Behavioral Economics

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Economics has an Achilles’ heel. Until recently many practitioners attempted to ignore or dispute this shortcoming — but it can ultimately be held responsible for many of the glaring mistakes economists have made for hundreds of years. It is the erroneous assumption that humans are rational.

Experience shows that people are by no means consistently rational. An obese smoker, were he truly rational, would go on an immediate diet and give up cigarettes, recognizing the danger he is causing to his health. Were each of us truly rational, we wouldn’t be so swayed by ‘buy one get one free offers’; we would judge the adequacy of our salaries based entirely on their absolute level rather than comparing them to what our neighbor, or our spouse’s sister’s husband, earned.

Yet, despite these commonplace examples of irrationality, standard ‘neoclassical’ economics hinges on the notion that people have a limitless capacity for rationality, willpower and selfishness. It is the foundation of Adam Smith’s invisible hand theory, which posited that when selfish, rational actions take place en masse, it will result, overall, in a more prosperous society. This typical rational man imagined by economists is often dubbed Homo economicus.

In reality, however, people are prone to emotion — to excitement, love, jealousy and grief, for example — which can make them act irrationally.

The Origins

Behavioral economics investigates why and how people act irrationally. It is among the newest and most fascinating areas of academic study, combining economics and psychology. Moreover, far from merely being an interesting realm of study, it is now starting to play a key role in economic policymaking. And as understanding develops as to how the mind and the brain work, so behavioral economists are providing greater insight into what really drives people to act as they do.

The pioneers of behavioral economics were psychologists Amos Tversky and Daniel Kahneman, who, in the 1970s, adapted theories on how the brain processes information and compared them with economic models.
They found that when people are faced with uncertainty, they tend to react neither rationally nor indeed randomly but in certain predictable ways. Typically, they use mental shortcuts — rules of thumb — which Tversky and Kahneman called heuristics. These can be influenced by experience or environment. For instance, someone who has been burnt by a frying pan will tend to be more careful when picking one up in the future.

The evidence People can also be influenced into taking particular decisions by the way a certain proposition is described to them — something known as framing. For instance, in one paper Tversky and Kahneman laid out the scenario that the US was facing the outbreak of an unusual Asian disease expected to kill 600 people. They posited two alternative courses of action: Program A in which a projected 200 people will be saved, and Program B, which has a one-third probability that 600 people will be saved and a two-thirds probability that no one will be saved. Some 72 per cent of respondents chose Program A, although the actual outcomes of the two programs are identical.

A more recent example comes from MIT behavioral economist Dan Ariely, who asked his students to write part of their Social Security number on a piece of paper, and then to suggest how much they would be willing to pay for a bottle of wine. The amount they were prepared to pay depended on their Social Security number — those with the lowest digits tended to bid the lowest and those with the highest bid more. This phenomenon is known as anchoring, and, like framing, it undermines the firmly held view that prices in the marketplace are a function of supply and demand.

The latest development in behavioral economics capitalizes on modern MRI technology to scan subjects’ brains and link the activity observed to economic decisions. One interesting finding from neuroeconomics is that when someone trying to sell something is offered an insulting price by a potential buyer, the part of the brain that reacts is the same that activates when people encounter a disgusting smell or image.

Nudge Economics

So people do not always make decisions based on their own self-interest. This is a profoundly important realization, since most economies are structured largely on such an assumption. For instance, economists usually assume that people will save throughout their lives because it is in their own interests to have money left over for when they retire. They assume that people will not take on more debt than they believe they can reasonably handle. In fact, according to behavioral economics, we are quite often pushed into taking on debt not by self-interest but by heuristics. The powerful implication is that people need to be nudged in a certain direction – to save, to lose weight, to improve their finances – rather than being expected to do it of their own volition.

This has led to what some call ‘libertarian paternalism’ or ‘nudge economics’ — efforts to put behavioral economics into practice. For instance, although people should not be deprived of free choice, some argue they should be pushed gently in a particular, positive direction. A commonplace example is that of automatically enrolling employees in a pension scheme but offering them an opt-out. Another controversial idea — mooted by UK Prime Minister Gordon Brown in 2008 — is to apply this idea of ‘presumed consent’ to organ donations, assuming by default that everyone is willing to be a donor unless they explicitly indicate otherwise.

However, such schemes clearly can be dangerous in the wrong hands. Governments have a duty to ensure their citizens are protected from war, crime and penury, but should they also be protected from their own irrationality? Where would such discretion stop? If people make the wrong decisions on savings, or on organ donation, might they not make the wrong decision in the polling booth?

Notwithstanding these concerns, the field of economics has been transformed by behavioral insights, which have irrevocably undermined the assumption that humans always act rationally and in their own self-interest. The truth is that people are more complex. For the economics of tomorrow, the task is to find a way to integrate these two models.