In my previous post I spoke about how, according to the behavioral economists, consumers may not behave rationally due to bounded rationality and bounded self-control. The consumers end up making heuristic decisions. In addition to this, behavioral economists argue further that some emotional, social and psychological factors can also affect our decision-making process which are called ‘cognitive biases’.
Cognitive biases can lead to erroneous judgments, distorted thinking, and irrational decisions. In this blog, we will explore some of the most common cognitive biases and how they can affect our thinking.
Anchoring Bias
Anchoring is when we have initial information about the value of one thing and we make our buying decision by keeping that as our reference point.
For example, the supermarkets will offer a product at a higher price and then they discount it and the consumer feels that they are getting a good deal. It works easily because usually a consumer is not aware of the real prices of any product. The stores anchor the consumers to high prices and that becomes a reference point.
A car salesman may initially offer a high price for a car, which becomes the reference point for subsequent negotiations. The buyer may then get tempted by subsequent lower offers, even though that might have been the actual price the car salesman might have been looking for.
Availability Bias
This bias is based on the premise that humans make decisions based on the availability of information examples they have come across in their lives.
For example, if we have an 80-year-old member in the family who has been smoking for years but has no medical condition. We assume that smoking is not so risky though the real medical facts may prove otherwise.
Another example, when we hear in the news about salmonella bacteria in chicken causing a death and we stop buying chicken though this could be a rare case.
Framing Bias
Framing bias is the principle that our choices are influenced by the way they are framed through different wordings, settings, and situations. This is a tactic used in marketing a lot.
Retirement plan pitches like the 401(k) are good examples of framing bias. Initially, companies offered 2 options to their employees:
Invest in the 401(k) plan,
Do not invest in the 401(k) plan.
It was an active election approach. But many employees willingly declined retirement plans. Hence, later, the presentation was amended, keeping framing bias in mind. Employees were told:
“You will participate in retirement plan unless you choose not to.”
The new automatic enrolment process paid off—the retirement-plan participation rate jumped from 37% to 86%.
Confirmation Bias
Confirmation bias is the tendency to seek out and interpret information in a way that confirms our pre-existing beliefs or hypotheses. We tend to look for evidence that supports what we already believe and ignore or discount information that contradicts our beliefs. This can lead to flawed decision-making and reinforce our biases.
For example, a person who believes that vaccinations are harmful may ignore scientific studies that demonstrate their safety and instead focus on anecdotal evidence that supports their belief.
Overconfidence Bias
Overconfidence bias is the tendency to overestimate our abilities or the accuracy of our judgments. We tend to be overly optimistic about our own performance, underestimate risks, and overestimate our ability to predict the future. This can lead to overconfidence in our decisions and underestimation of potential risks. We may underestimate our risk of getting cancer and overestimate our future success on the job market. A number of factors can explain unrealistic optimism, including perceived control and being in a good mood.
For example, a person who has invested in a stock may overestimate the likelihood of the stock's success and fail to recognize potential risks or uncertainties.
During Covid-19, the youngsters felt that Covid is only dangerous for old people and they started holidaying assuming that they are immune to any risk.
Social Norms
Social norms signal appropriate behavior and are classed as behavioral expectations or rules within a group of people. Norms vary across cultures and contexts. Our day-to-day behaviour is influenced strongly by what we understand to be the prevailing social norms or social customs.
For example, how much to tip in restaurants. We do it based on a cognitive bias of expected norm in the society, we live.
One study compared contribution levels for a public radio fundraiser in the US. When potential donors were provided with an information that a particular member has contributed a certain sum, this saw up to a 12% increase in average contribution amounts.
We want to follow what others do.
Loss aversion Bias
It is a cognitive bias that explains why for individuals, the pain of losing is much more powerful than the joy of gaining something. For example, the pain of losing $10 dollars is far greater than the joy of finding $10.
Status quo bias takes place because of the loss aversion bias. Rather than placing their money in investments with a certain degree of risk, people often leave their money in low-yield savings accounts. The status quo bias leads people to maintain their current financial situation instead of taking a risk and improving their financial gains.
Herd Behavior Bias
We tend to do what others are doing. We jump on the bandwagon without giving much thought to it.
For example, we see people investing in one particular stock, and we follow them. The other investors follow them which creates economic bubbles. The prices of stock rise much higher than their intrinsic value. Well-known examples of bubbles include the US Dot-com stock market bubble of the late 1990s and housing bubble of the mid-2000s.
Choice Architecture Bias
Our decisions can get affected by how things are placed.
For example, to promote healthy food habits in the students, the school cafeteria might place salad bars in an area which is more visible to the students.
In the supermarkets, consumers can be influenced to buy certain things if they are placed in the right place next to their ideal combination. Nowadays, one can find readymade salad sauces next to the packed salad isles for the consumer to make a convenient choice.
Conclusion
Most of our choices are not the result of careful deliberation, but are influenced by cognitive biases and heuristics, which are a natural part of being human. Heuristics and biases in behavioral economics demonstrate how consumers often do not act rationally, contrary to the assumptions of neoclassical economics. These biases impact various aspects of our lives, from personal relationships to professional decisions, influencing the way we think and behave.
By understanding heuristics and biases in behavioral economics and their effects on our decision-making processes, we can strive to make more informed and rational choices. This awareness also aids governments in designing policies that nudge people toward better decisions.
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