understanding of how much psychology plays into economics.

Although closely related to behavioral economics, behavioral finance relates more closely to the world of the investor. The behavioral finance theory states there are important psychological and behavioral variables involved in investing in the stock market and proposes psychology-based theories to explain stock market anomalies. For example, when a certain stock becomes "hot" and prices increase substantially without a change in the company’s fundamentals, behavioral finance theory would attribute this phenomenon to mass psychology.

In my opinion, behavioral economics is a decidedly valid theory. Although we humans pride ourselves on our high levels of rationality in comparison to other species inhabiting the earth, we are still very irrational and frequently behave in an impulsive manner. This impulsiveness gets accentuated when pursuing pleasure in the form of purchasing the objects we want or desire and often times don’t even need. Consumer economics is a very behavioral-based type of economics. Companies that produce the “objects of our desire” are well aware of this, and they often concentrate their marketing efforts to exploit this human weakness.

A perfect example of behavioral economics is the company Apple and its star player, the iPhone. As explained on the article “Apple’s Pricing Decoys,” writer Ben Kunz sees behavioral economics in iPhone pricing. The phone’s “reference price” (i.e. its original retail price of $599) and customer-perceived “transaction utility” (i.e. whether or not customers think they are getting a good or fair deal) explains Apple’s marketing strategy. Kunz goes against conventional wisdom when applauding the significant price cuts Apple regularly subjects its iPhone to shortly after the release of each of its generations as part of a shrewd strategic campaign.    

But how has Apple played this pricing game? First, by optimizing margins (margin per product x total sales). Simply put, you can either sell a few units with huge margins, or sell many of them with lower margins. Apple did both by launching the iPhone with its original price tag of $599 in order to obtain the rabid fans who were willing to pay that much in order to have it first. Then later, Apple slid the scale down to $399 and even $199 to reach more of the masses.  

A second way of playing the pricing game was to obscure the reference price altogether. As Kunz notes, most people buy a car, suit, or candy in a movie theatre by comparing it to what they think is a “fair price.” Apple’s clever marketing team was able to obscure this reference price to other smart phone products. Another example is movie theatre candy. It comes in unusually large boxes you won’t find anywhere else. The reason? You can’t easily calculate whether $4 for an oversized box of candy is a rip off or not. Steve Jobs obscured the reference price with an iPhone design that didn’t look like anything else.