Notes for: Behavioral Economics: The Basics

[!info] title: Behavioral Economics: The Basics author: Philip Corr, Anke Plagnol published: 2023 edition: 2 ISBN: 978-0367764326

Introduction

Behavioural economics uses insights from social sciences and psychology to inform economic thinking and theorising.

• The fundamental problem of economics: how to allocate scarce resources to maximise some benefit or “utility”
• Mainstream economics emphasises the depiction of ECON (homo economicus)
  • Concerned with how economic agents should behave under certain conditions
  • ECON is cold, rational, calculating, self-interested
• Behavioural economics emphasises the depiction of HUMAN (homo psychologicus)
  • Concerned with how people actually behaves in reality
  • HUMAN is limited in processing capability, and prone to biases, errors, influences, emotions in how they make decisions
• There are many examples of people “misbehaving” and deviating from how ECON is assumed to act under certain economic conditions and assumptions
  • People would go out of their way to save $10 on a $20 item, but would not do so to save $10 on a $1000 item. We are thinking in terms of discount on the item value, but the savings are absolutely equal, both are $10.
  • In 2008 global financial crisis, both the banks and the consumers took too much risk beyond what an ECON would do.
  • NYC taxi drivers plan their work one day at a time, instead of optimising their income for the entire month or year, which defies traditional economic thinking.
  • GDP or GNP does not measure happiness, and people may behave and make decisions that maximise their happiness, which is not adequately reflected in GDP numbers.
• Perhaps, the ECON model is a bad approximation of human economic behaviour after all

History of Economics

[!quote] The famous Chicago economist George Stigler was fond of saying that there was nothing new in economics; Adam Smith had said it all. Thaler, 2015

Classical Economics

Key ideas of classical economics:

• Prudent (people’s tendency to look after themselves) self-interest benefit the whole society by allocating scarce resources efficiently
• The individual knows what is best for them
• Government intervention will lead to inefficiencies
• Free trade benefits the whole economy
• Efficient productivity comes from division of labour
• Accumulation of profit and allocation of capital are necessary for efficient production processes
• Private capitalism is for the good of the public, and deprivations (like subsistence level of wages) are the necessary tradeoff
• International trade is required to overcome the scarcity of natural resources limiting increase in productivity
• Laws and punishments are necessary to regulate free economic system (to deter immoral economic behaviour from affecting general efficiency of trade)

Influential thinkers and their main ideas:

• Adam Smith (1723-1790)
  • Prudence drives people to optimise their self-interest, but moral impulses also causes people to empathise and act for the benefit of others, because humans are social creatures.
  • Greatest happiness in life comes not from materialism but from companionship of fellow men and women.
  • Justice system is required to regulate individual behaviours and maintain social harmony.
  • Individuals optimising their own interest leads to efficient production and benefit the society as a result (invisible hands)
• David Ricardo (1772-1823)
  • Comparative cost advantage (absolute cost advantage is not necessary) allows all parties in international trade to benefit
  • Law of diminishing marginal returns
  • Iron Law of Wages, which says paying wages above the level of subsistence would erode work motivation
• Jeremy Bentham (1748-1832)
  • Utilitarianism: greatest happiness of the greatest number should be the foundation of morals and legislation.
  • Consequentialism: actions, policies, rules, should be judged based on their consequences, or the utility that they yield
• Thomas Robert Malthus (1766-1834)
  • Food supply grows arithmetically but population grows geometrically
  • People can change their behaviour and curb population growth when appropriately incentivised
• Jean-Baptiste Say (1767-1832)
  • Say’s Law: supply creates its own demand
• John Stuart Mill (1806-1873)
  • Developed the idea of Opportunity Cost
  • The utility of society is maximised by allowing people to make their own free choices (market economy)
• William Stanley Jevons (1835-1882)
  • Marginal view of economic decisions
  • Diminishing marginal utility of consumption

Neoclassical Economics

• A general approach to economics (still rooted in classical) with a set of common assumptions and principles
• Still assumes the ECON model but is more relaxed about assumptions

General principles:

• People have consistent preferences “revealed” through their choices
• People behave “as if” their decisions and judgements can be derived from logical reasoning
• People strive to maximise their “utility”, and optimise allocation of scarce resources
• People process information in an unbiased way
• People are very sensitive and reactive to incentives
• People are “selfish” and place their welfare above others
• Self-interest of individuals benefits society
• Government interventions likely leads to inefficiency
• Economic principles are best expressed in mathematical forms, construct models from basic assumptions/tenets/principles/axioms to arrive at logical conclusions

Clearly, the reality of actual human behaviour deviates from these assumptions and principles, sometimes by a large margin.

