Economic psychology in a nutshell: the only three things you need to know

The human psyche seems too individuated, too intricate and too complex to be made sense of as a whole. This is not true. Underlying this are three basic properties of the psychological process: salience, chains and anchors.

“I can calculate the motion of heavenly bodies, but not the madness of men” said Isaac Newton. He was commenting on his having lost a substantial amount of money in the South Sea bubble. Contrary to his implied warning, economists have given a good shot at using the equations inspired by Newton to model economic behaviour. But the rational choice theory of individual behaviour they developed in this enterprise fared pretty well as Newton himself might have predicted.

Behavioural economists and psychologists have documented thousands of cases where people don’t seem to act even “as if” they were maximising utility over a well-defined and stable commodity “space” in an analogous manner to a particle maximising energy loss in physical space.

To continue the astronomical comparison, the project of responding to these problems has largely hitherto been a Ptolemaic affair. Rather than seek to fashion a new model with new foundations which can capture as much as possible about human behaviour at once, the exercise of behavioural economics has largely been one of adding “epicycles” to the course of the planets — modifying rational choice theory piecemeal to account for this or that deviation. Academia doesn’t reward synthesis, it rewards carving out and defending a niche against encroachers who might compete for publications.

Our view of human behaviour has suffered. It seems that we cannot make sense of the “madness of men” in but a fairly piecemeal manner. Human psychology and behaviour is too individuated, too intricate, too complex. There is no modern synthesis, nor even one or two less syntheses a la the physics economists so wish (rightly to my mind) we could emulate.

So, in building the “UQ model” we thought we might as well try, and sought to provide a new foundation for a model human psychology and behaviour. I’ve written about this model at some length elsewhere.

What’s nice about this model is that, outside of situations in which the mind itself was evolving, all of the tens if not hundreds of aspects of the human psyche which have confounded economists suddenly resolve into three simple aspects of the human psyche: salience, chains and anchors. The technicalities of these can be dispensed with in six pages.

These three aspects of the psyche are important to understand because they are the basic means by which behavioural change may be affected even when a state of substitutability does not exist. I want here to explain to you what these phenomena are and how they work to effect behaviour. But first we will briefly recap the model of the mind in which they exist.

The mind as network, the psychological process within it

The mind may be understood as a network connecting together things we see in our world to express our knowledge of it and our view of it. The nodes of this network are concepts which represent objects in our world: people, places, goods, services, money, attributes, emotions, needs, wants and other descriptors. The connections in this network represent our understanding of how these various things are related. This semi-permanent “map” of reality is from whence a “model” of any particular environment arises in the mind of the individual through a process of perception, analysis and decision.

We transform information in our world to conceptual representations of it in our minds by perception. Percepts are a subset of the nodes in our mental networks, concepts corresponding to the objects we observe in our environment. These form the basis for our analysis.

In the process of analysis we extract the relations contained in our mental networks between our percepts of the environment. Analysis is the process by which construct our understanding of how our environment “works” by. We connect together the objects in our environment; construe their relations to each other — “connect the dots”. We try to understand what is happening, and what will happen. This subnetwork is our “model” of our environment, our understanding of it.

Within this knowledge are chains originating at the various courses of action we may take, which represent our thinking about the implications of those courses of action, the outcomes we expect to follow from them. These have aesthetic qualities which allow us to establish preferability between them and allow us to posit a theory of decision.

People choose that course of action which they expect to be associated with what they think the most preferable outcomes. There is a truth to rational choice theory; it’s just that it isn’t backed up by a theory of the origins of preferences in the manner of a person’s thought.

Within this framework if we fix, for now, the structure of the network in our minds we can explain all psychological phenomena by way of three properties of the psychological process. Salience, chains and anchors.

Salience: noticing only what is noticeable

Human perception is summed up by an unusually informative tautology: we notice only what is noticeable. What does that mean specifically?

It means that the more does information make an impression on the sensory organs (the louder to the ear, the stronger the taste to the tongue, the greater the smell to the nose, the more grabbing of the eye, the more powerful the touch to the skin, the more the nervous system is excited) relative to the environment overall, the more likely the concept corresponding to that information will be perceived.

This concept is known as salience property of perception. The greater the noticeability of any information relative to that of the overall environment, the more likely the percept corresponding to that information is to be actually perceived.

Examples of this with relevance to economic behaviour are not difficult to find. We are far less likely to notice things which are out of the “foreground” or which are in our peripheral vision, which is why mandated warnings about gambling or drinking are typically squeezed into minute text in the corner of advertising. We notice garishly coloured and loud advertisements more than those which are more mild mannered. We notice things like our desire to buy things in our present far more than we notice the suggestion of things like our needs to buy things in the future.

We also find that the physical states which correspond to emotions have a greater hold on our attention than would more “rational” considerations. Aristotle knew this when writing about the need for the “political speech” (the one which aims to change our behaviour) to appeal to pathos (emotion) rather than logos (reason). Emotions are visceral and thereby are more noticeable by grabbing our attention.

I don’t necessarily have to change the information content of your environment either really to change the noticeability of information, I can just move it around so that it isn’t in your direct line of sight, isn’t in the immediate range of your hearing, touch, taste or smell. I can change what you see simply by changing the arrangement of the information in your environment. Not the content even, just the way it’s presented.

Chains: your personality can change what you notice

The physical basis for our thought is neural networks, specifically our perceptron and associative memory networks in which electrical signals from the nervous system are passed around our brain and our thoughts processed. Our neural networks are the physical basis for our personality, and so we are left with the fact that our personality can affect the very way in which we perceive our environment. The way we think can change the things we notice.

