INSIDE BEHAVIOURAL ECONOMICS
On October 9th 2017, Richard Thaler won the Nobel Prize in economics for his contributions to behavioural economics. Let’s have a look on what behavioural economics is and how it has changed the environment of economic studies.
WHAT IS BEHAVIOURAL ECONOMICS?
Behavioural Economics is a branch of economics that incorporates the study of psychology into the analysis of decision making behind an economic output. Its most marked characteristic is that it eliminates the strongest and most bothering assumption that dominates most of the neo-classical economics model, which is that all agents in the economy are perfectly rational and the decision-making process is entirely based on cold-headed logic. In fact, behavioural economics considers agents who make “gut choices” and distance themselves from the “homo oeconomicus” concept, one of the strongest bedrocks of micro and macro economic studies. By using the insight that psychologists have about the way people think make decisions, behavioural economics helps understand people’s economic conduct in the real world.
Richard Thaler, currently Professor of Behavioural Science and Economics at the University of Chicago and one of the fathers of the field, was awarded the 2017 Nobel Prize in Economics “for having provided a more realistic analysis of how people think and behave when making economic decisions” and for having transformed “a fringe and controversial” field into a “mainstream area” inspiring many other researchers. His recognition has been well accepted by the academic world as it emerged from the words of Tyler Cowen, Professor of economics at George Mason University, who described the prize as “well-deserved and one that is easy to explain”. He also said Professor Thaler’s work was more wide-ranging than many people appreciated, and claimed that his impact has concerned not just one or two narrow fields. In fact, even before receiving the award, Mr. Thaler’s ideas caught the interest of many heads of state and government, including both former US President Barack Obama and former UK Prime Minister David Cameron, because of their applicability to many fields.
What the US academic (who made also a cameo appearance in the well-known film The Big Short) has highlighted during his career is how gut instincts can often overrule rational choices. Professor Thaler’s work has incorporated insights from psychology to help explain why people behave in ways that are not fully rational. For example, many individuals struggle to save for retirement and place a higher value on items or money they already have rather than on those they might buy or win. Another example is the “mental account”, that is, people spend money differently if it is labelled for one specific purpose rather than another. It was with the publication in 2008 of the global bestselling “Nudge: Improving Decisions about Health, Wealth, and Happines” (co-authored with Harvard professor Cass Sunstein) that Thaler managed to spread his revolutionary so-called “Nudge theory”, giving concrete examples of applications of behavioural economics.
Given that logic thoughts are often overturned by irrational spirit, the nudge theory suggests to influence people’s behaviour by making things easy for them: if an institution, corporation, firm etc. wants the public to make a particular choice, then they should make that choice easy in order to make to prompt people to make it. While to some, these may seem common sense principles, they actually revolutionised the ways economics is approached. The great peculiarity of Prof. Thaler’s studies is that, unlike usual Nobel prize winner theories that are highly technical and mathematical and whose application to policies are not obvious, the “Nudge theory” is much more familiar to members of the general public outside the economic profession and it has already had an impact in policy making in UK, US and other countries.
Members of Barack Obama’s administration reportedly had contacts with Thaler and Sunstein, who has been personal friend with Obama since they both lectured law at the University of Chicago. The two academics were also mentioned in a public speech from David Cameron back in 2008. The former UK Prime Minister hired Thaler as an adviser on the creation of the the Whitehall “nudge unit” in 2010. Its primary subjects were obesity, alcohol intake and organ donation, but it later expanded on other subjects such as pensions, taxes, mobile phone theft and electronic cigarettes. Applications of the theories included changing the wording of tax declaration sheet (writing at the bottom of gas and electricity bills whether households were using more energy than their neighbours or less -by slightly using peer pressure households might be encouraged into using energy more efficiently-) and incentivize the substitution of cigarettes with a similar behaviour (e-cigarettes for instance) instead of trying to eliminate an entrenched one.
Formally called the Behavioural Insights Team, the nudge unit is credited with encouraging 100,000 extra organ donations a year and persuading 20% more people to consider changing energy provider. It also helped to bring into the Exchequer an additional £200m in tax revenues. Furthermore, behavioural economics influenced on Theresa May’s announcement of an “opt out” for organ donations (body parts donation would be presumed unless people state otherwise). According to Richard Thaler, the Brexit decision itself could be an example of behavioural economics in action. He argued British voters chose an economically irrational route when considering the options put in front of them. Prof. Thaler has also advised the Swedish government on improving the design of its pension system.
The attraction of Thaler’s ideas to governments can be explained by the fact that country executives are looking for methods to influence behaviour without a huge centralised bureaucracy. But the political discussion about the “Nudge” has become quite noisy since a British Liberal Democrat labelled the theory as “paternalistic and illiberal”. While accepting that some may view it as a right-wing tool, Thaler described the “nudge” as beyond left and right, saying that is used to achieve progressive ends. Nonetheless, Thaler himself and other behavioural economists have also raised questions about how far the arm of government should extend. Besides policy-making, the concept can be applied to individual situations and more broadly to actions in society or trends in the financial markets. The principle of behavioural economics can be taken as a guide also from marketing strategies in order to push costumers to buy.
In the financial field, behavioural economics is about capitalizing on the behavioural biases of investors. Thaler himself engages in this through his Fuller & Thaler Asset Management Inc., which runs $6.1billions for J.P.Morgan Asset Management Inc. and $261 million in the Fuller & Thaler Behavioral Small-Cap Equity Fund. Both funds have bested more than 90% of competitors in the past 5 years, averaging annual returns between 15.9% and 17,3%. The activity focuses on investors’ overreactions and under reactions to events.
In conclusion, the 2017 Nobel prize looks like the definitive consecration of behavioural economics as a fundamental field of economic studies. Indeed, it has the potential to exceed the limit of neoclassical studies and give a better description of how the world really works. Economic agents are far from being perfectly rational, and usually fail to make the choice that would ideally maximize their utilities. Behavioural economics is a field that seeks to give incentives to people to make more rational decisions and it will certainly change the way economics is studied and approached for years to come.
WRITTEN BY OLIVERIO BERTONI FOR BESA
PLEASE DIRECT ANY INQUIRY TO AS.BESA@UNIBOCCONI.IT