What Is Behavioural Economics?

by Oliver Clark

It was another of Miss Worley’s stellar IB Higher Level Economics where I was first introduced to the idea of Behavioural Economics in the form of Game Theory. When discussing collusion and it’s impacts on oligopolies, our class recreated the Prisoner’s Dilemma Scenario, where I decided to stay silent and put my faith in friend of 15 years, Sam Rush, hoping he would do the same, meaning we would both get a reduced jail sentence of 1 year. However, I was backstabbed and am mentally serving a 3 year prison sentence. The theory itself is said to be ‘the study of mathematical models of conflict and co-operation between intelligent rational decision-makers’. Rational is the key word here. Was it not rational of me to think that my ally from kindergarten would back me up?! On the other hand, was it not rational that he collude with the police so as to try to save his own skin, going all (escaping free of charge) or nothing (a 2 year sentence) if I were to also collude.

It was then that the penny dropped. All economic theory assumes that us, the unique, lazy and frequently dim humans of this Earth, act in a ‘rational’ way, making ‘rational’ spending decisions. Trying not to sound too much like a text book, rationality is said to be ‘making choices that result in the most optimal level of benefit or utility. But does the human race really make these perfect decisions all the time? Unfortunately I would not immediately find out, as outside of Game Theory and the Prisoner’s Dilemma, the IB do not seem too keen on exploring this area any further. So this summer, I set out to discover more about the concept of rationality, and so read three of the best selling Behavioural Economics books on the market. In this article, I am going to summarise the key points that I learnt from each of them, before bringing in my own thoughts on the topic as a whole.

Misbehaving: The Makings of Behavioural Economics - Richard H Thaler

This was where I started. The opening quote from Vilfedo Pareto stated that, ‘A day may come when we shall be able to deduce the laws of social science from the principles of psychology’. This book had me from the point that I discovered Thaler was a basketball fan! It was Thaler’s simplistic and frequent comparisons between the perfectly rational (and fictional) Econs and the hapless (and far more realistic) Humans. What was introduced to me here, in what is affectively a narration of the author’s academic life and the studies and breakthroughs that he made along the way, was the various ways that behavioural economics comes into every day life, and how it deviates so greatly from standard economic theories. Although this can seem trivial at times, with anecdotes of taking a bowl of peanuts away 15 minutes before dinner, or a fly in a station urinal, the topic really intrigues me when we begin talking about the role of BE with CEOs and managers in the business world. We as humans are loss averse, in that losses are statically likely to feel twice as painful (loss of utility) when we lose £100 in comparison to the feeling of joy (utility) when we win £100. When managers are contemplating a new idea that has an element of risk, they are far more likely to turn down the proposition, knowing that they, and their manager, will feel almost twice as bad if the plan loses £10 million than joy if it wins £10 million. The managers were value maximising with the information that they had available to them, and they should not be deterred by the combination of risk aversion and loss aversion. As cheerfully noted by Keynes, ‘In the long run, we are all dead’. Is it not more beneficial to encourage risk taking and entrepreneurship, especially in larger corporations, so as to lower costs for the public in the future, instead of just waiting for someone else to take the step? Thaler made an excellent conclusion to this book, admitting that his concept of ‘nudging’ (I will come back to this later) could be used by businesses, or more worryingly, governments, to self serve with bad consequences. But he sees a world of ‘liberal paternalism’, guiding people in a direction where they are free to choose what they wish, but the more harmful choices are taken out of the equation. Is that a bad world to live in?

Thinking Fast, and Slow - Daniel Kahneman

Moving swiftly into the realms of psychology, I looked next to one of the men who inspired Thaler to   run with his anecdotes that would eventually become an entire economic field. Kahneman’s two characters, System 1 (the quick thinking hero who originates impressions and feelings through immediate intuition) and System 2 (the methodical, reasoning self that has beliefs, makes choices and decides what to do). If I were to ask you to calculate 2+2, I would be engaging with your System 1. However, if I were to challenge you to solve 17 x 84, this is where System 2 is needed. The book, split into 5 sections, progressively helps us understand how and why we humans make decisions. Kahneman must be laughing at the thought of his readers looking at the various ‘lines that look different but are actually the same’ conundrums, as I continue to pull my hair out as I look for a ruler, trying to kick my brain into gear! From the Halo Effect, to Heuristics and Biases (for anyone looking for a thought provoking question, look up the ‘Linda Problem’, a real eye opener for how our brain works), the concepts of anchoring, availability and representativeness, I began to see how the idea of rationality really goes out the window, the second you encounter any real world questions. I particularly enjoyed the chapter on Overconfidence, as well as Truman’s one armed economist (no more on the other hand scenarios) and the idea of a ‘Pre-Mortem’ (5 minute speech detailing all potential flaws (and solutions) from one year on, after making a potentially risky business decision). This book, despite not being one focussed directly on the economics of rationality and decision making, it certainly gave me an insight into the way the brain works, and how easily it can be influenced, as highlighted by the final book in this thought provoking trilogy.

Nudge - Thaler and Sunstein

Some of the ideas within Nudge really showed me the uses of behavioural economics at their utmost. The changes being made in wording and policy, that are only very small in the context of the action, can hugely influence the decisions that we make. The return of the fly in the urinal, that apparently ‘reduces unwanted splashing by as much as 80%’ (I feel very sorry for those who had to collect the data for this experiment), simple as it is, shows how our minds can be harnessed by the most simplistic things, resulting in a preferred outcome. This book is where the two authors coined ‘Libertarian Paternalism’, the idea of letting people be free to choose, but helping them in a direction when help is needed. This is something that they hope will eventually remove the excess levels of prohibition and bans that governments enforce, something that I would be very happy to see! This isn't a government intervention, its just the government helping the public make decisions without intervening. Thaler has since worked with both the US and UK governments, setting up ‘Nudge Units’ to help governments in this area. Ideas such as introducing opt out pension and organ donor schemes demonstrated how this kind of help could improve the lives on millions of people around the world. It also demonstrated how these nudges can vary on the situation. A default, one fits all choice is helpful on a new computer, maybe not so with a life insurance policy. The emphasis on transparency here is key, as the kind of frailties in the human brain can be exploited, but the same can be said for any decision made by governments, firms, and even people, and behavioural economics is not the only culprit.

Conclusion

Although I would not say I am quite at the level of the writers of the books I have read, I feel that my understanding has advanced from my poor choice in the prisoners dilemma scenario. Like Thaler said in a talk given at the London School of Economics this year, I would love to see economics become ‘less like physics and more like engineering’ (ie when the wind blows, the bridge doesn't fall down). We therefore need to draw upon the social sciences in order to make economics credible and far more applicable in the real world. Are these sorts of studies, and the emergence of nudges, a thing that we should be worried about? As I write this, I now see Libertarian Paternalism as a direct parallel to autocorrect. Sure, I could type away all I want and make countless typos, but wouldn't it be better if someone just gave me a gentle prod every time I miss out the ‘g’ from ‘nudge’?