Behavioral Economics: The "Why" behind our Financial Choices

Creating wealth does not happen in a vacuum. It takes everyday actions from individuals to contribute to the ever-evolving “economic machine."

"How The Economic Machine Works" by Ray Dalio:

Economic theory tries to understand human action as it relates to prices, markets, production, and consumption. A price is the agreed-upon level at which a seller is willing to part with a good and the buyer is willing to assume it.

The study of behavioral economics, though, focuses on the why of individuals’ actions. Why don’t we save when we know it’s good for us? What influences someone to go to graduate school or not? Why did you choose to buy the apple and not the orange?

In short, behavioral economics seeks to explain why an individual decided to go for choice A, instead of choice B. If economists can understand the answers to these “why” questions, it could help them develop incentives and policies to encourage greater financial equity (hopefully).

Private corporations are also interested in behavioral economics. If they can understand why you bought an Apple product over a Microsoft product, they can change their business models to incentivize you to buy their products instead.

We saw a real example of this in 2007 when the price of an 8GB iPhone was introduced at $600 and then quickly reduced to $400. If Apple would have introduced the price of an iPhone at $400, an actual representation of the intrinsic value, it might have been considered too pricey. Starting at $600 and then dropping the price makes people feel like they are getting a good deal.

There are a few different theories that economists have come up with that explain why people behave the way that they do. The first, and most talked about, is Rational Choice Theory. This theory “assumes that human actors have stable preferences and engage in maximizing behavior.” Translation: Rational Choice Theory believes that every human always makes the best decision for themselves all the time, regardless of the external influences around them.

For example, if I was trying to lose 10 pounds, according to the Rational Choice Theory I would never eat something “unhealthy.” Even if I was running late for work and hungry, I would not buy something “unhealthy” because it would not be in my overall best interest.

Rational Choice Theory is admirable because it supports the idea that all human beings do want to make the best decisions for themselves. However, it doesn’t leave space for the fact that we are all prone to external forces that are influencing us in situations where we might not always make the best decision for ourselves.

But who can blame us? Advertisements are intentionally designed to manipulate us into buying products. Life can be so fast and chaotic that “good” and “bad” choices are made on a whim. Life happens. You have to work with the information that you have.

Bounded Rationality brings a more realistic picture of human problem-solving ability. According to this view, "our minds must be understood relative to the environment in which they evolved. Decisions are not always optimal. There are restrictions to human information processing, due to limits in knowledge (or information).”

Bounded Rationality argues that humans only have so much brainpower and time to make the best decisions for ourselves in each specific moment. For example, if you chose to buy the iPhone at $600, Bounded Rationality would argue that you probably didn’t have the time, or access, to the information that would tell you that the true cost of that iPhone was closer to $400. You worked with the tools you had in the moment of purchasing the iPhone.

These are just two theories of many. Because behavioral economics is a combination of psychology and economics, there are almost endless theories seeking to explain why human-beings interact with prices and the market the way that they do. If you’re interested in reading about more of these theories, check out this link!

Learn more from our sources:

"An Introduction to Behavioral Economics." | The BE Hub.

Kenton, Will. “Behavioral Economics.” Investopedia.

Ross, Sean. “How Does Economics Study Human Action and Behavior?” Investopedia.

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