Behavioral economics or understanding how consumers make financial decisions has become a very popular topic recently. Companies as varied as brokerages, auto manufacturers and fast food restaurants are all trying to better understand how their customers make buying decisions. With this understanding, they hope to be better able to design products and set pricing policies.
This article addresses some issues raised in a book Why Smart People Make Big Money Mistakes—And How to Correct Them by Gary Belsky and Thomas Gilovich. Many of the conclusions of these authors may be applicable in managing your business and also in better understanding your financial decision making process.
The two basic principles discussed in this book are:
- Mental accounting – Even though a dollar is a dollar, we often put a higher value on some dollars and thus tend to waste the less valuable dollars.
- Prospect theory – How we frame financial decisions (or label potential outcomes) affects our attitudes toward risk.