Are you a Human or an Econ?
I recently picked up the brilliant book, “Nudge” by Richard H. Thaler and Cass R. Sunstein and quickly read it cover to cover. I was thinking that I would write a review of this book, but as I was reading, I discovered it had so many useful insights (as it applies to personal finance and human decision-making) that my “review” would end up being a 2-hour read. Instead I’m going to break my “review” into multiple articles focusing on what I found to be the most useful aspects of the book.
My educational background is in Economics. I have a bachelor’s and a master’s degree in economics. It is not hyperbole when I say the first several chapters of this book made me question nearly everything I have learned during my years of studying economics.
In a way, the entire discipline of economics and economic theory sits on the foundation of one seemingly minor assumption, “that humans are rational actors”. Economics, and particularly micro-economics assumes that if provided with the correct incentives and information, humans will make the optimal decision. It’s one of those things you are told during your first day of micro-economics 101, you accept it and then you never really give it too much thought.
In the real world, we know with absolute certainty that most humans do not act rationally. People have known for years that smoking has disastrous health consequences including cancer. Many governments have added “incentives” not to smoke through the form of taxes. A rational actor would look at the health consequences, and/or react to the financial incentives put in place and decide not to smoke, and yet, people continue to smoke. The exact same thing is true of sugar consumption. We know it has health consequences, yet we continue to consume sugar daily.
We all know that we need to save money during our working years to fund our retirement. The government has put in financial tax incentives for contributing to a 401K (or RRSP’s for our Canadian readers), yet nearly 33% of all employees eligible for a 401K fail to even enroll in the plan.
I could go on and on about all the ways that most humans are not rational actors, but I think you get the point.
Humans VS. Econs
Nudge does a brilliant job of breaking people into two categories, humans and econs.
Most of us are humans, meaning we can be irrational, we lack discipline and often make decisions with “our gut”.
Some of us (including myself) are econs. When it comes to major life decisions that impact a person’s finances or health, econs will make an unbiased decision to optimize their well-being, considering all available data. That is not to say, econs are always correct but they will make a rational decision and respond to incentives.
If you are an econ, you will have maxed out your 401K contributions. If you are an econ, you will eliminate or reduce your sugar consumption. If you are an econ you will never buy a lottery ticket. Put simply if you are an econ you more closely match the “rational actor” that economic theory is built on.
Automatic Versus Reflective Thinking
To help us better understand the differences between humans and econs the authors introduce two systems of how our brains work; the automatic system and the reflective system.
The automatic system is associated with the oldest parts of our brain, if you have ever heard the term “lizard brain”, our automatic system taps into our lizard brain. When we use our automatic system to make decisions you can think of it as going with “your gut”. Unconscious, fast and effortless decisions come from our automatic system.
When you see someone eating a bacon cheeseburger and decide you need one too, that is your automatic system at work. The automatic system is extremely powerful because we aren’t even aware of it. If someone makes a bad first impression, it can be difficult to overcome because the other person’s automatic system has decided that they don’t like this person, even if on an unconscious level.
The reflective system is more deliberate and self-conscious by comparison. When you are working out a complex math problem, you are using your reflective system. The following characteristics are described as part of the reflective system: controlled, self-aware, slow, effortful and rule following.
The authors crystalize the difference between the automatic and the reflective system using the example of experiencing turbulence on a plane. The automatic system will say “we are going to crash and die!” while the reflective system will say “but plane travel is statistically the safest way to travel”.
When it comes to important life decisions such as major decisions on health or personal finances econs tend to use more of their reflective system while humans use their automatic system. The book later deep dives into how we can develop smart policies to “nudge” humans into more optimal decisions, which I will deep dive into in a future post.
Are You a Human or an Econ?
To help you learn if you rely more on your automatic or reflective system the authors implement the famous “Cognitive Reflection Test” created by Shane Frederick.
Give it a go for yourself, grab a pen and paper and answer the following 3 questions. I will post the answers below but NO CHEATING. This is not an IQ test, cheating completely undermines the objective of the test. Getting the answers wrong does not make you “dumb”, getting them right does not make you “smart”.
1. A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? _____ cents
2. If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? _____ minutes
3. In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? _____ days
The test is designed to reveal if you make an automatic decision or a reflective decision. If you used your automatic decision making you probably answered 10 cents, 100 minutes and 24 days which are of course, incorrect. If you used your reflective thinking you likely answered correctly: 5 cents, 5 minutes and 47 days.
Next post, I will deep dive into what the authors of “Nudge” have to say about saving for retirement a topic important to us all.
So, how many of the questions did you answer correctly? Do you think you are a human or an econ? Let me know in the comments.