Your Tank is Empty
You glance down at your gas gauge. You're coasting on fumes. Time to fill 'er up! There are two gas stations across the street from each other. Which gas station would you choose?
Gas Station A: The price for gas is $2.45 if you pay with cash, and a $0.05 surcharge for using a credit card.
Gas Station B: The price for gas is $2.50 for using a credit card, and a $0.05 discount for paying with cash.
What is "Behavioral Economics?"
I'm not sure if this is apocryphal or not, but I believe Hitler famously asked, "Guns or butter?" [1] At first glance, his statement seems like a false dichotomy. But if you dig a little deeper, you find that the common denominator is nitrogen. You can either turn nitrates into gun powder or you can convert them into fertilizer [2].What does "guns and butter" have to do with Economics? Simply put, Economics is the scientific examination of making decisions when resources are scarce. In a world of finite resources, you have to pick. Do you want guns and tanks, or do you want plows and tractors? You can't have both, so you have to choose.
Where, then, does the "behavioral" aspect of behavioral economics come into play? I'm glad you asked because Dr. Richard Thaler, author of the book Misbehaving, has a terrific answer [3].
What's the Big Idea?
Before delving into Dr. Thaler's big idea, a little context is necessary. Every scientific theory is based on a few core assumptions. Economics is no different. Neoclassical Economics assumes that people are rational and are able to make optimal decisions to further their own agenda. In other words, I know what makes my life worth living. It might be different from yours, but we both are able to decide what's best for ourselves. In economic jargon, we are experts at maximizing our own utility (read: "happiness"). For simplicity, Thaler refers to these rational types of people as Econs.Assuming people are rational, various factors are deemed irrelevant when making decisions. In the scenario that opened this post, both options should be equally appealing to an Econ. If we observed Econs filling up their cars, about half of them would choose Station A and the other half would choose Station B.
But what do we observe when we watch Humans purchase gas? Which gas station would you purchase gas from? Gas stations that offered a surcharge on credit cards quickly learn that humans overwhelmingly prefer discounts.
Thaler's book is chocked full of big ideas. Probably the biggest among them is the idea that economic theory is based on the faulty assumption that we are Econs instead of Humans. Unfortunately for Neoclassical Economics, humans are swayed by supposedly irrelevant factors, or "SIFs" for short.
The Big SIF: The Sunk Cost Fallacy
What's an example of a SIF? Personally, one of the hardest lessons for me to learn was to ignore "sunk costs." I bet this has happened to you, so I'm sure you can sympathize. A couple of years ago, I bought a ticket to a brew festival. The lineup of craft brewers was incredible, and I was excited to try some new libations. But on the day of the beer fest, I came down with fever. I tried to coax myself to go. I couldn't let all that money go to waste! But then a lesson from college came back to haunt me. That money is gone. I can't jeopardize my health because that would be considered, "throwing good money after bad." In the end, I had to stay home (and ignore the sunk cost of my ticket!).The sunk cost fallacy is just one example of many SIFs that Dr. Thaler describes and had a hand in discovering. By the end of the book, you are left wondering how Economist can continue to believe in a rational individual. More importantly, How must economic theory change to accommodate these SIFs? I guess it's up to us misbehaving Humans to figure it out.
Share and Enjoy!
Dr. Bob
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[1] According to the all-knowing wikipedia, it looks like Hitler didn't coin the term, but the Nazis did use the concept of "guns or butter" in their propaganda.[2] Making decisions on a stingy planet also calls to mind our discussion on Opportunity Costs.
[3] Thaler, R. H. (2015). Misbehaving: The making of behavioral economics. WW Norton & Company.
