The case for behavioural economics
Will behavioural economics shape public policy now that one of its advocates has won the Nobel Prize?
Mainstream economics assumes that humans take into account all the available knowledge to make decisions and thus identifies them as rational decision-makers. All of its theories are based on this core assumption. However, economists like Daniel Kahneman and Richard H Thaler have long challenged this paradigm, both winning the Nobel Prize in economics for their dissent. Kahneman won the award in 2002 for integrating psychological principles into economic theory and Thaler's award was announced by the Nobel Committee on October 9, 2017 for "his contributions to behavioural economics".
Economic thinkers appropriating behavioural economics say humans are irrational and that policies need to be designed in a way that they choose to make rational decisions. Some mainstream economists though consider behavioural economics as a quirky field and do not relate to it. There are also some from within the field, like economists Robert Sugden and Nathan Berg, who have questioned the empirical and ethical grounding of Thaler's work.
Now as the Nobel Committee has recognised Thaler's work, many economists, including Kahneman, have welcomed this shift in global attitude towards behavioural economics.
AKSHIT SANGOMLA speaks to three experts to discuss the significance of behavioural economics and its implications for creating effective public policy
"What other economics is there?"
THE 2017 Nobel Prize for Richard H Thaler is a significant moment in economics. Neo-classical economics assumes unbounded rationality and emotionless deliberation. Behavioural economics uses an explicitly economic framework, yet borrows freely from psychology, sociology and neuroscience. Its explanatory power is vastly superior to any currently available alternative.
Thaler used “loss aversion” (losses bite 2.5 times as compared to the elation from equivalent gains) to explain the following two important puzzles. First, the mere ownership of an object increases the value to the owner (endowment effect); parting with the object triggers loss aversion. This explains why humans and animals fight aggressively to defend their respective territories.
Second, the return on equities relative to bonds is too high, even after accounting for the extra risk on equities (equity premium puzzle). Thaler showed that loss aversion causes the downside movement in fluctuating equity prices to be magnified 2.5 times, requiring a premium relative to bonds. In 1980s, Thaler did experiments with Daniel Kahneman which showed that humans have social preferences that also take account of fairness concerns.
In a set of columns titled “Anomalies” (of the neo-classical model) in the Journal of Economic Perspectives, Thaler popularised behavioural economics. He showed that when people make choices over time, losses are discounted less than gains as are larger outcomes relative to smaller outcomes. He also showed that when bidders bid in auctions for an object with uncertain costs, then the bidder who estimates the lowest cost, bids the highest, but an unpleasant winner’s curse awaits the winner.
In a path breaking idea, Thaler showed that people have mental accounts across which money is not fungible (mental accounting). Further, people are averse to mental accounts going in red (net negative balance). Hence sunk costs, by pushing mental accounts into red can influence behaviour; under neo-classical economics sunk costs don’t matter. Thaler introduced emotions and self-control issues into economic models by modelling human decisions as a game between a long-run planner trying to control a series of short-run doers in his planner-doer framework. This can explain addictions, inadequate savings and procrastination.
Finally, in his most recent work with Cass Sunstein of Harvard, well described in their book Nudge, they have broken new ground in welfare economics. Their idea—libertarian paternalism—gives a gentle nudge to rational people to improve their welfare, yet has no effect on fully-rational people. Examples of nudges are default options, such as opt-in or opt-out, which have had a massive effect on savings, pensions, and organ donations.
Thaler’s recognition with the Nobel should finally eclipse the fictional creatures, Econs, in neo-classical economics and, usher a new era of a eclectic and empirically-founded science of economics based on behavioural economics.
"Everything else is not always equal"
CETERIS PARIBUS" or keverything else is equaly is the universal assumption in economic theories. For sociologists and psychologists, Thaler’s Nobel is a moment of glory, for it emphasises why economics is becoming more khumany with incorporation of psychological and sociological considerations.
However, does nudging always work in developing countries? Nudge theory presents us with behavioural interventions that are beneficial. Economists argue that people choose the most convenient option than what may be kwisesty to them, thereby succumbing to irrational temptations. This premise may explain the behavioural inertia experienced with Swachh Bharat Mission, where changing mindsets became the recent zeitgeist supplementing making toilets.
However, ka one size fits ally centralised application of nudge may go against the very idea of a bottom up decentralised paradigm, which the nudge espouses— that of enabling individuals.
A case in point to overhauling public policy dissemination was the annulment of the Planning Commission in 2015, and resurrection of decentralised principles of kcooperative federalismy through the niti Aayog. The think tank was formed with a vision to lend autonomy to states. However, it instituted a knudge unity in collaboration with Bill and Melinda Gates Foundation later, to propose solutions to behavioural impediments encountered in government schemes.
kInfluencingy behaviour by proposing solutions, so that communities steer towards directed outcomes is not democratic persuasion, rather akin to coercion and manufacturing consent.
Interventions guised as nudging require effective supplementation of efforts with adequate social, cultural and political wherewithal. Such holistic approach attempts at minimising binaries between kplannersy and kbeneficiariesy. Limited application of klibertarian paternalismy where people are not denied a choice, yet nudged in a direction may, however, result in choreographed outcomes to fulfil targets, without any regard for the autonomy of an individual.
For example, the sudden change induced by declaring 86 per cent currency null and void last November, to gravitate towards a cashless society, while penalising those with unaccountable cash, caused grave discomfort to rural and tribal populations.
While the intent of this scheme was noble, a sudden expectation in behavioural change resulted in a complete breakdown of ecosystems. kDigitising behaviour,y by encouraging people to use ke-moneyy, required deeper empathy with people’s agonies; understanding the elderly’s plight, differently-abled’s hardships and poor’s marginalisation. Effective implementation in this case first required creation of critical infrastructure and awareness on use of digital payments. Such kIndianisation of nudgey resulted in a catastrophe with ripple effects paralysing the unorganised sector that accounts for over 90 per cent of our workforce.
A successful example of nudge by the government is PM Ujjwala Yojana through which bpl households switch from firewood to
SANJIT DHAMI Professor of Economics at the University of Leicester and a Fellow of CESinfo, Munich
SWASTI PACHAURI social sector professional. Was a Prime Minister's Rural Development Fellow during 2012-2014