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Mohammed Tanweer Merchant Taylors’ School
In recent years, there has been a surge of
academic articles, blogs and books written in
the name of Behavioural Economics, but what
exactly is it? Behavioural Economics is the name
given to the discipline that tries to mix insights
from Psychology with Economics, and looks at
economic 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, emotionless
being who can do cost-benefit analyses at will, and
is never (ever) wrong. These are the basis for many
of the old Classical models. “Humans” on the other
hand, do make mistakes, do get angry, do act
irrationally or inconsistently. They are not infinitely
rational, but rather face “bounded rationality”, with
people adopting rules of thumb instead of calculating
optimal solutions to every decision. Given so many of
us fit into the latter category, Behavioural Economics
(hereafter, B.E) attempts to embrace Humans instead
of brandishing them as “irrational” and leaving them
outside their theories. Dan Ariely in his excellent
book Predictably Irrational, explains it succinctly
when 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 and
then coming up with a theory.
Ariely uses numerous examples to illustrate that not
only do Humans act irrationally (or more accurately,
inconsistently), but worryingly they do so repeatedly
and on both simple and complicated matters. He
ponders questions such as why a headache tends to
persist after taking a 5p aspirin, but why that same
headache vanishes when that same aspirin costs
50p? The point here is that people make perceptions
of quality based on the price, especially when their
health depends on it, and thus actually demand more
of higher priced goods (contradicting standard
demand theory).
Another issue that is discussed at length is the issue
of social norms – why would we help a stranger fix
his car by the roadside for free, (and are offended if
offered a notional payment), but would pursue legal
action if our employer didn’t pay us for the same
work; 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, with
the former dictated by price, but the latter dictated
by norms; and mixing the two can have very adverse
consequences.
Thaler and Sunstein discuss how Humans are
influenced by the choice architecture when making
decisions. That is to say, an Econ would see an
option on a form such as “Do you want to donate
your organs after death?” and be able to assess all
the costs and benefits of the decision and come to
a decision; or when presented with 100 different
pension plans, an Econ would be able to assimilate
all the information and calculate the right one for
him. However, Thaler and Sunstein find that, in
reality, both these questions are so complicated that
Humans will choose the choice that is chosen for
them - the default. In the case of organ donations,
this has stark implications for people in different
countries who need organs – countries that have
organ donation as the default option when individuals
get 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 choosing
health insurance, or retirement funds, since it means
that even if a better option comes up later on,
consumers rarely change to it The message from
behavioural economists is that policymakers should
understand these occurrences and incorporate them
into the choice architecture (If you want to know
how, 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 too
much weight at Christmas, tempted by just one more
pudding; they smoke too much despite reading the
health 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 the
world behave like this, we should try to incorporate
it into our models. The reasoning for this behaviour
can 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 doing
nothing, a better idea is to try to help the Reflective
System overrule the Automatic System, through
binding commitments.
To commit to losing weight next year, you could
make a deal with a colleague that you will pay him
£40 a month and if at the end of each month you
can show you have lost weight, you get the £40
back, otherwise, he will give the money to charity.
This binds you to not give in to temptation.
The Reflective System in people knows that they
should save money for their pension, but it is always
very hard to commit to this, given it means foregoing
some current consumption, which the Automatic
System 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 your
income towards your pension – since this saving
comes from a future increase in income, there is no
current consumption foregone, and thus does not
conflict with your Automatic System, and at the same
time 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 same
premise, which should lead to higher charitable
donations).
Thaler and Sunstein make the point that in reality
instead of doing accurate cost-benefit analyses on
all our decisions, people reference new decisions to
past decisions; reverting to rules of thumb. We use
anchors (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, if
you 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 recently
been a huge hurricane well covered in the media,
you will increase your estimate. Since murders are
reported more often than suicides, people incorrectly
think the probability of murders are higher than
suicides – in short, we are easily influenced, and are
not Econs. Rather than pretending this does not
happen often as traditional economic theories claim,
the behavioural economists prefer to incorporate
these findings into theories that reflect the real world
better.
