The rise of behavioral economics
Economics in real life deals with imperfect information and less than rational decision makers.
The Nobel Prize for economics in 2017 was given to Richard Thaler for the field of behavioral economics. His book Nudge propounded on the effectiveness of small steps, as in the recommendation to paint the drawing of a small fly on urinals in an airport to motivate users to reduce splatter. By aiming the piss at the image, male patrons reduced the cost for cleaning male washrooms.
This economics award for the field of behavioral economics follows an earlier (2002) prize given to psychologist Daniel Kahneman on the influence of psychology (and emotions) on “human judgment and decision making under uncertainty.”
The Nobel for economics was a later addition (1969) to this distinguished prize established in 1895, originally only for five categories — Chemistry, Literature, Peace, Physics, and Medicine. The economics prize “in memory of Alfred Nobel” was established by Sveringes Riksbank, the Swedish central bank. It has been given 48 times to 78 awardees. For certain years, the prize went to more than one winner.
Traditional economics previously relied on the rational man with complete information. Decision making was often reduced to mathematical models with these assumptions.
More contemporary economic writers like Steven Levitt and Stephen Dubner ( Freakonomics) delve on the psychological drivers of economic decisions — like why parents bequeath more to their grown-up children who visit them regularly. Tim Harford, an economist and part of the editorial board of the Financial Times also gets quirky with his undercover economist pieces and books. He notes the merits of kleptocracy — “the dictator has to keep the economy functioning in order to keep stealing from it.”
The model of the consumer in the rational school of economics is a construct known as “homo economicus.” This mythical person is always looking to optimize monetary value and weigh options with only money in mind, looking for complete information on other options and opportunity costs. Does this type of behavior describe real life and how consumers or investors behave?
The investor relying solely on quantifiable data like price/earnings ratios, price as a multiple of book value, present value of an acquisition will always be there, usually in the research departments of banks or stock brokerages. Not only are statistics usually late in coming, but they can sometimes be unreliable. This is also the basis of the theory of efficient markets which holds that even if the market is wrong, it is still right.
Hence, the topics in behavioral economics now routinely stray from the usual path of GDP, tax reform, and the theory of efficient markets. In his 2007 book, Discover Your Inner Economist, Tyler Cowen, delves on the subject of using cash outside a non-transactional corporate setting. Should you give cash to your daughter to wash the dishes (don’t). Economics involves signaling intent and paying for what should be one’s contribution to household chores sends the wrong message. (Can I also get money for doing my homework?)
Cowen also propounds on the whole business of Christmas gifts (timely, with just 69 days before Christmas). He thinks these are often a waste of money, as there is always a gap between the value perceived by the recipient (receiving a book one already has places that gift to zero value) and the actual price of the gift to the giver. The asymmetry of expectations and benefits become equal only with an exchange of cash gifts. Another economist, Steven Landsburg ( The
Armchair Economist, 1993) argues that cash gifts work best for Christmas as there is no problem with color or fit when the recipient can choose for herself what to buy with the money, or whether she will spend it at all. What about the allocation of scarcity, in this case time and effort to get a perfect gift? Landsburg argues that money is after all even a scarcer commodity which the giver had to work for.
Going back to the Nobel laureate of 2017, Richard Thaler — his observations often have the ring of street wisdom. His comment may explain why people order the same menu over and over in their favorite restaurant — “never underestimate the power of inertia.”
Economics in real life deals with imperfect information and less than rational decision makers. Now, there is also the new element of fake news blogs… and those with an economic incentive to push them.