The following article was originally published on gottaquirk.com.

Adrian Saville is a FoQer (Friend of Quirk) and our guest author today. Adrian is the CIO of Cannon Asset Managers, a visiting professor at the Gordon Institute of Business Science, and an Economist Intelligence Unit Business Professor of the Year Awards nominee.

BEHAVIOURAL ECONOMICS - OPENING DOORS FOR DIGITAL MARKETERS

Traditional economics is based on the assumption that people are rational beings and they make rational decisions.  Thus, economics defines homo economicus, or the economic human, as having the ability to make sound judgments toward maximising their utility as a consumer, or maximising economic profit as a producer.  As an example, traditional economics argues that an increase in price causes people to demand less of a good or a service.  Yet there are many cases where people do not behave in the rational manner that traditional economics assumes.  Advertising bans, for instance, see people consuming more of a good once the ban is in place. Additionally, people are willing to pay a higher price for the exact same wine if they are not equipped to identify the wines as identical (see below).

Despite this fundamental weakness, traditional economics remains widely taught in universities and business schools and tends to dominate business decision making.  As a result, when considering how consumers will react to a price increase, the default position tends to be informed by traditional economics. This shortfall in economic thinking has implications for all industries, including marketing and advertising.  As Rory Sutherland, Vice Chairman of the Ogilvy Group recently observed: “The great issue in our industry over the last 15 years is that, while there has been an explosion in the technologies and media available to marketers, our models and metrics describing human behaviour and decision-making have often been left stuck in the 1970s.”

The time to update our models of how homo economicus behaves is long overdue. Behavioural economics offers the much needed remedy that looks at the way people make decisions which, as already suggested, are often irrational.  By providing insights into the decision-making of the economic human, behavioural economics gives us a better understanding of how to build reliable economic models and more robust business models, which makes for better business.  In the same breath, behavioural economics allows irrational consumers or producers to make better decisions.

Behavioural Biases

Behavioural economics is built on the foundation that biases or irrational behaviour can be grouped under one of two headings, namely heuristic biases and frame dependence.  Understanding these behavioural biases is of relevance to all industries, including digital marketers. Some of the core arguments are captured below. 

Heuristic Biases

In the case of heuristic biases, people make decisions based on approximate rules of thumb rather than a rigorous analysis. They look for cues – heuristics – to help them choose.  A perfect example of this comes from a 2008 experiment by Antonio Rangel, associate professor of economics at Caltech, who found that the stated price of wine influenced the subjects’ enjoyment of it, both in terms of how they felt it tasted as well as through activity in the part of the brain associated with pleasure.

The subjects were presented with five wines, priced at $5, $10, $35, $45, and $90 per bottle, which they tasted and evaluated. They consistently preferred the higher priced wines to the cheaper wines and their brain activity confirmed this.  However, only three different wines were used: the $5 and the $45 wines were the same and the $10 and $90 wine also were the same.  In this case, the subjects used price as a guide to quality – and by inference buying patterns – rather than relying on taste. For digital marketers, this type of knowledge can be invaluable in helping businesses and customers make better decisions.

Frame Dependence

In the case of frame dependence, people break complex problems into smaller parts.  They then behave differently to the same problem framed in a different context.  An example of this is mental accounting which occurs when sums of money are treated and valued differently depending on where they come from or where they are kept.  A person could have two savings accounts, one for a child’s education and the other for entertainment.  They will tend to be highly conservative with the education money, yet frivolous, even reckless, with the entertainment funds.  Of course, in reality the money in each account is indistinguishable and decisions relating to spending these funds should be treated the same.  The framing bias has many obvious applications for digital marketers, such as recognising consumer patterns around bonus time or after an interest rate cut by the South African Reserve Bank. 

The A/B Split Test – A Revelation

If we can identify and explain behavioural patterns – which often are irrational – then we are getting into the business of bringing the economics of marketing out of the 1970s and up to speed.  Once we have started to build better models of consumer and producer behaviour, digital marketing is blessed with a rich laboratory to test these models.  The case is made convincingly by the success that Dan Siroker, the CEO of Optimizely, has had with A/B Tests.

As Wired magazine (wired.com/business/2012/04/ff_abtesting/) notes, “using A/B, new ideas can be essentially focus-group tested in real time: without being told, a fraction of users are diverted to a slightly different version of a given web page and their behaviour compared against the mass of users on the standard site. If the new version proves superior—gaining more clicks, longer visits, more purchases—it will displace the original; if the new version is inferior, it’s quietly phased out without most users ever seeing it.” 

Siroker used A/B Testing to help Barack Obama’s last election campaign.  Whilst the campaign’s homepage was receiving a lot of traffic, visitors were not hitting the “Sign Up” button.  For the button, an A/B test of three new word choices – “Learn More”, “Join Us Now”, and “Sign Up Now” – revealed that “Learn More” garnered 18.6 percent more signups per visitor than the default of “Sign Up.”  In this way, A/B allows seemingly subjective questions of design, colour, layout, image selection and text, to become irrefutable matters of data-driven social science. This is exactly the attributes to which economics should aspire.

It is time for economics to “learn more” and, in so doing, replace the models of traditional economics with the better informed models of behavioural economics. This, if only to ensure that economics makes the contribution it should make to marketing, or any other industry for that matter.