Whilst B.E can be extended to a vast array of cases,
the recent credit crunch is a good one. Consumers
have bounded rationality (they have limitations
to the information they can analyse optimally) and
as mortgages (especially subprime ones) became
increasingly more complicated, they became confusing
for those who took them on, and thus made incorrect
choices, often taking on too much debt and not
being able to afford the repayment schedules.
Furthermore, since banks were so willing to offer
easy mortgages, consumers could not exercise the
self-control to say no to these “good” offers. Finally,
credit card debt has risen astronomically since
consumers do not treat spending on plastic the same
as spending hard cash. Thus people’s debt problems
spiral out of control. Under Classical Economics,
since we are Econs, we should have seen the Credit
Crunch coming around the corner, but given the
current mess we are in, perhaps it would be fruitful
to 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 behavioural
traits they identified in people making decisions
under uncertainty, one of which is how people value
losses and gains differently. Their descriptive theory
tries 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 “loss
averse”, 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 how
framing is very important in optimal decision making
processes. Framing the same statement in different
ways 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 600
people, Program A offers “200 people will be saved”
and Program B offers “400 people will die”, if an
Econ 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 by
how the Programs are framed. The implications of
this particularly affect referendums and government
policies.
Other ideas in the B.E literature include, why stock
markets are inefficient; why herding behaviour
occurs (in stock markets, obesity levels and teenage
pregnancies); why the word FREE! causes
consumers to do strange things; why people are
more likely to drink a can of Coke that is not theirs,
but refuse to steal 50p from a table; why consumers
simultaneously buy fire insurance but also play the
lottery… the list of applications really is endless.
Ariely summarises the difference between B.E and
Classical Economics well when he likens Classical
Economics to Shakespeare’s Hamlet: “What a piece
of 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 still
think the right hand one is bigger. You are (consistently) wrong, due to the way the diagrams are
drawn – framing and relativity matters (choice architecture).
For further reading and exposition of the ideas presented here, I would highly recommend
Thaler and Sunstein’s Nudge; and Dan Ariely’s Predictably Irrational.
Which inner circle is bigger?
Image taken from www.predictablyirrational.com

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Mo Tanweer on Behavioural economics (2010)

  • 1. Mohammed Tanweer Merchant Taylors’ School In recent years, there has been a surge of academic articles, blogs and books written in the name of Behavioural Economics, but what exactly is it? Behavioural Economics is the name given to the discipline that tries to mix insights from Psychology with Economics, and looks at economic 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, emotionless being who can do cost-benefit analyses at will, and is never (ever) wrong. These are the basis for many of the old Classical models. “Humans” on the other hand, do make mistakes, do get angry, do act irrationally or inconsistently. They are not infinitely rational, but rather face “bounded rationality”, with people adopting rules of thumb instead of calculating optimal solutions to every decision. Given so many of us fit into the latter category, Behavioural Economics (hereafter, B.E) attempts to embrace Humans instead of brandishing them as “irrational” and leaving them outside their theories. Dan Ariely in his excellent book Predictably Irrational, explains it succinctly when 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 and then coming up with a theory. Ariely uses numerous examples to illustrate that not only do Humans act irrationally (or more accurately, inconsistently), but worryingly they do so repeatedly and on both simple and complicated matters. He ponders questions such as why a headache tends to persist after taking a 5p aspirin, but why that same headache vanishes when that same aspirin costs 50p? The point here is that people make perceptions of quality based on the price, especially when their health depends on it, and thus actually demand more of higher priced goods (contradicting standard demand theory). Another issue that is discussed at length is the issue of social norms – why would we help a stranger fix his car by the roadside for free, (and are offended if offered a notional payment), but would pursue legal action if our employer didn’t pay us for the same work; 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, with the former dictated by price, but the latter dictated by norms; and mixing the two can have very adverse consequences. Thaler and Sunstein discuss how Humans are influenced by the choice architecture when making decisions. That is to say, an Econ would see an option on a form such as “Do you want to donate your organs after death?” and be able to assess all the costs and benefits of the decision and come to a decision; or when presented with 100 different pension plans, an Econ would be able to assimilate all the information and calculate the right one for him. However, Thaler and Sunstein find that, in reality, both these questions are so complicated that Humans will choose the choice that is chosen for them - the default. In the case of organ donations, this has stark implications for people in different countries who need organs – countries that have organ donation as the default option when individuals get a driver’s licence have many more organ donors,