This concept is known as the “follow-on” property of perception, which can give rise to “chains” in perception. The “follow-on” property states that if some percept A is connected by a sufficiently “strong” (think “vivid”) connection to another, B relative to the environment, then the perception of A will be sufficient for the perception of B.

Aristotle again knew this when writing about the need for an orator seeking to persuade an audience to be mindful of the personality of their audience. The incautious speaker will, if they are not careful, make statements which arouse adverse attitudes in the audience. The classic example is Socrates making reference during his trial to his own wisdom and constitutional conduct during the Peloponnesian War, as well as his belief that he ought to have been honoured for the same. One could hardly expect the fickle, proud and defiant Athenians to associate these percepts with endearing attitudes to Socrates, and indeed their jury famously had him executed.

This property of perception lies behind what Daniel Kahneman and Amos Tversky called the “availability” and “representativeness” heuristics. In the case of the former people objects in the environment relative to the most “available” objects in their minds (those most strongly connected to them), for instance Malaysian airlines with the disasters of MH370 and MH17. In the case of the latter people perceive their environment based on connections which construe the representativeness (“likeness”) of one thing to another — how many people can name a type of financial institution other than a bank?

This is an extremely important property of the psyche for understanding the entrepreneurial personality, or the personality of the thief. Both see the world as awash with opportunities for profit which others don’t tend to see, simply because of the associations their minds make between objects in the world. Their different personality allows them to see the world differently.

Anchoring: small things can change your whole thinking

Understanding that the mind, and the process of thinking operates within and upon networks changes our thinking about it in one especially important manner — we always remember the mind is a connected structure. It is not necessarily the case that our thinking will be “modular” (consist of separate, disconnected networks). The opposite is intuitively more common in fact: thinking occurs in the context of a whole. Change one part of the network which emerges from our analysis of our environment and you can change the whole framing of someone’s thought.

The great psychologist George Kelly taught that things cannot make sense in and of themselves, they must be related to other things, we will call them “anchors” (Kelly called them “axes”). Anchors are elements of the psyche, concepts, by which objects in the world can be “anchored” and thereby described. If you change one of these anchors, you can change not only the relations connecting it with others, but other relations “downstream” or “upstream” which are contingent upon it. If you change one anchor in the environment, you can change the whole network of a person’s thought; the whole way a person thinks about a situation.

A whole investment strategy might depend upon whether the economy is in recession or boom, our entire assessment of some person based on where they went to school, or an entire mood on whether someone’s bus was irritatingly late in the morning.

Anchors are only really interesting for us as economists when they are non-inert. They are non-inert when their presence not only changes the way a situation is thought about, but they also change the preferability of the outcomes expected to attend upon the various courses of action available to the individual.

Again, examples of this with relevance to economic behaviour are not difficult to discover. Emotions make another spectacular appearance here on the trading floor of major financial institutions. Forget the academic studies proving it, simply meditate on the way Gordon Gekko played on the emotion (dressed up as reason) of Teldar Paper stockholders in Wall Street and the truth of his famous “greed is good speech”. Once powerful emotions enter the way individuals think about an environment they can anchor it so spectacularly they can drive stock market bubbles like the one which we saw drove Newton to despair.

Thorstein Veblen, James Duesenberry and John Kenneth Galbraith gave us another example of behaviour driven by the anchors the behavioural economists. The income and spending habits of our peers, our neighbours, or even ourselves in the past frames the way we think about our current income and spending — anchors it. Not only does this lead to us desperately trying to “keep up with the Jones’” in our spending habits, it also contributes to risky behaviour aimed at avoiding “falling behind”. These three things are what the behavioural economists call “reference dependence”, “reflection effect” and “loss aversion” (or sometimes the “endowment effect”).

The effect of anchors can be more subtle and even, on the face of it, quite odd. Dan Ariely hypothesises an interesting example of a choice between a holiday in Rome, Paris, or having your car stolen. Surely the third option wouldn’t change your decision between Rome and Paris? Actually the evidence suggests that it just might.

Let’s up the stakes. Consider a choice between a holiday in Rome, a holiday in Paris, or dying in a terrorist attack. Surely the option no sane person wants wouldn’t affect the choice right? But what if the option of dying in a terrorist attack were to become attached as an anchor to a holiday in Paris? This isn’t a particularly unreasonable expectation in recent times. It not only would change one’s behaviour then to add the option to the choice set, it would make sense because that action would anchor one of the actions, change the thinking about it, change the preferability of the outcomes expected to attend upon it, and change behaviour.

Why this matters: if you know people their behaviour can be changed

That’s it. The only three things you need to know about economic psychology: salience, chains, and anchors. I’m yet to discover a situation outside of mental evolution or straightforward substitution where I couldn’t explain human behaviour by some combination of them.

I’d challenge you to test my claims here by thinking about your everyday decision making, or that of others. How much of your or others’ behaviour can you make sense of using one of these three properties of the psyche or some combination thereof?

The importance of these three aspects of the psyche is quite obvious: they give us means by which behaviour may be changed. Indeed, these give us means by which behaviour may be changed even when a state of substitutability does not exist and we need to change the way an individual thinks about a situation wholesale.

By rearranging the environment so that the information corresponding to certain non-inert anchors, or certain percepts strongly connected to certain non-inert anchors are elicited, we can change the way people think about their environment. If we change the way people think about their environment we change the way they think about the outcomes to be expected to follow from various courses of action within it, the preferability thereof, and potentially behaviour.

All government policy and business strategy is ultimately about engineering behavioural change, and what we have seen here is that outside of manipulating tradeoffs (when thinking about a situation has to be changed wholesale) and outside of changing the mind itself, there are three roots to all psychological and behavioural phenomena. The “madness of men” isn’t quite so infinite, and so it’s not a hopeless task to understand it; it’s the result of three fairly straightforward properties of the mind: salience, chains and anchors.