We’re Only Human: Behavioral Economics And British Policy (Part 1)
July 19th, 2011
 by
Adam Oliver
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Editor’s Note: This is the first of a two-part post discussing behavioral economics and how it is being used by British policymakers. Part 1 below focuses mostly on the development and general principles of behavioral economics. Part 2, which discusses some of the ways British policymakers are seeking to use insights from behavioral economics, will appear tomorrow.
David Cameron famously, and, among political leaders, uniquely, gave his MPs a reading list in the summer of 2008, at the top of which he placed Nudge: Improving Decisions about Health, Wealth and Happiness, authored by Richard Thaler and Cass Sunstein. Nudge is a book that applies the findings of behavioural economics to public (and private) policy, in an attempt to increase the likelihood that policy will have a significant and lasting effect. The essence of the approach, which Thaler and Sunstein perhaps unadvisedly termed ‘libertarian paternalism’, is that behavioural economic insights can be used to change the ‘choice architecture’ (i.e. the environment) so that people are more likely to make voluntary decisions that, on reflection, they would like to make, and yet ordinarily fail to do so.
Within the UK, this approach appears to be having a real (if, as yet, mostly potential) policy impact. On being elected to government, Cameron established a Behavioural Insights Team in the Cabinet Office (the so-called ‘Nudge Unit’), with Chicago-based Thaler – arguably the foremost behavioural economist of the last thirty years – serving as an official (unpaid) advisor. (Sunstein, a distinguished professor of law who has written much on behavioural economics, is currently serving as Barack Obama’s regulation ‘tsar.’)
The Development Of Behavioral Economics
Behavioural economics arose out of critiques of neoclassical economics, which has dominated economic thought over the last century. Neoclassical economics – the sustenance of the fabled homo economicus – assumes that people are the best judges of their own ‘utility’ (or happiness), and that they will seek to maximise the happiness they gain from the choices that they make – that is to say, they are ‘optimisers’. Moreover, it is assumed that their preferences are fixed and stable over time.
In the 1950s, scholars such as Herbert Simon began questioning this optimising approach. They claimed that humans face ‘bounds on their rationality’ and will often employ heuristics (rules of thumb) in their decision making which will lead them to “satisfice” — to identify an adequate, but not necessarily optimal, choice. From the 1960s, through work by Paul Slovic, Daniel Kahneman and Amos Tversky (among many others), it became apparent that people’s preferences are often not ‘fixed and stable’, but rather that they are regularly constructed in response to how choice contexts are ‘framed’, and are influenced by the manner in which preferences are elicited. The finding that preferences depend on – and are influenced in systematic ways by – how choice contexts are described, is central to the nudge agenda.
The Heuristics And Biases Identified By Behavioral Economics
Simon thus implied that humans will not search extensively for an optimal choice, but will instead invariably satisfice, or make do, with something that is good enough by employing rules of thumb – the evolutionary responses that normally serve us well enough to meet our basic needs. Unfortunately, these heuristics can also cause us to make serious mistakes. A great many biases have been identified in the literature, with some of the main ones being associated with representativeness, availability, anchoring or overconfidence, all of which can perhaps best be illustrated with simple examples (mostly reported previously by Kahneman and Tversky).
The representative heuristic. Take the representativeness heuristic, for instance, and imagine a group of one hundred men, ninety of whom are engineers and ten of whom are librarians. Now imagine an individual from this group called Steve, who is very shy and withdrawn, invariably helpful, but with little interest in people or the world of reality. Steve, you are told, is a meek and tidy soul, who has a need for order and structure and a passion for detail.
When asked whether they think Steve is more likely to be an engineer or a librarian, many people overlook the prior probability that, statistically, Steve is much more likely to be an engineer; they state, on the basis of the description, that he is more likely to be a librarian. That is, when acting upon the representativeness heuristic, people evaluate probabilities not necessarily in the economically rational sense, but by the degree to which A resembles B.
The availability heuristic. Consider words that begin with the letter ‘r’ – robot, rabbit, rich, for instance – and words that have ‘r’ as their third letter, such as tarnish, carrot and bird. Which type of word is more common in the English language? Most people are likely to think that words that begin with ‘r’ are more common, because thinking of such words is easier. In fact, words with ‘r’ as the third letter are more common, and thus people when faced with this question seemingly make an error due to the availability heuristic – the tendency for people to assess the probability of an event by the ease with which similar instances can be brought to mind. The availability heuristic is also an explanation for why people are more likely to think that average annual global deaths from shark attacks (forty per year) is higher than those from falling coconuts (one hundred and fifty per year, apparently), indicating that the media, by choosing to focus upon some stories over others, has a powerful pull on people’s perceptions.
