Let's Break It Down - What Is Behavioral Economics?

What Is Behavioral Economics?

Behavioral economics is the study behind how psychology, emotions, and human behavior are able to influence economic decisions. Typically, traditional economic models assume that people make rational choices, real life decisions are frequently affected by habits, social pressure, and personal feelings. Behavioral economics explains why people may impulsively spend money or make certain choices that harm them down the road.

The general field of behavioral economics is typically relevant to everyday financial decisions, whether it be deciding whether to buy something online or choosing the amount of money one may want saved. Being able to understand the psychology behind these choices help explain why people don’t always act on their own best interests.

Why do people make irrational financial decisions?

An important concept when it comes to financial decisions is present bias, which occurs when people attempt to prioritize immediate rewards in comparison to future benefits. For example, a teenager may spend $50 on clothes instead of saving for something that may benefit them down the road. While saving may have been able to provide long-term benefits, the immediate satisfaction may seem more appealing.

Another important concept is loss aversion – describing how people often feel the pain of losing money more strongly than the pleasure of gaining the same amount. As a result, someone may hold onto a losing investment rather than making a practical decision. Instead of evaluating their options objectively, they focus on avoiding the feeling of accepting a loss.

A major influence on spending habits is social pressure. For example, ads, influencers, and friends are all major encouragements to people to purchase products that a consumer may not particularly need. For example, if someone's friends bought expensive sneakers, they may feel pressured into buying the same pair to fit in. Certain influences can lead people to spend more than they originally intended.

Why do people make irrational financial decisions?

By understanding behavioral economics, people are able to recognize what influences their financial decision.Behavior economics shows that financial decisions aren’t based on money alone – emotions, habits, and social influences shape how individuals spend and save, sometimes without them realizing it. By recognizing these influences, individuals can make more thoughtful financial cookies and build better habits for the future.