Behavioral economics studies how individuals behave, and how thinking and emotions affect individual decision making. By adding insights from psychology, behavioral economics tries to modify the conventional economic approach, and to analyze how people act in social contexts. It is the study of psychology as it relates to the economic decision making processes of individuals and institutions. Rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction. It assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for that particular individual. The rational individual has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. However, behavioral economics explains that sometimes humans are not rational and can’t make good decisions.
As humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if an individual wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories. Behavioral economics states that even if he wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. Behavioral economics draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models. It seeks to explain why an individual decided to go for choice A instead of choice B.
Companies are increasingly incorporating behavioral economics to increase sales of their products. As companies begin to understand that their consumers are irrational, an effective way to embed behavioral economics in the company’s decision-making policies that concern its internal and external stakeholders may prove to be worthwhile if done properly. For example, in 2007, Apple priced the first iPhone at $600 but then quickly reduced it to $400. However, If they had introduced the phone for $400, the initial reaction to the price in the smartphone market might have been negative as the phone might be thought to be too pricey. But by introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal and sales surged for Apple. This is how companies use behavioral economics.