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Behavioral Economics

10 Lessons from Behavioral Economics

Hidden forces of behavioral economics shape our choices.

Choice and decision making is a fundamental aspect of life, and the choices people make determine in part the quality of life. The following are 10 basic elements that should be considered in approaching most daily choices.

1. Incentive matters. The pursuit of self-interest is a fundamental economic motive. The fundamental human motive is the desire to seek pleasure and avoid pain. People organize their actions around those twin pursuits. They evaluate each alternative by balancing imagined pleasure against imagined pain and selecting the alternative with greater average pleasure.

2. The forces of supply and demand. The forces of supply and demand determine prices or wages. In a commodity market, price is the result of balancing supply and demand. For example, to earn higher wages, college students are advised to find a field that most people find less attractive, because that would limit the supply of people entering that field. It is also equally important to work hard to nurture a “growth mindset” in pursuit of any field.

3. The power of luck. Talent and hard work are key ingredients of success. However, luck and random events beyond our control contribute to our economic success. For example, a graduating student can be lucky and enter the job market when it is strong, or unlucky and enter the job market in the middle of a recession. Other random factors include where you are born, where you go to school, your health, and so on.

4. Money is not everything. People are motivated by much more than money. The great joys of life come from pursuing one’s passion, spending time with friends and family, and enjoying experiences. People are not merely motivated to judge everything by its monetary value. It was Oscar Wilde that famously said “What is a cynic? A man who knows the price of everything and the value of nothing.”

5. The law of diminishing sensitivity. The law is a tendency for the value derived from additional consumption of most goods and services to decline after a certain point. For example, the more a listener is exposed to a given song the more she tends to like it up to a point. All pleasures (e.g., a cup of coffee in the morning, an afternoon walk) follow this law of diminishing sensitivity, and a few aspects of life escape this reality. That is why people eat chocolate bars in pieces, waiting and savoring. They scale back stimulation deliberately in order to prolong the enjoyment.

6. Social vs. market norms. We live in two worlds: one characterized by social norms and the other characterized by market relations. People react quite differently to the two different norms. For example, let's say your friend calls you and says he needs help moving. You might reluctantly show up to help. But what if your friend asked the same question and offered you pay $10 for your trouble. Chances are you would decide that the money was not worth your time. Introducing market norms into social relations violate social norms and hurt relationships. However, using gifts, even small gifts, can maintain social norms. So when you are in a restaurant with a date, good advice is not to mention the price of the selection. When emotions and markets collide, the situation feels awkward.

7. Fairness concerns. People care about being treated fairly. Consider this thought experiment: In the Ultimate Game, two players are offered a chance to win a certain sum of money. For example, the first player makes a proposal about how to split a reward, say $100, between herself and a second player. The second player can accept or reject the deal. If the deal is rejected, neither player gets anything. The optimal strategy is for the first player to offer the second player a small amount, say one dollar. And the second player should accept the deal because getting something is better than getting nothing. However, in practice, the first payer offers close to a fifty-fifty split, out of concern for fairness. When people do attempt to keep most of the money for themselves, the second player is willing to forego the money because the offer is unfair.

8. Sunk cost. Sunk costs are those costs that are beyond recovery at the moment a decision is made. Sunk costs should have no bearing on future decision-making. But sunk costs often matter to individuals. We like to fix the past before moving forward. Consider membership in a warehouse club that costs $40 a year. The natural inclination is to continue buying stuff so that you can “recoup” the membership fee. The result could be overspending, even on things we don’t need. In this case, sunk cost is the motivation factor.

9. Aversion to loss. We don’t like to lose things that we own. We tend to become extremely attracted to objects in our possession and feel anxious about giving them up. Loss aversion is an expression of fear of loss. This explains why we tend to focus on the negative events (a setback) more than the positive ones (making progress). If you feel tired of everything you possess, pretend that you have lost all these things and are missing them desperately. Doing so may make you value what you already have.

10. Preferences are fickle. Individuals’ tastes and preferences not fixed. Our behavior seems to be controlled by a narrow-minded “doers” who cares about immediate gratification and a farsighted “planner” who is concerned with long-term satisfaction. The person who makes plans and the person who fails to implement them are different parts of the divided self. Having just a plan or goal is not enough. No matter how strong the goal intentions, there is no guarantee that the goal will be achieved, because of the planner-doer gap (or the intention-action gap). We can act as a single individual through the exercise of self-control.

More from Shahram Heshmat Ph.D.
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