Critics of Neoclassical Economics

• Thorstein Veblen (1857-1929)
  • Conspicuous consumption: production of socially valued artefacts at the expense of general welfare of society
  • Economic life serves social ends, which is not captured by neoclassical ideas
• John Kenneth Galbraith (1908-2006)
  • Firms conspiring against the welfare of consumers (also mentioned by Adam Smith)
• John Maynard Keynes (1983-1946)
  • Failure of market equilibrium
  • Economic conditions are influenced by “animal spirit” and do not merely reflect evaluation of numerical facts
  • Use fiscal means to smooth out the troughs and peaks of business cycle

Reality of Economics

• Economics is not at all like natural sciences
• Variables that make up the economic system are fluid, changing, subject to influence from social and political environment, conditioned by individual and collective psychology
• Economic system is dynamic and people are active participants in it

And these are what behavioural economics assumes

ECON (Homo Economicus)

• The assumptions and principles of neoclassical economics are exemplified by the ECON: a rational person. The main tenets are:
  • Rationality, expressed in consistent (maybe latent/hidden) preferences revealed in choice behaviour when incentives are sufficient to motivate individuals
  • Individuals aim to maximise personal utility by allocating their scarce resources most efficiently by employing good-enough mathematical (may not be conscious) calculations
  • Individuals act on full and relevant information (or at least good enough information)
  • Individuals look out for themselves first and foremost, and when they help others, it is assumed that it leads to an increased in their own utility (warm glow effect from charity), this is an example of non zero sum game
• These simplifying assumptions allows rigorous mathematical modelling of human behaviour
• Therefore, neoclassical economics is also characterised by being more normative: it prescribes or predicts what should happen, which often deviates from what really happened
• Marginalism
  • Alfred Marshall focuses his work on “the firm” economic entity, the focus of the subfield of Microeconomics
  • Introduces demand and supply graphs, which represents the concepts of market equilibrium, law marginal of utility/returns, and price elasticity
  • Firms and consumers making decision using marginal analysis leads to the most efficient outcome for resource allocations
• Consistent Preferences
  • Related to the Rational Choice Theory
  • Assumes that people are innately motivated to have a preference for certain choices and they are not influenced by how the choice outcomes communicated/framed
  • Completeness: the consumer can rank their choices in a preference ordered list
  • Transitivity: if the consumer prefers A over B, and B over C, then they must prefer A over C
  • More of a good is always better, with all else being equal
  • Continuity: a small change in a bundle of goods should not lead to a jump in preferences
  • Convexity: mixtures of goods (averages) are preferable to extremes
• Rationality
  • The rational behaviour expected by neoclassical economics (encompasses all the above assumptions) may not align with how decisions are made in reality:
  • People often consider sunk cost when making decisions. But they should only consider the marginal analysis and seek to maximise their utility.
  • People often do not consider their opportunity cost when making decisions.
  • People often do not react to incentives the way that economics have predicted
  • Given full information, people still did not behave in informed or unbiased way
• Expected Value/Utility Theory (EUT)
  • Risk: possible outcomes are known, and each outcome has some assigned probabilities
  • Uncertainty: outcomes are hard to predict and hard to know the probability profile
  • The theorem (by von Neumann and Morgenstern) is a form of precise mathematical reasoning for rational decision making to arrive at optimal outcome considering the risks
  • However, in reality the probability are subjective to the person playing the economic game, and different people may then derive a different expected utility from the situation
  • Even when real people makes the theoretical rational choice, they may unfortunately obtain a bad outcome in the short term. They may not have sufficient resources to play the same game for the long term (which is why people may be loss averse in reality)
  • People may make choices that deviates from EUT when the choices are framed differenly
  • People may also be “present bias” and prefers obtaining outcome in the short term than the long term
• Bounded Rationality
  • People are not perfect, but under certain conditions, people still behaves rationally and therefore the economic theories are still relevant and can even be good predictors
• Heterodoxy
  • The market in reality is not the perfectly competitive market structure described by Alfred Marshall
  • It is made up of small and big firms
  • Firms uses advertising and collusion to maximise their profit
  • Within firms, management are optimising other utility like their salary or free time, which can happen at the expense of overall welfare of society

