My conversion to behavioural economics

This week we heard that Richard Thaler, the Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business, has been awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017.

This news has spurred on opinion pieces across the globe on what behavioural economics is and how behavioural insight can inform our understanding of how markets and consumers work.

I myself am a bit of a fan, but it’s not been a simple conversion.

I wouldn’t consider myself to be a natural ally of anything that made positive use of either the words ‘libertarian’ or ‘paternalism’. As seemingly contradictory as those two things appear to be on first sight, ‘libertarian paternalism’ was the term Thaler and his co-author, the legal scholar Cass Sunstein, created in a 2003 article in the American Economic Review.

It can be defined as the idea of private and public institutions affecting people’s behavior while also respecting freedom of choice.

This gave rise to the popularised term ‘nudge’ which defines the way in which a choice is presented, increasing the chance of someone choosing to do what you want them to do.

In other words, you present a set of choices to someone in such a way that you are gently guiding that person’s choice, but the other person doesn’t feel their choice is being guided at all.

Another term is useful here: ‘choice architecture’. The well-known way that Thaler and Sunstein describe this term is in page 1 of their book Nudge: a dinner assistant at a school wants the schoolchildren to eat healthily but doesn’t simply want to force this upon them; they also want this decision to be the children’s choice (not really their free choice but as close as dammit).

Now typically children being children they’ll want to take the chips over the carrots. Instead of limiting their choice (taking the chips away altogether and feeling the full ire of the children the next lunchtime) why doesn’t the dinner lady change the architecture of the choice at hand: have the carrots at eye level and the chips harder to see/reach.

As it happens, it’s not this bit of behavioural economics I like particularly. If ‘nudging’ and changing the ‘choice architecture’ was only about good intentions then that would be fine. But what about when the ‘nudge’ is for bad purposes? What if we are trying to, say, nudge people into buying things they don’t need? Or what if the ‘nudge’ in reality turns into coercion and rather than it feel like a free choice, albeit one that’s gently and subtly guided, is actually perceptibly pressurised?

I think a lot more work needs to be done to differentiate good ‘nudge’ from bad ‘nudge’ and to make the distinction between nudging and arm-twisting a little more apparent. (As it happens I’m currently doing some work on this with some very smart advocates of good ‘nudge’).

We also have to be mindful of how the interplay of nudging might work in real life: nudging might not actually work if we are nudged to do two contradictory things, such as spend money on things we don’t need and save any spare cash we might have (admittedly Sunstein has dealt with this question specifically more recently here).

I guess I’m sceptical of how this branch of behavioural economics might be abused, not because I think it’s a load of rubbish but precisely because I think it’s important; I’m invested in seeing that its good application is properly defined. If you care about something you’ll see that it’s not abused.

What I do really, really like about behavioural economics, however, is how it creates a level playing field for all of us humans, whatever our particular circumstances.

While, say, our exposure to ‘present bias’ (where someone only thinks of the ‘here and now’ rather than the future) might differ, essentially behavioural economics says that we are all given to certain behaviours that might seem a bit irrational from the outside. In fact there’s probably no such thing as “rational” behaviour at all.

I recently did a piece of research looking at people’s financial savings habits and I discussed at length certain definitions in behaviouralism that can help us to understand how we conduct ourselves as financial beings.

For example:

• Anchoring (Using an initial piece of information to make subsequent judgments, even when the initial piece of information is irrelevant or arbitrary): for example reaching a particular savings target and feeling like you don’t have to save any more, even if you can.
• Bandwidth (Cognitive resources — working memory and executive control — that allow us to reason, to focus, to learn new ideas, to make creative leaps and to resist our immediate impulses): for example having low bandwidth, in times of particular stress, financial or non-financial, that impedes our overall ability to proactively put money aside for savings.
• Framing effects (The effect that the way a choice is presented has on an individual’s decision-making): for example if having savings is framed primarily as a way of preparing for an emergency which we’d rather not think about, this might have an effect on our ability or willingness to save money.
• Friction costs (Seemingly irrelevant details that impose a small effort cost to perform a behaviour but disproportionately discourage action): for example the feeling that one has far too many other commitments to be able to put money aside, even if strictly speaking that individual has enough that they could put away as savings. This concept has most commonly been utilised by savings providers: if you add levels of friction individuals are seemingly less likely to think of savings in the same way they think of disposable cash.
• Locus of control (A person’s perception of their control over events that affect them): for example this may lead someone to believe that they can exert control of a situation that, to someone else, would otherwise be alleviated by having savings. It might also lead someone to defer responsibility over things they feel are outside of their control — as long as they behave in a way they feel to be correct.
• Loss aversion (People strongly prefer to avoid losses than acquire gains of an equivalent amount): for example this may lead to someone having a preference for spending money and experiencing gratification in consumption rather than wishing to defer that gratification and saving money.
• Present bias (The tendency to place greater value on immediate rewards and discount those in the future): for example this may lead to someone preferring not to defer gratification and spending less in order to save money for the future, in favour of spending towards gratification in consumption today. In a review of the evidence, The Behavioural Insights Team found that there “is little evidence on whether low-income groups in the UK are more likely to suffer from present bias.”
• Self-efficacy (An individual’s belief in their own abilities to complete a task, achieve a goal or overcome an obstacle): for example this may lead someone to believe that won’t need to plan for a savings buffer because any given unexpected circumstance, or income shock, they will be able to weather when/if that time comes. This feeling might be coupled with someone “burying their head in the sand” about certain situations, particularly about spending money without a budget versus planning ahead.
• Status quo bias (The preference towards maintaining the current state of affairs, whether that be through avoiding behaviours that could alter the status quo, favouring decisions that sustain it, or doing nothing): for example this may lead someone to find it hard to accept that their current state of affairs, if it is relatively manageable, could change, and risks that person finding it difficult to prepare for situations or circumstances that alter that state of affairs. This may be particularly problematic for people who don’t like to think of “rainy days” and who, for that reason, prefer not to save for the future, or find saving to avoid a negative situation/circumstance itself demotivating.

What we learn from these behavioural insights is that we are all generally prone to certain behavioural types under particular situations, no matter our financial situation.

The tendency towards ‘present bias’, referred to above, is not unique to one household income level alone.

The difference, however, is the frequency with which people on particular income levels experience financial situations that affect their behaviour. Financial situations that cause ‘cognitive overload’ (such as pressure to pay multiple outstanding debts) are more likely to affect low income households: but that makes it no less likely that someone on a higher income experiencing ‘cognitive overload’ would act any differently as a result.

Once upon a time people might have thought a person stupid for doing something one way and not the way they would do things. Now we understand that behaviours do not exist in a vacuum; there’s a reason why we do things. Behaviouralism gives us insight into why we do the things we do.

I wasn’t always convinced but now I’m a convert. Understanding why we do what we do should not be an excuse for exploitation (and as I’ve pointed out above sometimes that’s futile anyway), but it can help us better understand the day-to-day effects that inform the decisions we make.