Behavioural Economists in Action

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“Simplicity is the ultimate sophistication.”

Leonardo da Vinci

With Apple’s compelling headline for the first marketing brochure, Steve Jobs proclaimed his guiding tenet of simplicity. The world’s multinational corporation may have derived inspiration from the field of economics. Just as simplification allowed Steve Jobs to establish his reputation, economists cleave complex processes to assume theories and develop understanding.

One of the assumptions undertaken for the benefit of modelling is that individuals are rational through the fundamental credo of rational choice theory. Since all people act differently in the real world, such a simplification fosters economist to structure the understanding of human behaviours. In his 1953 essay titled “The Methodology of Positive Economics,” Milton Friedman regarded the scientific method as the basis: assumptions to provide pragmatic predictions.

However, though assumptions allow economists to create a model with constancy, behavioural economics researchers have recently suggested that individuals are prone to suboptimal decisions.

Contrasting to the assumptions of the singularly rational Homo economicus, psychologists and behavioural economists have been analyzing the thinking processes through the dual-process model for years. Such a model assumes that people consist of two principal methods of thinking: System 1 and System 2. Though traditional economic models assume that System 2 is the dominant hand that guides our decisions, recent behavioural research disagrees.

While both of these systems collaborate to help human decision-making be efficient, System 1 is prone to biases, rendering our actions irrational. This irrationality opposes the assumptions made by traditional economists about Homo economicus.

As the revolutionary study was done by Daniel Kahneman and Amos Tversky, the pioneers of behavioural economics, cognitive biases refer to human decision-making’s irrational errors. Behavioural economist Herbert Simon states that when individuals face complex decisions, they depend on heuristics through System 1 thinking. Though heuristics, one of the forms of cognitive biases, are convenient when dealing with imperfect information5 and limited time in which to make a decision, it may be irrational. This suggests that consumers’ rationality is easily compromised; humans are rational, but only in certain situations.

The anchoring and framing heuristics:

Anchors generate a bias for particular decisions. For example, if a grocery store displays a ‘15% off’ sign at the entrance and has ‘up to 25% off’ sign inside, the first sign would be the anchor, which becomes the standard for judgment. Therefore, consumers will consider ‘up to 25% off’ sign attractive as it has a relatively higher discount rate than the anchor. Moreover, even the entirely irrelevant anchor may affect people’s decisions, according to Kahneman and Tversky. One of their studies surprisingly showed that the judges who rolled a high number tended to order longer prison sentences to a shoplifter than those who rolled a low number: the numbers on a dice affected judges’ decisions without them realizing it. This again limits making rational choices as individuals may be subject to anchoring in markets and other real-life situations.

The process of framing also affects individual choices just as anchoring does. The way that a choice is ‘framed’ is likely to affect the actors’ choice, even when different options have the same outcomes. An experiment known as the Disease Problem asked participants to assess two different methods of curing a disease. Astonishingly, people tended to choose a proposal that framed the percentage of people who would ‘live’ over another that expressed the percentage of people who would ‘die,’ even when the probabilities were the same. A rational System 2 thinker would notice that the two proposals were the same, but the result proved how framing affects most people not to consider the choices deliberately.

As with all interlinked concepts, bounded rationality and bounded self-control are crucial to understanding other limitations to human rationality.

Bounded rationality and imperfect information:

Cognitive biases do not assure that human behaviours are completely irrational; instead, Dan Ariely points out that humans deviate from the traditional assumptions predictably.

In a real-life situation, we rarely encompass perfect information to evaluate our choices fully. If one were to buy a mobile phone plan, one probably would not have access to every firm’s data. Even if one did, as the information would be presented in different structures and with different wordings, it would be tough to compare those data. Imperfect information and limited time are what make one’s decision not entirely rational.

With all these limitations, consumers often make choices that are indeed satisfying, but not maximizing.

