When Dan Ariely (author of “Predictably Irrational”) presented at the London School of Economics in 2008, visiting professor Larry Phillips, who introduced Ariely, said that if the lecture was given in 1982 he might have reserved a small classroom for it. The lecture took place in their main auditorium in which every seat was taken. Such has been the popularity of behavioural economics that it has been applied to various aspects of economics including optimal taxation, addiction, financial crisis, development etc. However, there is an overriding question – Is Behavioural Economics a new discipline and has it actually assisted governments in policy design?
Richard Thaler, co-author of “Nudge” has suggested that economics has always been about behaviour. Adam Smith’s first book “The Theory of Moral Sentiments” is in fact a Behavioural Economics treatise and within it Smith talks about its contribution to both psychology and ethics. Its purpose is to find a rationale for ethical judgement in human psychology. The latter is found in human nature: a human being put in a certain situation has a tendency to react in a certain way eg. includes sympathy, feelings and approval by others. It was Smith’s belief that human behaviour was impacted by emotions such as fear and anger and drives such as hunger. However according to Smith these emotions and drives were checked by an “impartial spectator”.
The impartial spectator allows one to see one’s own feelings and the pulls of immediate gratification from the perspective of an external observer.
In the domain of self-control and self-governance, the impartial spectator takes the structure of a long-term interest – “I won’t have that rich cream cake at morning tea because I can see that I will feel guilty about it later”. In the area of social interaction, the impartial spectator allows us to see things from another’s perspective rather than to be blinded by our own needs. The dissention is especially significant when you consider savings decisions – savings is a precision choice to delay immediate indulgence for a long-term interest. So we have the conflict between the voice of a short-term pull versus the voice of the impartial spectator.
Only recently has the field of economics advanced enough to have the tools to reincorporate the factors that Smith had always felt were important in human interaction: our caring about each other and about fairness, our difficulties with aligning our long-term interests with short-term pulls, etc. One of the most unexplored areas, which we are only now beginning to be able to measure, is the degree to which people are motivated by reputation and social status, something Smith thought was a crucial motivation for economic activity.
The essence of behavioural economics stems from a concern that rational behaviour driven by self-interest will not guide many of us to health, wealth and happiness. People tend to make bad decisions whether it is not saving or eating the wrong type of food. This disturbing state of affairs arises because homo economicus tends to be in a continuous condition of information overload, and consumer makes errors because of their unfamiliarity about options and their effect. Richard Thaler and Cass Sunstein argue in ‘Nudge’ that subtle changes can influence peoples decision so that they can make choices that will improve their well-being. However, consumers use various methods in deciding their optimal consumption as the cost (time and effort) of acquiring all the information about the benefits of product/service might outweigh the benefits of consuming it.
Homo Economicus – the basis for a majority of economic models is the assumption that all human beings are rational and will always attempt to maximize their utility – whether it be from monetary or non-monetary gains
Is Behavioural Economics a new field of economics? Adam Smith publication “The Theory of Moral Sentiments” in 1759 seems to relate what behavioural economists have been rigoursly studying ie. human behaviour and socialization
Adam Smith, Behavioural Economist? 2006 – Harvard Business School – Nava Ashraf
Nudge, Nudge …… Frown, Frown. – 2010 – Grant Scobie – Asymetric Information, New Zealand Association of Economists
Nudge: Improving Decision about Health, Wealth and Happiness. 2008 – Richard Thaler & Cass Sunstein
Here is a social experiment to see if people would buy a T shirt if they are aware of how it is made. A vending machine is selling T shirts for €2 and after you put €2 into the vending machine a video is played on how the T shirt is actually made. When it is finished the buyer is asked if they still want to buy the T Shirt or donate the €2. The results are interesting.
HT Grant McKibbin
In the recent American Economic Review (May 2015) there is a interesting paper on Behavioural Economics in the Classroom by David Liaison (Harvard University) and John List (University of Chicago). They talk about ways of incorporating behavioural economics into first-year undergraduate economics courses. Rather than teaching it as stand alone they prefer an integrated approach as it enable behavioural insights to show up where they are conceptually most relevant.
We want students to see that behavioral economics is an integrated part of economics, not a freak show that is isolated from “the standard ingredients” in the rest of the economics course.
They emphasize 6 key principles of behavioural economics:
1. People try to choose the best feasible option, but they sometimes don’t succeed.
In other words, people try to make the optimal choice—they are optimizers—but they sometimes make mistakes. It’s important to emphasize that these mistakes are partially predictable. One of the key explanatory factors is experience and training: experienced decision-makers tend to make better choices than inexperienced decision-makers.
