An offshoot of economic theory, behavioural economics focuses on the effects of psychological, cognitive, emotional, cultural and social factors on the economic decisions taken at individual and institutional levels, and how those decisions differ from those set out by classical economic theory. It has used psychological experimentation to develop theories about human decision making and has identified a range of biases emanating from people's psychological outlook and mindset.
According to behavioural economics, people are not always self-interested, benefit-maximising and cost-minimising individuals with stable preferences. Their views are subject to insufficient knowledge, feedback, and processing capability, which often involves uncertainty, and is affected by the context in which the decision is made. Besides, most of the choices made by humans are not the result of careful deliberations. Rather, people are influenced by readily available data, automatically generated effects, and salient information in the environment. People also live in the moment, in that they tend to resist change, are poor predictors of future behaviour, prone to distorted memory, and affected by physiological and emotional states.
Finally, humans are social animals having social preferences, such as those expressed through trust, reciprocity and fairness. They are therefore susceptible to social norms and behavioural tendencies with a felt need for self-consistency.
The study of behavioural economics encompasses how market decisions are made and the mechanisms that drive public choices. One of the applications of behavioural economics is 'Heuristics', which is the use of thumb rules or mental shortcuts to arrive at a quick decision. However, when the decision leads to error, Heuristics can lead to cognitive bias. The 'Game Theory' can also be applied to behavioural economics, as it helps run experiments and analyses people's decisions while making irrational or rational choices. Another field in which behavioural economics can be applied is 'Behavioural Finance', which seeks to explain why investors make rash decisions when trading in the capital market.
Till now, notable exponents in the area of behavioural economics have been the Nobel Laureates Herbert A Simon (1978, theory of bounded rationality), Gary S Becker (1992, motives, consumer mistakes), George A Akerlof (2001, asymmetric information, natural norms), Daniel Kahneman (2002, psychology of judgement and decision making, illusion of validity, anchoring bias), Robert J Shiller (2013, empirical analyses of stock prices, irrational exuberance), and Richard H Thaler (2017, behavioural economics, behavioural finance, nudge theory).
The 2017 Nobel Memorial Prize in Economic Sciences went to the University of Chicago Professor and US Economist Richard Thaler for his incorporation of psychologically realistic assumptions in the analyses of economic decision-making by humans. He has demonstrated through his studies on the consequences of limited rationality, social preferences and dearth of self-control how these human attributes systematically influence individual decisions and market outcomes.
In the context of limited rationality, Thaler's theory of 'mental accounting' explains how financial decision making is simplified in the minds of people through creation of separate accounts in their minds that focus on narrow impact of each decision instead of the overall impact. His theory of 'endowment effect' demonstrates why people value the same thing more highly when they own it than when they do not, because of aversion to losses. Thaler has also been a founder of behavioural finance, which explores the influence of cognitive limitations in the financial markets.
With regard to the realm of social preferences, his theoretical and experimental studies of 'fairness' has generated much interest as it highlights how the concern for fairness by consumers may lead to halting of price-increase by firms during periods of high demand, but not at times of spiralling costs. Along with his peers, he created the experimental tool called 'dictator game', which measures attitude towards fairness among different groups across the globe.
As for the area related to dearth of self-control, Thaler demonstrated how problems of self-control could be analysed through the application of 'planner-doer model', which bore resemblance to the framework used by psychologists to illustrate the inner tension between long-term planning (such as New Year's Resolution) and short-term actions. He showed that an important reason why our long-term plans to save for old age or make healthy life-style choices get thwarted is because we succumb to short-term temptations. The famous 'nudge-theory' co-authored by Thaler and Cass R Sunstein demonstrated how simple 'nudging' can aid people in exerting better self-control in important decision-making like saving for future pension.
Thaler's academic career was greatly influenced by the works of Daniel Kahneman and Amos Tversky, who promoted the idea that economics needed to look at actual human behaviour, instead of making assumptions about it while explaining economic decisions. He played a critical role in pushing economists away from the simplifying assumption of mainstream economics that people always behaved rationally while making economic choices. Instead, he demonstrated through his studies that people departed from rationality in consistent ways in real life situations; consequently their behaviour could still be anticipated and modelled.