HUMAN (Homo Psychologicus)

Common behaviour of HUMAN that is not accounted for by neoclassical economics:

• Loss Aversion
  • People have a stronger tendency to prefer avoiding losses to achieving gains of the same magnitude
  • Endowment effect: when asked to price their own cup vs the same cup on the market, people tend to price their possession higher (people value the things they own much higher than the same things they do not)
• Money Mental Accounting
  • Scenario 1: you are going for a concert, ticket costs $10, but you lost $10 before you reach the venue. People are likely to go ahead and buy the ticket.
  • Scenario 2: you already bought the concert ticket, but when you reach the venue, you realised you lost the ticket. People are less likely to buy the ticket again.
  • (People tend to compartmentalise their money for different purposes even though the money is fungible)
• Availability Heuristic
  • E.g. thinking that you are more likely to encounter a terrorist attack (People tend to overestimate the frequency of occurrence of an event if that event easily springs to mind)
  • Illusory correlation: the first few people you met in a foreign country are friendly, so you assume everyone in this country are generally friendly (perceive a relationship between two unrelated event because they come to mind at the same time)
  • Confirmation bias: we already have a preconceived belief, and any events we encounter, we simply choose to think that they confirm our belief
• Representativeness Heuristic
  • Stereotype
  • Dilution Effect: when more facts are provided about a subject, it helps to dilute the representativeness (breaking stereotype)
  • Base Rate Fallacy: people tends to over/under estimate the probability of an event occurring
• Conjunction Fallacy
  • Scenario: Alex is a boy that loves pokemon. Which of the following sentence is more likely to be true?
  • Sentence 1: Alex is a student.
  • Sentence 2: Alex is a student who collects pokemon cards.
  • People tend to choose the Sentence 2, when in fact Sentence 1 than Sentence 2, will always have equal or higher probability of being true.
  • The conjunction does not contribute to higher probability, but people that to think it does.
• Anchoring and Adjustment Heuristic
  • When asked to estimate a figure, if a person is provided a number, they tend to anchor to that number and make adjustments around it, even if the number is very far off from the correct figure (Coherent Arbitrariness)
• Affect Heuristic
  • Our emotions about a given scenario and options influence our decision
• Framing Effect
  • The way options are presented influence the decision people make
  • Prominence effect: when an option emphasise on personal/individual impact, that option exerts more influence on people, than an option that talks about the general population

Systemic Deviation from Rationality

• Risk Aversion
  • Instead of making decisions based on EUT, people prefers to eliminate risk all together instead of maximising expected value
• Ambiguity/Uncertainty Aversion
  • People also tend to prefer making decisions in scenarios where all possible outcomes are known

Prospect Theory

• A simple model to accommodate the separate effects of the above
• Represents human judgement and decision making under uncertainty
• It is about how people actually behave, instead of how they should behave
• It has the following focus:
  • Certain outcomes are preferred over uncertain ones, even when uncertain outcomes offer greater expected utility
  • Greater sensitivity to loss than to gain, of the same magnitude
  • Decisions about loss and gain are made from a reference point, not in absolute terms
  • How information is framed is critical, and the same content framed differently can lead to different behavioural outcomes
• Status Quo Bias
  • People tend to prefer to stay with the status quo
  • Changes are perceived as incurring loss, due to possible “transaction cost” associated with making a change (e.g. hassle, mental effort)

System 1 and 2 Thinking

• From Daniel Kahnemann (Thinking Fast and Slow)
• System 1 is fast, reflexive, automatic, biased, intuitive, emotional, habitual, non-conscious, prepotent. Also called implicit/procedural.
• System 2 is slow, reflective, controlled, effortful, can be conscious. Also called explicit/declarative.
• Problem of neoclassical economics
  • Most activities are carried out by System 1 thinking
  • The perfectly rational ECON agent requires System 2 thinking for all decisions
  • Therefore neoclassical assumptions are fundamentally at odds with how our mind works