2. People care (in part) about how their circumstances compare to reference points.
This refers to loss aversion when people lose or gain relative to their reference point. Research has shown that people are more sensitive to losses compared to gains of similar magnitude. The endowment effect also applies here. It refers to is the hypothesis that people ascribe more value to things merely because they own them. This is illustrated by the observation that people will tend to pay more to retain something they own than to obtain something owned by someone else—even when there is no cause for attachment, or even if the item was only obtained minutes ago.
3. People have self-control problems.
In a traditional economic model there is no gap between a person’s good intentions and their actions. By contrast, in the model of present bias, people plan to work hard (or diet, or exercise, or quit smoking, or save for retirement, or stop borrowing on their credit card, etc.) and then renege at the last second.
4. Although we mostly care about our own material payoffs, we also care about the actions, intentions, and payoffs of others, even people outside our family.
These “social preferences” come in many systematic forms, especially negative reciprocity, behindness aversion, and social pressure. The ultimatum game could be played here. The first player (the proposer) receives a sum of money and proposes how to divide the sum between himself and another player. The second player (the responder) chooses to either accept or reject this proposal. If he rejects neither party get anything.
5. Sometimes market exchange makes psychological factors cease to matter, but many psychological factors matter even in markets.
If investors with behavioural biases are a small part of the total stock market, their beliefs will not drive stock prices because perfectly rational traders will sell the stocks that the biased investors are buying, keeping stock prices near their “rational level.” However, if biased investors compose a large portion of the total asset market (and marginal traders), their beliefs will matter.
6. In theory, limiting people’s choices could partially protect them from their behavioral biases, but in practice, heavy-handed paternalism has a mixed track record and is often unpopular.
Behavioural insights imply that if the government is well intentioned and sophisticated, paternalistic policies might be helpful. However, heavy-handed paternalism raises new problems.
They make some good comments about nudges which recommend certain decisions from consumers without impacting on their freedom – libertarian paternalism. They recommend asking students the question should the obesity problem that is prevalent worldwide be solved by nudges or sugar taxes, or is obesity a choice that has little or no role for government intervention?
In conclusion they say:
If you want to boil behavioral economics down for a classroom summary you might say that most people are located somewhere between Mr. Spock and Mr. Simpson (aka Homer). Like Mr. Spock, Mr. Simpson is also an optimizer— he tries to choose the best feasible option. He’s just not good at it. We need to study and model all optimizers: the good, the bad, and those in between.
Here is a great interview with Richard Thaler on the PBS NewsHour – Making Sense by Paul Solman. He explains the concept of sunk costs, time and money already spent with some Cameroonian students. Also the way most people value their time.
Richard Thaler has a new book out entitled “Misbehaving” and notice that the book is 30% off in the Chicago Booth Bookstore. As Thaler says people love deals and can be driven to purchase things that they don’t really want if the deal is good enough.
The top 25 U.S. food and beverage companies have lost an equivalent of $18 billion in market share since 2009 as shoppers are choosing fresh and organic alternatives.
“There’s enormous doubt and skepticism about whether large companies can deliver naturality and authenticity.”
Try this simple test. Say the following out loud: Artificial colors and flavors. Pesticides. Preservatives. High-fructose corn syrup. Growth hormones. Antibiotics. Gluten. Genetically modified organisms.
If any one of these terms raised a hair on the back of your neck, left a sour taste in your mouth, or made your lips purse with disdain, you are part of Big Food’s multibillion-dollar problem.
It’s pretty simple what people want now: simplicity. Which translates, most of the time, to less: less of the ingredients they can’t actually picture in their head.
The U.S. Department of Agriculture (USDA) is suggesting major changes to grocery stores to “nudge” Americans to purchase healthier foods when they shop. Two preferred strategies—offering discount coupons for healthy food and changes to store marketing—will be examined in pilot studies. The USDA envisions that supermarkets, superstores, small grocers, specialty stores, and farmers markets would adopt changes in the future through an agency program.
Here is a clip that I will be using in my Behavioural Economics class. At the Odenplan transport hub in Stockholm they have nudged commuters to take the more healthy option of the stairs rather than the escalator. The interactive playful musical stairs resulted in over 66% more people using the stairs than the escalator. The object is to change people’s behaviour for the better by making it fun to do.
Here is a useful animation on the Behavioural Economics topic of nudging from the Rotman School of Management in Canada.
“A nudge, as we will use the term, is any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives. To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting fruit at eye level counts as a nudge. Banning junk food does not.” Thaler and Sunstein
People don’t always act rationally. In fact, they tend to act irrationally – but in predictable ways. The concept of the nudge, involves making a deliberate change in choice architecture to engineer a particular outcome.