Economists are notorious for disagreeing, Harry Truman famously asked for a one-armed economist after hearing “on the other hand” too many times from his economists. The definition of economics is also a subject of hot debate. British Economist Alfred Marshall defined economics as “the study of man in the ordinary business of life”, but this begs the question: if economics is the study of ordinary man why are economic models of people so unrealistic?
Richard Thaler, one of the grandfathers of Behavioural Economics, points out that economic models “econs” fail to model humans. Econs are bastions of rationality who always choose to optimise, are selfish, unbiased and their preferences don’t change. We humans are nothing like econs, so why are we modelled as such? Thankfully, economists understand this and have their reasons. Many economists are aware that econs are fictional, but as voiced by Schumpeter, many believe this fiction is “sufficiently near to reality” to be useful. After all, if behaviour deviates randomly from how econs are modelled, on average our models will still be extremely useful as deviations on each side cancel out. However, we don’t deviate randomly, we deviate systematically, as pointed out by two historic Israeli Psychologists who tried their hand at economics.
Daniel Kahneman was a naturally sceptical man, and while accompanied by his surprisingly optimistic colleague and friend Amos Tversky, set to work to understand systematic human biases. They did this through a psychological framework they called system 1 and system 2, which explains two distinctly different methods of making decisions. System 1 is quick, impulsive and responsible for most decisions but acts unconsciously, whereas System 2 is more rational but has finite attention. Econs would make all their decisions with system 2 however humans aren’t as fortunate. Not only do humans make most of our decisions in system 1 but many of our system 2 decisions use data brought by system 1, bringing alone subsequent biases with it.
From this framework, they found many biases but the most famous are loss aversion and priming. Loss aversion claims that humans feel losses more intensely than gains, priming is when exposure to one stimulus influences a response to another unconsciously. Meaning that every day in our decision making, we are overweighting losses that are primed by a multitude of factors and affected by hundreds of other biases unconsciously which are all stopping you and I from acting like the selfish, optimising and rational econs which we are modelled as.
Introducing systematic biases into economics has two major implications. Firstly, it has the potential to rewrite economic models, essentially rewriting how economists view the world. When Khanaman and Trverski published Prospect Theory in 1979, they updated expected utility theory and the subsequent utility curve. In their new model, they incorporated frames of reference and most importantly loss aversion, showcasing what behavioural economics has to offer. But most importantly, it has provided a new tool for governments to use in macro and microeconomic issues.
Policymakers aim to influence behaviour, and traditionally have worked through two methods. They can offer a proverbial carrot, such as giving tax incentives, subsidies or other rewards. Alternatively, they can use a legislative stick by banning or heavily taxing certain behaviour. However, a new tool has been added referred to as nudging. Nudging, coined by Thaler, is a method of encouraging a choice by subtly changing the options available or how they are presented, without limiting the choices available in a low-cost manner.
An existential issue that policy makers around the globe are struggling to tackle is climate change, nudging has added another tool to their arsenal. Overconsumption is a huge factor for climate change, specifically in energy consumption. When nudging people to consume less, Alex Laskey found that messages on the environmental impact and saving money had little effect. However, pointing out how your consumption compared to your neighbours had a huge effect. Alex Lansky used the idea of pointing out how your consumption compared to your neighbours had a huge effect to build his company Opower which delivered personalised energy reports and use social pressure to reduce energy consumption across America.
Nudges can also be used for tackling macroeconomic issues such as incentivising saving, which appears to be an area where financial invectives are as effective as a car with square wheels. Chetty analysed the effectiveness of tax subsidies for retirement saving accounts, he estimated that “each $1 of government expenditure on the subsidy raised total savings by 1 cent”. Thaler noticed this and created his Save More Tomorrow plan using behavioural economics to appeal to biases. It uses loss aversion by increasing the amount saved proportionately with a pay rise, so earnings never decrease and uses commitments made in the future as opposed to now. His plan resulted in average saving rates increasing from “3.5% to 13.6%” for participants, once again displaying the power of nudging.
In the future, nudging has the potential to increase productivity by improving health. The World Health Organisation (WHO) estimates that Africa loses an astonishing $2.4 trillion in productivity per year due to diseases. Nudging can help encourage the purchase of mosquito nets, chlorine tablets and sanitary products to reduce disease when financial incentives aren’t enough. However, only those who can afford will buy.
Behavioural economics has given us a glimpse into the future of economics. Economics is once again about the study of people, models are becoming more realistic, and policymakers are gaining new unconventional tools to nudge human behaviour, but this is just the start.