Mohammed Tanweer Merchant Taylors’ School

In recent years, there has been a surge of academic articles, blogs and books written inthe name of Behavioural Economics, but whatexactly is it? Behavioural Economics is the namegiven to the discipline that tries to mix insightsfrom Psychology with Economics, and looks ateconomic problems through the eye of a“Human”, rather than an “Econ”.

Thaler and Sunstein, in their excellent book Nudge,refer to an Econ (a.k.a Homo Economicus) as an infinitely rational and immensely intelligent, emotionlessbeing who can do cost-benefit analyses at will, and is never (ever) wrong. These are the basis for manyof the old Classical models. “Humans” on the otherhand, do make mistakes, do get angry, do act irrationally or inconsistently. They are not infinitely rational, but rather face “bounded rationality”, withpeople adopting rules of thumb instead of calculatingoptimal solutions to every decision. Given so many ofus fit into the latter category, Behavioural Economics(hereafter, B.E) attempts to embrace Humans insteadof brandishing them as “irrational” and leaving themoutside their theories. Dan Ariely in his excellentbook Predictably Irrational, explains it succinctlywhen he says Classical economics is about creating

What is Behavioural Economics?a theory and then using it to explain actual behaviour;whilst B.E is about observing actual behaviour andthen coming up with a theory.

Ariely uses numerous examples to illustrate that notonly do Humans act irrationally (or more accurately,inconsistently), but worryingly they do so repeatedlyand on both simple and complicated matters. Heponders questions such as why a headache tends topersist after taking a 5p aspirin, but why that sameheadache vanishes when that same aspirin costs50p? The point here is that people make perceptionsof quality based on the price, especially when theirhealth depends on it, and thus actually demand moreof higher priced goods (contradicting standard demand theory).

Another issue that is discussed at length is the issueof social norms – why would we help a stranger fixhis car by the roadside for free, (and are offended ifoffered a notional payment), but would pursue legalaction if our employer didn’t pay us for the samework; and why do we think it is acceptable to take a bottle of wine to a dinner party, but not the equivalent value of the wine bottle in hard cash. The point here is that the world is full of two types of transactions, market ones and social ones, withthe former dictated by price, but the latter dictated by norms; and mixing the two can have very adverseconsequences.

Thaler and Sunstein discuss how Humans are influenced by the choice architecture when makingdecisions. That is to say, an Econ would see an option on a form such as “Do you want to donateyour organs after death?” and be able to assess allthe costs and benefits of the decision and come to a decision; or when presented with 100 differentpension plans, an Econ would be able to assimilateall the information and calculate the right one forhim. However, Thaler and Sunstein find that, in reality, both these questions are so complicated that Humans will choose the choice that is chosen forthem - the default. In the case of organ donations,this has stark implications for people in differentcountries who need organs – countries that haveorgan donation as the default option when individualsget a driver’s licence have many more organ donors,

than countries in which the default is “opt-out”.Furthermore, there tends to be a “status quo” bias,where the first choice consumers make persists for a very long time – (think how students tend to sit in the same seat in class, despite no seating plan) –this is particularly dangerous, especially when choosinghealth insurance, or retirement funds, since it meansthat even if a better option comes up later on, consumers rarely change to it The message from behavioural economists is that policymakers shouldunderstand these occurrences and incorporate theminto the choice architecture (If you want to knowhow, I’d nudge you to go read Nudge).

Even if Humans manage to calculate the optimal solution to a problem, they may still fail to choose it, due to self-control reasons. People put on toomuch weight at Christmas, tempted by just one morepudding; they smoke too much despite reading thehealth warnings and they fail to save enough for retirement. The Classical literature puts this down to “irrational behaviour”, whilst the B.E approach acknowledges that since so many people in theworld behave like this, we should try to incorporate it into our models. The reasoning for this behaviourcan be attributed to what psychologists call the Automatic System, the one that makes instant decisions (“the Doer”), overruling the Reflective System (“the Planner” in you) – since people tend to choose immediate pleasures over long term utility.But instead of branding this as irrational and doingnothing, a better idea is to try to help the ReflectiveSystem overrule the Automatic System, throughbinding commitments.

To commit to losing weight next year, you couldmake a deal with a colleague that you will pay him£40 a month and if at the end of each month youcan show you have lost weight, you get the £40back, otherwise, he will give the money to charity.This binds you to not give in to temptation.

