Behavioral economics: Can you predict the “rationally irrational?”

According to classical economists, financial decisions should be made in a rational, calculating manner, with self-interest at the helm. How then, do economists explain the allure of “Black Friday” sales?

According to The Cambridge Business English Dictionary, behavioral economics is “the study of the influence of emotions, opinions, etc. on the decisions people and organizations make in spending, saving, etc.” Behavioral economics explains why we, as rational human beings, often behave irrationally when faced with economic decisions, and seeks to predict when we will act in a manner contrary to that predicted by classical economists. This is often referred to as being “rationally irrational”, a term popularized by economist Bryan Caplan, and a concept best illustrated by an example.

The story is told of a rather intelligent young man, who set up a booth to sell water on a sweltering summer day. His sign read, “Ice-cold Water - 1 bottle for $1, 3 bottles for $5”. Strategically placed across from a construction site, he served a steady stream of construction workers on their break, as they were ill-prepared for the heat. Each of the men placed down a dollar, in exchange for a bottle, and immediately took their place at the back of the line, until each worker had bought three bottles at a dollar apiece, and returned to work. As the last worker approached for his third bottle, he kind-heartedly pointed out the flaw in the young man’s calculations, perhaps feeling a little bad for taking advantage of the budding entrepreneur. The young man just smiled and said, “Yes, I know it doesn’t make sense. But I just sold each of you three bottles of water, didn’t I?”

This clever boy has stumbled upon a prime application of behavioral economics in today’s marketplace. While it is likely that one, perhaps two, bottles might have quenched his customers’ thirst, he was quick to design his pricing structure to encourage “rationally irrational” behavior – the purchase of more water than necessary. Behavioral economics terms this phenomenon “nudge” theory, and we will explore this concept further in the next blog.

Behavioral economics has been around for centuries, and can be used to explain irrational economic behavior such as “bubbles,” like the controversial Dutch Tulip Mania, where a single tulip bulb was rumored to have sold for many times one’s annual salary, or, in more recent times, significant bubbles in the housing and investment markets. Notably, the increasing popularity of Black Friday shopping is a perfect demonstration of many core concepts of behavioral economics.

Contrary to classical economic theory, individuals do not always behave rationally, or predictably, when finances are involved. As a Licensed Insolvency Trustee, I often see the financial difficulties that result when distressed individuals make poor financial decisions due to lack of information, clever sales tactics designed with “rationally irrational” behaviour in mind, or even choices made out of habit. Understanding and applying behavioral economics concepts is a key component of financial literacy. CPA Canada’s Financial Literacy education seminars, tools and resources can strengthen the financial capability of Canadians.

Keep the conversation going

Can you think of a time when you acted “rationally irrational” in making a financial decision? With the benefit of hindsight, would you make the same decision today? Why or why not? Post a comment below.

Disclaimer

The views and opinions expressed in this article are those of the author and do not necessarily reflect that of CPA Canada.

About the Author

Crystal Buhler, CPA, CGA, CIRP

Crystal is a Licensed Insolvency Trustee (LIT) with Keith G. Collins Ltd. Crystal is licensed to act as an LIT in administering bankruptcies, to administer proposals pursuant to the Bankruptcy and Insolvency Act, and to act as a financial counselor. She is a member of the Canadian Association of Insolvency Restructuring Professionals (CAIRP).