Social, Emotional, Personality Factors

Other factors that affects human behaviours:

• Priming
  • The scientific theory which states that thoughts, emotions, acts make further thoughts, emotions, acts more readily accessible
• Prudent Self-interest and Trust
  • People coordinate their behaviour to ensure harmonious social relations
  • Non-selfish cooperative behaviour is also observed even in non-repeated/one-time games
• Nash Equilibrium
  • best equilibrium in non-cooperative games involving two or more players
  • People in reality often violates Nash equilibrium
• Inequality Aversion
  • People make decision to avoid being seen as unfair, or they feel guilty of taking too much advantage
• Social Norms
  • It is the accepted rules of behaviour, communicated and received implicitly
  • It leads to compliance, obedience, and conversion
  • Violating the rules leads to punishment, which is typically social exclusion
  • It helps reduce uncertainty about how to behave appropriately, in ambiguous situation
  • It helps to coordinate individual’s behaviour, facilitate group cohesion
  • It helps constrain an individual’s impulsive response, and reduce cognitive and emotional load
• Emotion and Mood
  • The current emotion and mood of a person will affect their decision, even if their decision is made for an outcome that only arrives some time in the future.
  • Empathy Gap: being in a particular emotional state now (e.g. happy) may make people less able to empathise with others in an opposite emotional state (e.g. sad)
• Personality
  • There are many different framework, that classifies personality
  • In general, personality that is more responsive to rewards may make more selfish decisions (in economic games) and personality that is more agreeable to others may make more cooperative decisions
  • The personal preference that is mentioned by neoclassical economics may ultimately depend on personality
  • Economic success (employment) of an individual is correlated to their self-control and conscientiousness personality
  • Cognitive Dissonance: people change their attitudes/beliefs to be consistent with behaviours that have already performed, even when they were initially against those attitudes/beliefs

Nudge

• Concept of Nudge
  • People do not make good decisions (in terms of their own true preferences)
  • The nudge is any aspect of the choice architecture that alters behaviour in a predictable way without forbidding any options or changing economic incentives
  • A nudge must be easy and cheap to avoid
  • According to Nudge, the choice architect do not decide what is best for people, because people still have the freedom to choose any choice (this is merely Libertarian Paternalism)
• Choice Architecture
  • The design of how choices are presented
  • A choice architect makes decision on how to design the choices
• BASIC model (Danish)
  • Behavioural mapping: collect data to define the problem
  • Analysis: why people are behaving the way they are currently
  • Solution mapping: scientific and systematic process of making suggestions
  • Interventions: test the possible nudges before full implementation
  • Continuation: ongoing monitoring and adjustment of the implemented solution
• MINDSPACE framework (UK)
  • Messenger: who is delivering the message greatly influence the receiver
  • Incentive: the timing, type, and magnitude of incentive matters. Social aspects of incentives also matters. The mind takes mental shortcuts (system 1 thinking), and people can be incentivised to adjust their behaviour through messaging.
  • Norms: reinforcing and reminding social norms influences social behaviours
  • Defaults: people tend to go with the flow and avoid making changes, so the default option is a powerful tool to fix their choice
  • Salience: information that are novel, accessible, and simple, captures more of our attention, and what captures more attention will also be given more cognitive processing
  • Priming: subconscious cues and stimuli like sights, sounds, smells can prime subsequent behaviour
  • Affect: emotional association
  • Commitment: people seek to be consistent with their public promises and reciprocate acts
  • Ego: people act in ways that makes them feel better about themselves
• EAST framework (UK)
  • Easy, Attractive, Social, Timely
• Critics on the theory
  • The nudge choice architecture may not be making people better off as judged by themselves, but they may be better off as judged by the choice architect
  • The best choice may be subjective as it depends on situation, and the people may have certain true preferences, that contrast with the best choice that the architect assumed
  • According to the Nudge theory, the chooser bears the responsibility of the choice, but what if a poor default option set by the choice architecture unfairly burdens the chooser
  • The choice architecture relies on the architect being benign and acts in the interest of the chooser
• Social Comparison and Subjective Well-being
  • People tend to feel that the measure of their happiness and well being depends on they compare to their peers

