During a recent promotion, Nytro Multisport sold the Felt B2 triathlon bike for $4,798.99. Aside from the question of whether it is rational for anyone to pay that much money for a bicycle, why would the retailer not simply charge $4,800? The difference, $1.01, is 1/4,751th of the price. Could that matter? TV ads routinely offer products for $19.95 rather than $20. Gasoline prices typically end in 9/10ths of a cent. And Steve Jobs arguably revived the music industry by charging 99 cents for iTunes music downloads. Traditional economic theory does nothing to explain the importance of shaving a price down from an even number to a substantially equivalent odd number, yet some 90% of advertised prices end in “9” or “5.” Psychological influences clearly matter, whether or not those influences can be categorized as rational. A melding of psychology and economics, behavioral economics is the study of economic decision making as influenced by the limits of the human mind.

Economists have made great strides with models starring “economic man” or Homo economicus, a fictional economic actor and amalgamation of all people, who makes self-interested, informed, rational judgments in pursuit of wealth and leisure. In neoclassical models, Homo economicus represents the typical member of society. Homo economicus is a reasonable facsimile of the average economic decision maker in many contexts, in that variations in behaviors either average out across people or are unimportant. In those cases, the neoclassical models form the basis for useful conclusions. For example, those models predict that people will buy more of a product when the price falls, work more when the wage rises, and prefer some money to none at all. This module, however, explains challenges to the traditional assumptions about Homo economicus, and explores the implications of irrationality among economic actors.

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Behavioral economics unveils Homo economicus and finds an individual who is sensitive, flawed, and biased in ways that can disrupt the efficient allocation of resources. Human decisions can go awry due to the scarcity of time, intelligence, and information. The importance of the psychological side of economic behavior is still controversial, but acceptance of the field of behavioral economics has grown considerably over the past four decades. Herbert Simon and Daniel Kahneman won Nobel Prizes in economics in 1978 and 2002, respectively, for their research on behavioral economics. In addition, the Journal of Behavioral Economics was established in 1970. And a surge in popularity in the 1980s and 1990s led scholars at virtually every top economics department in North America to dive into the field of behavioral economics. Now it is your turn.

There are differing schools of thought about the extent of information problems and behavioral anomalies. The work of neoclassical economists such as Milton Friedman, Arthur Pigou, and Gary Becker placed considerable reliance on rational choice theory, which holds that decision makers are able to compare all of their alternatives with full information about their choices. For example, based on this theory, one would predict that when Nytro Multisport lowers the price of the Felt B2 bicycle from the list price of $6,199.00 down to $4,798.99, it will sell more bikes. The assumption is that consumers are aware of the product, its virtues, and the price change. However, unless you are a bicycle enthusiast, chances are that you did not know much about the Felt B2 before reading this module. In reality, information is imperfect, and consumers do not know every product’s availability, quality, or price. The large amounts of money people pay for Internet access, smartphones, and college educations exemplify the value placed on information. Yet the cost of perfect information is prohibitive—no one has the time or money to become all knowing. The result is ill-informed behavior, such as people paying the list price for a Felt B2 because they are unaware of the deals that are available at particular bike shops.

Researchers in the field of behavioral economics study the rationality of market participants under realistic constraints on time, information, and intelligence. Because information takes time and sometimes money to obtain, it is appropriate to continue seeking information until the marginal benefit of doing so no longer exceeds the marginal cost. This is why rational people often act on incomplete information. For example, if you live in a large city, you wouldn’t want to call every shoe store in town to check prices before buying a new pair of shoes. After you call a few stores, the likely savings from additional calls falls below the value of your time.

Many uses of information are not so rational. In defiance of rationality, individuals often respond to the way in which information is presented. For example, would a half-empty glass of soda pop sound as appealing to you as a half-full glass of soda pop? In a related experiment, psychologists Daniel Kahneman and Amos Tversky found that respondents who were presented with four identical outcomes with differing descriptions overwhelmingly preferred a disease-control program that would save 200 out of 600 people to a program that would allow 400 out of 600 people to die. In other words, it is perceived as better to have one-third of a population live than to have two-thirds of a population die.

Descriptions also drive perceptions of products and policies. For example, New York Super Fudge Chunk ice cream is a top seller for Ben and Jerry’s, whereas Bovinity Divinity and Dastardly Mash, though similarly chewy and chocolaty, were discontinued for lack of interest. Similarly, policies that environmentalists say would weaken current standards have gained steam due to appealing names such as the Clear Skies Initiative and the Healthy Forests Initiative. And, while the prospect of higher wages motivates employees to work harder, so does the prospect of loftier job titles, such as vice president or office manager.

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Uninformed consumers may buy too much of products that have health risks, such as junk food; pay more for products or services than they are worth, such as counterfeit watches; or purchase products that are inferior in price or quality to those available elsewhere, such as full-priced triathlon bicycles. Uninformed managers face the same problems when purchasing from vendors. Incomplete information and irrational behavior also stab at the heart of Homo economicus. With perfect information and rationality at the foundation of efficient decision making in many economic models, there is reason to be concerned about errors, bias, and incomplete information.