Bounded self-control:

In addition to the assumption that rational consumers would know how to maximize their utility
(what to choose), they should know how much to consume. According to the law of diminishing
marginal utility, consuming more than when marginal utility is zero will decrease total utility.
While the traditional assumption suggests that consumers are fully aware of when precisely this
is, it is complicated to determine in real-life. There are even some cases when consumers make
choices that will result in negative utility.

Think about how often you spent on Netflix or excessive leisure times with friends. Even during an important period, people make these choices despite the cognizance of negative impact on their learning or duty. This is because of bounded self-control.

This brings up another link with behavioural economics theory that consumers value the present more than the future: people consume too much leisure at the expense of their future successes. Such hyperbolic discounting causes consumers’ preferences to be inconsistent over time. People cannot control their present selves to achieve their future goals especially when choices and the following consequences are separated with ample time. Thus, the assumption that our preferences are consistent over time does not always hold.

While economists assume that consumers behave rationally to price changes according to the law of demand, the aforementioned cognitive biases could overturn the theory. Businesses can also manipulate this cognitive bias, i.e., setting a high anchor price to render consumers pay more. However, not all producers follow the incentives to maximize profits as there are firms that pursue alternative objectives. They must be identified to understand business decision-making’s full complexity.

Corporate social responsibility (CSR):
Firms that pursue CSR may commit to providing fair wages to their employees and offering
decent benefits – good health care coverage and family leave. They may not abuse their power to weak suppliers or even give back to their communities for improvements. Many businesses realize the necessity of reducing social and environmental risks for their future businesses. Coca-
Cola has made significant changes to reduce 25% in their carbon footprint (avoid pollution), through investing in new fueled trucks.

It could be argued that actors in the market do not always make optimal choices with all these myriads of factors that influence them. Market corrections and bubbles, and even income inequality, could be the implications of choices that behavioural economists would argue are irrational. Government policy can be used a means to rectify this.

Default choice:
Setting a default choice is one way to craft the choice architecture. The purpose addresses the
consumers who do not use System 2 to make rational choices or without clear preferences.
A successful example would be retirement savings. As saving for retirement over a long-time
during employment is essential, joining an appropriate pension saving plan would be a necessary choice that people confront. Realizing this, many firms and organizations now automatically register their employees in a retirement plan – but they could actively choose to opt-out. Such a change has already helped people to have more considerable savings over time.

But still, such a solution has implications of limitations. Intelligent businesses may abuse default
choices to maximize their revenues, to the expense of consumers. For example, many online
magazine subscriptions have an automatic choice of renewing subscriptions annually. However, a portion of subscribers may not want this. Then consumers might eventually spend more on
subscriptions than they desire.

Thus, default choices may be a powerful tool to help consumers make rational choices, but businesses may manipulate choice architectures and cause unintended consequences.

Nudge theory:
As a relatively new behavioural economics concept, nudge theory gained publicity by the book
Nudge by Richard Thaler and Cass Sunstein. Governments across the world currently use nudges
as a component of policies in order to influence consumer behaviour: UK’s Behavioral Insights
Team. Successful examples of nudges could be the default savings plan mentioned earlier,
painting of flies on urinals to curtail cleaning costs in men’s bathrooms and text reminders to pay taxes.

Still, nudge theory has been criticized for ethical issues as critics view it as a form of
manipulation. However, Richard Thaler and Cass Sunstein state that decision-making context
always affects choices; suitable nudges do not limit human decision-making. As long as choice
architecture is set along with people’s general preferences, nudges would be an appropriate
public policy.

The traditional economic theory has been claiming that individuals use rational calculations to make rational decisions. Economists simplified people’s behaviours to an assumption for the benefit of providing pragmatic predictions. Indeed, those assumptions improve the constancy of an economic model. Nevertheless, the recent behavioural economics study – cognitive biases, bounded rationality, and alternate objectives of firms – must be acknowledged to absorb human decision-making’s full complexity. (Is this a nudge?)

Ki Myoung (Andrew) Cheon

He is a Student in NLCS Jeju

Economics

Dongwook Kwon

He is an Editor for NLCS Hub Humanities

NLCS Hub