Have you ever added an item to your online shopping basket, only to back out at the last minute? “£5 shipping? It’s not worth that!” Now ask yourself: would you have done the same if the item had cost £5 more, but came with free shipping? Behavioural economics argues that you might act differently in those two scenarios, despite the cost being the same.

Behavioural economics affects us in all parts of our lives – from the everyday products we buy to large investments like buying a house, all the way to companies making huge business acquisitions. No one is immune from it. But how does it work, and why is it important that we know about it?

What is behavioural economics?

We once thought that the way we make economic decisions is rational. Economics is all about supply, demand and scarcity, right? However, behavioural economics challenges this, suggesting that there are psychological mechanisms that lead us to make irrational economic decisions. Behavioural economics acknowledges that we’re not rational machines – but rather flawed, biased, and most of all, human.

The £5 versus free shipping scenario is an example of what’s known as ‘loss aversion’. The theory suggests that the pain of losing something is greater than the pleasure of gaining the same amount. Psychologists even argue that the loss can feel twice as intense as the gain; it’s where the phrase “losses loom larger than gains” comes from.

Who started it? 

Kahneman, Tversky, and Thaler are seen as the forefathers of behavioural economics. In 1979, psychologists Amos Tversky and Daniel Kahneman introduced the “Prospect theory”, which we know now as ‘loss aversion’. Meanwhile, Richard Thaler was one of the first to identify the “anomalies” in human behaviour that can’t be explained with standard economic theory: that people are influenced by their environment, past experiences and emotional and mental states.

However, like most things, people were discussing behavioural economics long before we coined the term. 18th-century economist and philosopher Adam Smith argued that behaviour was determined by the struggle between the “passions” and the “impartial spectator”. 

What are some examples of behavioural economics? 

Once you know about behavioural economic theory, you start to see it everywhere: 

• Free trials. The theory of loss aversion says that people are persuaded to keep using a product or service after the trial ends.
• Mental accounting. Treating money differently depending on its origin or intended use. For example, people are more likely to drive across town to save £10 on a £20 purchase, than £10 on a £1,000 purchase (even if it’s the same amount of effort).
• Discount pricing. Ending prices in “.99” makes people perceive a lower price.
• Limited-time offers and scarcity. Buying something if it’s on sale for a limited time only, or if there’s limited stock available.
• Social proof. Trusting products that other people seem to approve of.
• Loss aversion. People feel the pain of losing something more intensely than the pleasure of gaining something of equal value.
• Framing. The way information is presented can influence choices.
• Winning streaks. Or the ‘hot-hand fallacy, which is the belief that a player, team, investment (etcetera) on a winning streak has a higher chance of winning their next game.
• Sunk-cost fallacy. When a person is reluctant to abandon something because they have already invested time or money into it, even if abandonment would be better for them.

Why should businesses care about it? 

Businesses should treat their customers like the humans that they are. “By paying attention to the individual decision-making process, we are slowly building a much richer picture of human economic behaviour,” says Dr Vera te Velde, a Senior Lecturer from the University of Queensland School of Economics. 

It’s also important to have an understanding of behavioural economics from a global perspective. For example, major economic crises, especially the 2008 financial crash, can’t always be explained by traditional economic theory. It’s why some economists ask us to lean into “radical uncertainty” – to embrace the things that can’t be explained by probability or ‘rational thinking’. 

How can businesses make use of it? 

Businesses that grasp behavioural economics might think about “nudging” potential customers. To “nudge” is to use psychological insights to gently influence people to make decisions that would benefit them, in an ethical and informative way, without taking away their freedom of choice. It’s about understanding customers, not manipulating them.

The pioneers of “nudge” Richard Thaler and Cass Sunstein say in their book of the same name: “To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.”

Further reading

• Toward a positive theory on consumer choice – Richard Thaler
• What is Radical Uncertainty – The Beautiful Truth
• Nudge: Improving Decisions About Health, Wealth and Happiness – Richard Thaler and Cass Sunstein