  • 2. 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 choosing health insurance, or retirement funds, since it means that even if a better option comes up later on, consumers rarely change to it The message from behavioural economists is that policymakers should understand these occurrences and incorporate them into the choice architecture (If you want to know how, 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 too much weight at Christmas, tempted by just one more pudding; they smoke too much despite reading the health 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 the world behave like this, we should try to incorporate it into our models. The reasoning for this behaviour can 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 doing nothing, a better idea is to try to help the Reflective System overrule the Automatic System, through binding commitments. To commit to losing weight next year, you could make a deal with a colleague that you will pay him £40 a month and if at the end of each month you can show you have lost weight, you get the £40 back, otherwise, he will give the money to charity. This binds you to not give in to temptation. The Reflective System in people knows that they should save money for their pension, but it is always very hard to commit to this, given it means foregoing some current consumption, which the Automatic System 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 your income towards your pension – since this saving comes from a future increase in income, there is no current consumption foregone, and thus does not conflict with your Automatic System, and at the same time 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 same premise, which should lead to higher charitable donations). Thaler and Sunstein make the point that in reality instead of doing accurate cost-benefit analyses on all our decisions, people reference new decisions to past decisions; reverting to rules of thumb. We use anchors (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, if you 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 recently been a huge hurricane well covered in the media, you will increase your estimate. Since murders are reported more often than suicides, people incorrectly think the probability of murders are higher than suicides – in short, we are easily influenced, and are not Econs. Rather than pretending this does not happen often as traditional economic theories claim, the behavioural economists prefer to incorporate these findings into theories that reflect the real world better. Whilst B.E can be extended to a vast array of cases, the recent credit crunch is a good one. Consumers have bounded rationality (they have limitations to the information they can analyse optimally) and as mortgages (especially subprime ones) became increasingly more complicated, they became confusing for those who took them on, and thus made incorrect choices, often taking on too much debt and not being able to afford the repayment schedules. Furthermore, since banks were so willing to offer easy mortgages, consumers could not exercise the self-control to say no to these “good” offers. Finally, credit card debt has risen astronomically since consumers do not treat spending on plastic the same as spending hard cash. Thus people’s debt problems spiral out of control. Under Classical Economics, since we are Econs, we should have seen the Credit Crunch coming around the corner, but given the current mess we are in, perhaps it would be fruitful to 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 behavioural traits they identified in people making decisions under uncertainty, one of which is how people value losses and gains differently. Their descriptive theory tries to model real-life choices, rather than optimal Mohammed Tanweer Merchant Taylors’ School
  • 3. Mohammed Tanweer Merchant Taylors’ School (Econ) decisions, and describes how people are “loss averse”, 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 how framing is very important in optimal decision making processes. Framing the same statement in different ways 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 600 people, Program A offers “200 people will be saved” and Program B offers “400 people will die”, if an Econ 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 by how the Programs are framed. The implications of this particularly affect referendums and government policies. Other ideas in the B.E literature include, why stock markets are inefficient; why herding behaviour occurs (in stock markets, obesity levels and teenage pregnancies); why the word FREE! causes consumers to do strange things; why people are more likely to drink a can of Coke that is not theirs, but refuse to steal 50p from a table; why consumers simultaneously buy fire insurance but also play the lottery… the list of applications really is endless. Ariely summarises the difference between B.E and Classical Economics well when he likens Classical Economics to Shakespeare’s Hamlet: “What a piece of 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 still think the right hand one is bigger. You are (consistently) wrong, due to the way the diagrams are drawn – framing and relativity matters (choice architecture). For further reading and exposition of the ideas presented here, I would highly recommend Thaler and Sunstein’s Nudge; and Dan Ariely’s Predictably Irrational. Which inner circle is bigger? Image taken from www.predictablyirrational.com