The coming of age of behavioural economics
The Nobel Prize recently awarded to Richard Thaler marks an important landmark in the long march to the academic respectability of behavioural economics – the juncture of economics and psychology that departs from the standard homo economicus assumption of fully rational and egotistical players (whom Thaler labelled “Econs”) to the more realistic model of decision-makers with bounded rationality, limited willpower and preferences for fairness and reciprocity (“Humans”).
This is not the first Nobel Prize for behavioural economics: Daniel Kahneman (whose recent book Thinking, Fast and Slow we highly recommend) received the Prize in 2002 for his work on behavioural economics with the late Amos Tversky. Robert Shiller received the Prize in 2013 for his research on inefficient markets (showing that behavioural economics matters for understanding stock market investors). But this year is different as it is a single-winner prize (which has become very rare) and because Richard Thaler is essentially the founder of behavioural economics and whose whole career was built on promoting its principles in academic and policy work.
Thaler himself described a gripping history of this journey in a book Misbehaving: The Making of Behavioural Economics, published two years ago. In the book Thaler recalls a puzzling episode in his early teaching career – an episode that traditional economic models had no way of explaining. When applying a grading curve for an exam in which the average score was 72 points out of 100, he faced a storm of protests from his students. He changed the top score to 137 (so the average score rose to 96) – which caused universal delight among the same students (even though there was no change in the ultimate letter grades – driven by the same curve based on relative grades). They were clearly not behaving according to the standard assumptions of rational economic actors, and as economics students they should have known better! In terms of orthodox economics at the time, the students were “misbehaving”.
Policy applications: the importance of nudging
Thaler’s writings had a profound effect on public policy, with its implication that if humans make suboptimal choices due to irrational perceptions and behavioural biases, policy should correct for these by non-coercively “nudging” people towards the optimal choices. This insight became the subject of a major bestseller Nudge: Improving Decisions about Health, Wealth and Happiness, published by Thaler and the legal scholar Cass Sunstein in 2008. The approach has since revolutionised important public policy areas. For example, by making pension plan savings the default option, policy makers have succeeded in dramatically increasing pension savings rates. “Nudge” policy units have been established within the US and UK governments – as well as in many other countries. His co-author Sunstein was actually running the US “nudge unit” (Office of Information and Regulatory Affairs) in the first Obama administration. The UK “nudge unit” (Number 10’s Behavioural Insights Team) was created and led by a psychologist David Halpern (who wrote a book about his experience Inside the Nudge Unit).
Facing criticism from free market economists that nudging amounted to paternalism, Thaler pointed out that the nudge approach does not take away the free choice from economic actors; the policy just makes the optimal decisions easier. As he stated “much of nudging is just removing barriers to better choices”. As someone aware of the importance of positive framing, he described his approach as “libertarian paternalism”. So if Thaler’s writings have since become acceptable to both free market liberals and more interventionist and socially minded left-wing economists, he certainly nudged them in that direction!
Relevance for transition and development economics
Behavioural economics and Thaler’s work, have important implications for economic transition and development. Policies based on a more accurate understanding of how people actually think and make decisions can help in addressing some of the most difficult economic transition and development challenges, such as increasing productivity, supporting economic inclusion, acting on climate change and promoting good governance.
Economically excluded people are more likely than others to make bad economic decisions. This is not because they are irrational or unwise but because the playing field is biased against them. They are more likely to lack the basic information needed to make good choices, such as which financial product is best for them – or the availability of support programmes (nudge interventions are now a very common tool for increasing the rate of pickup of SME support programmes and so on). They are also more likely to live in societies where mistaken or harmful stereotypes that reinforce exclusion are common, such as that girls should not go to school. They face higher levels of stress and lower margins for error, as any external shock, such as sickness or crop failure, can be life-threatening. This leads to risk aversion and is not conducive to long-term planning and investment. Policymakers can overcome such constraints and biases through nudging towards the socially optimal choices.
Another example is tackling climate change, which also implies dealing with many cognitive biases. The climate changes slowly, whereas individuals’ judgements about the climate are based on what they have perceived recently. People are far more concerned with the present than with the future, whereas many of the worst impacts of climate change could take place many years from now. Some of the risks remain ambiguous, and people tend to procrastinate in the face of the unknown. At the same time promising approaches to action on climate change can also draw on psychological and social insights, addressing the abovementioned biases. For example, people can be nudged to save energy through default energy consumption plans that are environmentally friendly.
Good governance is another area where behavioural economics insights are used. Corporate governance codes and ethics codes help design the “default” behaviour that aligns the interests of principals, agents and society at large. This helps to create new norms – and behavioural economics shows that Humans prefer to follow norms even where the Econs would prefer to pursue their narrow self-interest.