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Behavioral Economics and Finance

Decision making is a vital component of business success. On efficient markets, decisions are based on the maximum utility theory (Aaker, 2001). However, as Aaker (2008) observed, this approach does not work on the markets that are not efficient. This paper, therefore, discusses the role of behavioural economics in decision making with regard to markets that are not efficient.

Behavioural economists study the effects of cognitive, emotional and social factors on decision making (Knoll, 2010, p. 23). Knoll (2008) found that behavioural economists also focus on the consequences of these factors on returns, market prices and allocation of resources. They determine how decisions are made in the light of distorted information and other limiting factors (Knoll, 2010). Knoll (2010) asserts that human beings are not as economically rational as the traditional utility maximization theory suggests (p. 25). According to Knoll (2010), people often make systematic errors during decision making (p.26).

According to Knoll (2010), while some people avoid making decisions due to lack of sufficient information, others make decisions based on anecdote evidence whose reliability cannot be assessed (p. 27). In other circumstances, people make decisions based on rules of thumb; which are mere approximations rather than strict logic (Knoll, 2010, P. 28). Knoll (2010) also found that people favour the status quo and default choices which may not necessarily be the best (p. 27).

Wrong decisions can also be caused by market anomalies such as wrong pricing and wrong decisions by other players (Stanovich & West, 2008). In this case, behavioural economics seek to determine factors that fuel wrong decisions so that they can be addressed during planning and policy formulation. They help policy makers understand factors that shape their success and how some of the popular decisions may not be good after all. As Stanovich et al. (2008) found, this theory can be applied in Business Management and Strategy, Corporate Finance, Micro Economics and Strategic Marketing (p. 672).

Business management is about making decisions (Stanovich et al, 2008). Most of these decisions are of a strategic nature with significant implications on the future of the company. However, such decisions often end up being influenced by factors not anticipated by the planners; thereby delivering totally different results (Stanovich & West, 2008). According to Stanovich et al. (2008), this discourages such teams from taking initiatives in future; thereby missing out on some investment opportunities (2008). Most of these factors are behavioural and this is where behavioural economists come in.

Behavioural economics help management in predicting the outcomes of some decisions based on the behaviours of those involved (Stanovich & West, 2008). For example a decision to introduce incentives and rewards to employees will trigger some response. In this case, behavioural economists determine the likely results of such rewards and their impact on the overall performance of the company. While rewarding best performers has always been used to encourage hard work, it can demoralise employees whose performance is not good enough to earn them rewards. It can also cause resentment and disharmony within groups (Berman & Knight, 2008). Therefore, consultants in behavioural economics should predict such behaviours and advise appropriately.

In addition to management of employees, behavioural economics play a significant role in Corporate Finance (Berman & Knight, 2008, p. 32). According to Berman & Knight (2008), Behavioural Finance explains how errors are systematically made in financial management; affecting prices and profitability in the involved industry (p. 32). Information regarding future market opportunities makes firms to increase investment activities due to irrational exuberance (Berman & Knight, 2008, p. 33).

These researchers claim that such over-reaction or under-reaction affects prices and can lead to formation of economic bubbles (2008, p. 34). In this case, companies make decisions to invest when they should not or fail to invest when they should. Behavioural finance consultants should help in determining the best investment decisions when the markets are not efficient.

Behavioural economics has also been used in Strategic Marketing (Semenov, 2009, p. 234). In this case, behavioural economists help in determining factors other than economic that influence consumption patterns of the target market and how such markets are likely to respond to certain marketing initiatives. For example offering free items to customers has been assumed to attract more clients but research has found cases where such initiatives do not increase sales (Semenov, 2009). Therefore, it is necessary to know how target groups make decisions before implementing any marketing strategy.

In microeconomic, demand, supply and pricing keep each other in balance on efficient markets (Charter, Huck & Roman, 2010, p. 3). Managers have used this balancing to maximise profits. But on inefficient markets, reducing prices may not necessarily lead to an increase in sales (Charter, Huck & Roman, 2010). Such abnormal curves are sometimes caused by non-economic factors and behavioural economist should help planners to understand and address them.

In conclusion, not all markets are efficient as the traditional maximum utility theory assumes. In the case where markets are not efficient, behavioural economics and economists help in determining the factors beyond economics that affect markets and decisions. In this regard, behavioural economics is vital when formulating policies relating to management, investment, marketing and other strategic decisions. Companies should, therefore, hire the services of behavioural economists to enhance sound decision making especially when operating on inefficient markets.

References

Aaker, D. (2001). Developing business strategies (6th ed.). New York, NY: John Wiley & Sons.

Berman, K. & Knight, J. (2008). Financial intelligence for HR professionals. Boston, MA: Harvard Business Press.

Charter, N., Huck S. & Inderst R. (2010). Consumer decision-making in retail investment services. A Behavioural Economics Perspective. 1(1). 3-8.

Knoll, M. (2010). The role of behavioural economics and behavioural decision making. Americans’ Retirement Savings Decisions, 70(4). 23-31

Semenov, A. (2009). Departures from rational expectations and asset pricing anomalies. Journal of Behavioural Finance, 10, 234-241.

Stanovich, K. E., & West, R. F. (2008). On the relative independence of thinking biases and cognitive ability. Journal of Personality and Social Psychology, 94, 672-695.

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StudyKraken. (2022, January 30). Behavioral Economics and Finance. Retrieved from https://studykraken.com/behavioral-economics-and-finance/

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StudyKraken. "Behavioral Economics and Finance." January 30, 2022. https://studykraken.com/behavioral-economics-and-finance/.

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StudyKraken. 2022. "Behavioral Economics and Finance." January 30, 2022. https://studykraken.com/behavioral-economics-and-finance/.

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StudyKraken. (2022) 'Behavioral Economics and Finance'. 30 January.

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