Predicting the unpredictable

“A deeper understanding of human behaviour is every bit as important to running a successful business as is an understanding of financial statements and operations management. After all, humans run companies, and their employees and customers are also humans.” – Richard Thaler

As a marketer of a life insurance company, behavioural economics comes closest to helping me understand my consumers. Richard Thaler’s unique approach to merge new discoveries in behavioural psychology with the theories of economics, further improves our notions of a consumer’s financial behaviour.

In his book, Thaler divides people into two kinds based on their financial decisions: econs and normal. He believes that most people in this world, while making an economic decision, do not take every economic rationale to consideration. They instead, more often than not, make disadvantageous and inconsistent decisions based on ‘supposedly irrelevant factors’. He argues that if we are able to decipher these ‘irrelevant factors’ then we can model ‘human financial behaviour’ more accurately.

He argues that traditional economic thinking gives people a robot-like behavioural pattern, when in actuality, human behaviour is often individual and unpredictable. Thaler describes our often biased error-prone buying pattern as misbehaviour. It could include anything from buying a wall clock to applying for a house loan. He states that none of these decisions are based on actual economic rationality, but are instead mostly need or situation based and that though economists have dismissed this ‘misbehaviour’ as miscalculations, they affect the markets monumentally.

His concepts on pricing communication are especially interesting. He talks about how removing discounts is not nearly as disagreeable as adding a surcharge, even though both actions amount to the same thing. What is important is the way it is communicated. Thaler also talks about the concept of ‘transactional utility’ where the experience of a good deal affects a consumer’s purchasing decision. The concept states that the feeling of having saved money or being ripped off goes beyond the understanding of standard economic consumption of acquisition utility.

Another example, probably more apt in my line of work, was that of mortality risk. He poses a two-fold question: The first: How much would you pay to eliminate a mortality risk of 1 in 100,000? The second: How much would you have to be paid to accept a mortality risk of 1 in 100,000? You would expect most people to answer both questions in an identical fashion. But they don’t. The answers to the second question are much higher (often in the range of $500,000) than the answers to the first (often in the range of $2,000). Many people even answered “there is no amount you could name.”

His understanding of whether Uber should charge more at peak hours is another interesting concept to note. Why wages don’t drop with recession, he asks. Employees think that it is grossly unfair for employers to cut their wages. Employers are aware of that, and they are afraid of how their employees will perform if they believe that they have been treated unfairly. So they don’t cut their wages. He calls this business fairness.

One of his best examples in the book is of a ski resort which allows skiers to buy packs of ten-day passes at a 40% discount only to have them redeem an average of 60% of these passes. The end result being that the ski resort got all their fees up front, without even having to increase their customer base.

Thaler does not claim to provide answers to all economic questions, but only offers his theory as a tool, which can either be used successfully or with ambiguous results. Engaging and often hilarious, Thaler’s Misbehaving is packed with case studies and the author’s personal experience, doggedly trying to make the academic discipline of economics simple and relatable, so that we can better understand its impact on our world.