The Reflective System in people knows that theyshould save money for their pension, but it is alwaysvery hard to commit to this, given it means foregoingsome current consumption, which the AutomaticSystem doesn’t like. So an idea to counter this is the “Save More Tomorrow” scheme. This works by committing now to save a future increase in yourincome towards your pension – since this savingcomes from a future increase in income, there is nocurrent consumption foregone, and thus does notconflict with your Automatic System, and at the sametime binds you to save more in the future. (The Save

More Tomorrow scheme could also be extended to a Give More Tomorrow scheme using the samepremise, which should lead to higher charitable donations).

Thaler and Sunstein make the point that in reality instead of doing accurate cost-benefit analyses onall our decisions, people reference new decisions topast decisions; reverting to rules of thumb. We useanchors (reference points) and work from there (e.g.in estimating the population of Bath, you are likely to use your own city as an anchor). Furthermore, ifyou are asked about the probability of a hurricane occurring, whilst you know very little about hurri-canes, you will use the availability of salient events to base your probability on – so if there has recentlybeen a huge hurricane well covered in the media,you will increase your estimate. Since murders arereported more often than suicides, people incorrectlythink the probability of murders are higher than suicides – in short, we are easily influenced, and arenot Econs. Rather than pretending this does not happen often as traditional economic theories claim,the behavioural economists prefer to incorporatethese findings into theories that reflect the real worldbetter.

Whilst B.E can be extended to a vast array of cases,the recent credit crunch is a good one. Consumershave bounded rationality (they have limitations to the information they can analyse optimally) and as mortgages (especially subprime ones) became increasingly more complicated, they became confusingfor those who took them on, and thus made incorrectchoices, often taking on too much debt and notbeing able to afford the repayment schedules. Furthermore, since banks were so willing to offereasy mortgages, consumers could not exercise theself-control to say no to these “good” offers. Finally,credit card debt has risen astronomically since consumers do not treat spending on plastic the sameas spending hard cash. Thus people’s debt problemsspiral out of control. Under Classical Economics,since we are Econs, we should have seen the CreditCrunch coming around the corner, but given the current mess we are in, perhaps it would be fruitfulto pay more attention to the behavioural economists.Amos Tversky and Daniel Kahnemann, have developed Prospect Theory as an alternative to Expected Utility theory to explain some behaviouraltraits they identified in people making decisionsunder uncertainty, one of which is how people valuelosses and gains differently. Their descriptive theorytries to model real-life choices, rather than optimal

Mohammed Tanweer Merchant Taylors’ School

Mohammed Tanweer Merchant Taylors’ School

(Econ) decisions, and describes how people are “lossaverse”, that is more sensitive to losses than gains(of the same value); but both as gains and losses increase, our sensitivity to them diminishes.

Kahnemann and Tversky have also emphasized howframing is very important in optimal decision makingprocesses. Framing the same statement in differentways can cause systematic reversals of preferences,which contradicts the predictions of rational choice(that is, of an Econ). Faced with a question of choosing a vaccination program in which out of 600people, Program A offers “200 people will be saved”and Program B offers “400 people will die”, if anEcon goes for Program A over another Program C,he should also go for Program B over Program C, but reality tells us that Humans are influenced byhow the Programs are framed. The implications ofthis particularly affect referendums and governmentpolicies.

Other ideas in the B.E literature include, why stockmarkets are inefficient; why herding behaviour occurs (in stock markets, obesity levels and teenagepregnancies); why the word FREE! causes consumers to do strange things; why people aremore likely to drink a can of Coke that is not theirs,but refuse to steal 50p from a table; why consumerssimultaneously buy fire insurance but also play thelottery… the list of applications really is endless.

Ariely summarises the difference between B.E andClassical Economics well when he likens ClassicalEconomics to Shakespeare’s Hamlet: “What a pieceof work is a man! How Noble in Reason? How infinite in faculty? In apprehension, how like a God?The Paragon of Animals…”; whilst behavioural economics is more like… Homer Simpson.

Both are exactly the same size, but everyone thinks the right hand one is bigger. And furthermore,even when you are told both are exactly the same size, and you look at the circles again, you stillthink the right hand one is bigger. You are (consistently) wrong, due to the way the diagrams aredrawn – framing and relativity matters (choice architecture).

For further reading and exposition of the ideas presented here, I would highly recommendThaler and Sunstein’s Nudge; and Dan Ariely’s Predictably Irrational.

Which inner circle is bigger?

Image taken from www.predictablyirrational.com