Section I: Background on Behavioral Economics and Cognitive Psychology
Let’s start with a hypothetical example. Imagine you’re buying a new car. It’s going to cost $20,000. While at the dealership, you learn that adding a top of the line radio will add $150 to the total cost. You do a quick online search to see if this is a good deal, and learn that 15 minutes across town, another dealer is charging only $15 more for the same radio addition and the car price is the same. Will you drive across town to save $135? An economist would predict that you would calculate the cost in terms of your time and gas, and compare it with the benefit of saving $135, so you would make the trip. In reality, a human will say, “what’s $135 more when you’re spending over $20,000?” and then not bother with the effort of going across town.
Now take the same person who, 3 months later, is now buying a $150 smart speaker for their home. They learn that another store 60 minutes away is selling the same speaker on a flash sale for $15. Will the person go buy it? An economist would say that the time and gas would result in zero net savings, and so that a person would not go make the purchase. But chances are, this human will go the extra distance to save 90% and get such a good deal (even if the cost associated in terms of time and gas money means they aren’t saving anything).
Another great example comes from Dilip Soman, a professor at University of Toronto and the author of one of our favorite Behavioral Economics books, The Last Mile. In it, he shares, “Something that was salient to me a few years ago here in Canada, our Canadian government introduced a welfare scheme called the Canada Learning Bond. Without diving into details, it was essentially $500 for eligible low income families, with the goal of educating your kids. When the program was being put into place, I vividly recall an economist saying, ‘Who would not accept the Canada Learning Bond?’ The take up rate should be like 100 percent. It turns out take up was only 16 percent for the first few years. The challenge wasn’t that people didn’t want the money, it was a great product, but you needed a bank account, and a particular kind of bank account to accept the money. These low income people, for whom it was designed, didn’t have the time to go to the bank or didn’t want to go to the bank. So the solution wasn’t in promoting the bond or increasing the amount of dollars, it was actually making it easy for people at the last mile to sign up. That in essence is what we mean by the last mile—the fact that people inside of the organization have a particularly hard time relating to what’s going to happen at the last mile.” This is exactly why behavioral economics are so important. If we can truly understand people, we can then design solutions in partnerships with them that will truly work.
Here are a few other examples of solutions that are built on behavioral economics that defy the economic idea of the “rational actor”, but are incredibly effective:
- Painted flies in male urinals to increase accuracy
- The Save More Tomorrow retirement savings plans
- The redesigned military airplane cockpits differentiating levers by touch and sight
- Outsmarting the debt trap by starting with the easiest way to pay-off debt (not the most expensive)
- Changing the default selection for organ donation
Daniel Kahneman, author of Thinking, Fast and Slow and a pioneer in this field of study, said “It seems that traditional economics and behavioral economics are describing two different species.”
This is, in fact, behavioral economics at work. And, according to Dan Ariely, humans make irrational decisions like this all the time. In fact, he argues in his best-selling book that we are predictably irrational. Understanding our irrationality, and the irrationality of others, is a vital ingredient for solving last-mile barriers to social impact.
Beyond saving money, behavioral economics affects the way people make any decision, from who they love, how they spend time, where they work, and choices they make related to their health. It also helps explain why we have corruption in government, why it is so hard to pull oneself out of poverty, why leaders are not acting with enough urgency to address the climate crisis, and why we have rising inequalities.
Sections II and III will help you think more about how to use the powerful principles of behavioral economics in social impact programs and social entrepreneurial initiatives. But first, let’s take a moment to better understand the foundations of behavioral economics.