While declaring the Nobel Prize in Economic Sciences for 2017, the Royal Swedish Academy of Sciences declared, "Richard Thaler's contributions have built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy." The Nobel Committee credited Thaler for moving economics towards a more realistic understanding of human behaviour, and for using the resulting insights to improve public policies. Another winner (2013) Robert J Shiller hailed Thaler as "One of the most creative spirits in modern economics."
Nudge theory and its applications: Richard Thaler co-authored the global best-seller 'Nudge: Improving Decisions about Health, Wealth and Happiness' in 2008 with another US professor Cass Sunstein, which generated much interest across the globe. The book argued that governments could use behavioural insights to improve the quality and efficiency of a wide range of public services. The theory has influenced politicians and policy-makers alike at many places over the years and even helped boost British tax-receipts and encouraged smokers to become 'vapers'. Governments could observe that people's behaviour could be altered or influenced even by changing the wording of tax demands. Apart from advising policymakers in several countries including Denmark and France, Thaler was made an advisor by the British coalition government of David Cameron in 2010 to establish a 'Behavioural Insights Team', nicknamed 'Nudge Unit' at the heart of Whitehall. Harvard Professor Cass Sunstein, on the other hand, was similarly recruited by the administration of President Barack Obama in the White House to work on practical applications of the nudge theory.
The Nudge Unit of the UK government ran dozens of experiments, and the early results were promising. In one case, the use of plainer English led to doubling of the number of people paying vehicle taxes, and addition of a photo led to a tripling of the payments. In another instance of 'goal substitution' by replacing the term 'lower energy use' with 'cleaning out the attic', a threefold increase was observed in the receipt of insulation grants for improving energy efficiency at home. Elsewhere, a study on the teaching of technical drawing in French schools discovered that the boys did better if the subject was called 'geometry', but the girls did equally well or even better when it was called 'drawing'. This led to the training of teachers in using appropriate terms for better academic output or outcome.
Founder of the Danish Nudging Network (a non-profit organisation) Pelle Guldborg Hansen tested two potential 'social nudges' in Copenhagen by partnering with the local government. They used symbols in their attempts to influence consumer choices. Green arrows pointing to the stairs were drawn next to a railway-station escalators in one trial with the objective of encouraging people to choose the healthier option, but it had almost no effect. A series of green footprints leading to rubbish bins were painted in the other trial. This led to a reduction of littering by 46 percent during a controlled trial when wrapped sweets were distributed. Hansen concluded that there was no social norm about taking the stairs, but there was about littering.
Cultural differences can also have a big impact in nudge-based decisions. In America for example, high users of energy tended to use less when told about how they compared with their neighbours in terms of energy consumption. In contrast, the French tended not to comply as easily with perceived social norms like those by the Anglo-Saxons, a study in France revealed. The nudge theory adherents hold the view that requiring the members of the public to take a decision is likely to make them overcome an inclination to procrastinate over unpleasant choices. The nudge theorists also focused on the role inertia played in decision-making and the tendency among people to adopt the default option from a range of choices. Based on this, the British adopted a legislation whereby the employees are automatically enrolled in corporate pension plans unless they actively choose to opt out.
As claimed by the popular periodical The Economist back in March 2012, the nudge revolution in a nutshell encourages the use of plain language by governments, favours the design of policies that take account of real-world behaviour, and supports the testing of ideas on a smaller scale before their implementation on a wider range. It certainly holds much potential for applications in public policy and governance, as well as the capital market and marketing of commodities by the private sector in developing countries like Bangladesh.
The conduct of speculators in the stock market of Bangladesh can be understood better in the light of behavioural economics. Their behaviour cannot be called rational based on indicators like price-earnings ratio of shares. This phenomenon broadly explains the apparent unpredictability of share prices in Bangladesh, and provides opportunities to numerous manipulators to make quick money from the market through ploys like insider trading or collusion.
Similarly, appropriate or lucrative wordings in advertisements can draw mostly uninformed Bangladeshi consumers to many products, including real estate and housing, medicines and contraceptives, despite their dearth of quality. Here again, the manipulators often succeed in hoodwinking the Bangladeshi public through attractive texts, messages and pictures.
(Dr Helal Uddin Ahmed PhD is a retired Additional Secretary, former Editorial Consultant of The Financial Express, and ex-Editor of Bangladesh Quarterly. Email: [email protected])