Commercial and Political Persuasion

• Evaluative Conditioning
  • Powerful and ubiquitous phenomenon in all areas of life
  • Change in attitude toward some stimulus
  • Pairing one stimulus (that evokes certain valence) to another one to evoke the same response
  • E.g. Lewis Hamilton advertising Rimowa luggage
• The Butterfly Effect (Sutherland)
  • Finding a small, preferably inexpensive nudges, that have disproportionately large effect on behaviour
• Psychological Value
  • People perceive certain goods, typically branded, or luxury, goods with additional intangible psychological value, and this affects their purchase decisions
  • Veblen Goods: demand of the goods increases as price increases
• Commercial Preferences
  • Experiments and commercial successes by advertising firms have proven that consumers are susceptible to all sorts of nudges
  • Effective advertisements may have no rational content
  • Familiarity principle: mere exposure to advertisements can influence people
  • Social proof: people tend to mimic the behaviour they see
  • Internet shopping: uses browser activity and behaviour tracking to nudge people to make purchase decisions

Techniques of Persuasion

• Information Processing Model
  • Before 1980s, most theories of persuasion assumes systematic processing (the recipient change their attitude because of the message they processed)
• Cognitive Response Model
  • Late 1960s, this alternative model states that response elicited is determined by what the recipient heard rather than what is said
• A/B Testing
  • Testing the effectiveness of different variation of messages
• Transaction utility
  • People perceived that the same goods sold by a luxury place should cost more, even if it does not offer higher consumption utility
• Customer journey
  • In a physical store, guide the customers through sections to entice more purchases
• Buyer’s Remorse and Regret Theory
  • Consumers wants to avoid making a bad and regretful purchase, and may decide on a more expensive but more “trusted” brand of the same goods
• Reactance Theory:
  • Trying to get people to not consume certain goods may backfire and make them consume more of those goods.
• Anchoring Effects
  • Saying that one customer is only allowed to buy one piece of an item creates the illusion that this is a popular item that must be bought
• Framing
  • Saying that digital payment enjoys $2 discount is more acceptable than saying that cash payment will suffer a $2 penalty (this is also related to Loss Aversion)
• Decoy Pricing
  • Given 3 choices, Standard, Premium, and Super Premium, people tend to go with the middle Premium choice
  • Having a decoy option helps to nudge people into making certain purchase
  • Attraction Effect: it is easier to compare options if they have similar attributes
  • Compromise Effect: people tend to avoid extremes (also called Extremeness Aversion). Perhaps they don’t want to be labelled as a “cheapskate” or a “show off” so they go with the middle option.
• Hedonic Adaptation
  • Pleasure, satisfaction, utility from goods and services wane over time.
  • People need another hedonic stimulus to return to previous hedonic level.
  • This demands that commercial goods and services are novel, exciting, and the “new thing to have”.
  • Due to this hedonic treadmill, people are bad at forecasting how satisfied they will be before they made their purchases
• Social Media
  • The goldmine of behavioural data
  • Also a good platform to nudge their behaviour

[!quote] The first principle is that you must not fool yourself and you are the easiest person to fool. Richard Feynman, 1985

Other Books Mentioned

• Misbehaving, Richard Thaler, 2015
• The Theory Of Moral Sentiments, Adam Smith, 1759
• An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith, 1776
• The Theory of the Leisure Class, Thorstein Veblen, 1899
• The Affluent Society, John Kenneth Galbraith, 1958
• New Industrial State, John Kenneth Galbraith, 1967
• The General Theory of Employment, Interest, and Money, John Maynard Keynes, 1936
• Principles of Economics, Alfred Marshall, 1890
• Theory of Games and Economic Behaviour, John von Neumann, Oskar Morgenstern, 1944
• Predictably Irrational, Dan Ariely, 2008
• The End of Alchemy, Money, Banking, and the Future of the Global Economy, Mervyn King, 2016
• Nudge: Improving Decisions About Health, Wealth and Happiness, Richard Thaler, Cass Sunstein, 2008
• Alchemy, Rory Sutherland, 2019
• Confessions of an Advertising Man, David Ogilvy, 1983
• Influence: The Psychology of Persuasion, Robert Cialdini, 2007
• Scientific Advertising, Claude Hopkins, 1923
• The New Psychology of Money, Adrian Furnham, 2014