The anchoring heuristic. The anchoring heuristic is also intrinsic to human cognition, and yet is overlooked in standard theories of rational choice. For instance, when asking people to calculate 1*2*3*4*5*6*7*8 and 8*7*6*5*4*3*2*1, many appear to anchor on the first few digits in each calculation, and adjust insufficiently for the latter digits. Consequently, the median answer for the latter tends to be very significantly higher than that for the former, when in fact the two, of course, give an identical result. In a further demonstration of the anchoring effect, the behavioural economist, Dan Ariely, asked a group of American respondents to think of the last two digits of their social security numbers. He then asked them how much they would be willing to pay for a fine bottle of wine. Those who had a high social security number (e.g. 79) were willing to pay substantially more than those with a low social security number (e.g. 23), indicating that humans can unconsciously anchor on entirely irrelevant cues when making decisions.
The overconfidence bias. Finally, we often appear to suffer from an overconfidence bias, which has obvious implications for our (and others’) choices in financial markets. To demonstrate this bias, ask a room full of people if they think they are better than average drivers, or ask any recently married couple if they think they have a lower than average chance of getting divorced at some point in the future. The operation of this particular heuristic should then be clear enough to see.
Standard economics is of course a science of behaviour, but behavioural economics identifies systematic patterns of behaviour that are not explained by standard economic theory. As implied above, the latter assumes that we are analytical, fully ‘rational’ maximisers. Keith Stanovich and Richard West define this as ‘system 2 thinking’, with ‘system 1 thinking’ being the intuitive, automatic responses that are consistent with the heuristic driven, satisficing approach. Thaler and Sunstein attach to these ways of thinking the more intuitive labels of ‘Econs’ and ‘Humans’. Others – notably the UK Government – have recently attempted to distil the heuristics into a list of distinct features that behavioural economics encompasses.
MINDSPACE: The British Government’s Take On Behavioral Economics
In 2010, the Government’s Cabinet Office, in collaboration with the Institute for Government (whose Director of Research, David Halpern, has subsequently moved to head up the Government’s Nudge Unit), published MINDSPACE: Influencing Behaviour Through Public Policy. The authors of this report identified what they perceived to be six key features of behavioural economics that are not accounted for in standard economic theory. These include: (i) the observation that losses loom larger than gains, a phenomenon known as loss aversion – for instance, if one were to lose £20, the magnitude of the hurt felt would be far greater than that of the pleasure of winning £20; (ii) that reference points matter – in standard economic theory, it is assumed that the carriers of value are final assets, but empirical observation has discovered that people often care more about what they gain or lose around what they already have, rather than what they end up with; (iii) that people tend to overweight small probabilities, which is a partial explanation for why a single individual may demonstrate extreme risk loving behaviour (e.g. buying lottery tickets), whilst at the same time in different contexts seeming to be highly risk averse (e.g. purchasing appliance insurance). Daniel Kahneman won the 2002 Nobel Memorial Prize for Economics largely for his work in relation to (i) to (iii), which together form the essence of prospect theory, currently the principal challenger to standard economic theory.
The remaining features, according to the authors of MINDSPACE, are: (iv) that people allocate their money to discrete bundles, so that the value that we attach to a particular amount of money will be contextual (e.g. we might think £5 is a lot if we observe a £5 difference in the price of cinema tickets, but not if we observe a £5 difference between dealers in the price of a particular model of car); (v) the observation of motivational crowding, which confounds the mainstream economic expectation that people will respond predictably to the price mechanism. Standard economic theory assumes that if we pay people to do something, they will do more of it, and yet in a variety of contexts — as shown over recent years notably by the work of Bruno Frey — offering money to people to do something has been shown to ‘crowd out’ their intrinsic, altruistic motivation to do that very thing; and finally, (vi) ‘hyperbolic discounting’, which is the observation that people tend to place an enormous weight on the ‘immediate’ compared to the future, living for today (e.g. eating too much junk food, smoking) and overlooking the future consequences of their actions.
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