ABCs of Behavioral Economics

What is Behavioral Economics?

The axioms and the theories in the field of economics have all one thing in common: they are based on this hypothesis that the economical agents are Homo-Economicus; meaning that they are rational, logical people, capable of taking all the aspects of each situation into account, and analyze rigorously all the options, and then choose the optimal one; the choice that yields the best outcome in sense of either utility or other optimal and efficient results.

These Homo-Economicus agents (or “Econ”s) are efficient, logical, and the best decision makers. They never make mistakes; they never fall into temptation of choosing sub-optimal choices. Just like Odysseus, when he tied himself up on the deck of his ship in order not to fall under the enchanting spells of the Sirens, and at the same time being able to enjoy the beautiful sound of their singing, all the ‘Econ’s are able to control themselves and make the best of each situation and maximize their utility.

behavioral economics
[‘Odysseus and the Sirens’ painting by English School, July, 2016]

But these are all in theory. Convincing and beautiful theories, which unfortunately hardly can be convertible to real life. The truth is that we, as Humans, are imperfect. We have bounded rationality and irrational behaviors and ideologies and we are extremely susceptible to biases, errors and illogical and irrational decisions. We make mistakes. Lots of them, and frequently; and sometimes without even knowing it. We make sub-optimal decisions on daily basis and we may not even realize it.

One might argue that almost all social sciences are broad and just theoretical and hardly applicable to real life. But Economics (the so-called ‘dismal science’), should have a different outlook than other social sciences. Ever since Paul Samuleson, the ingenious American economist, applied mathematical approach to economics, it has been regarded as a more rigid and directly applicable field.

Due to these mathematical foundations, field of Economics has been able to survive all its critics and the whirlwind empirical studies that show the ineptitude of the most economic models. Nevertheless, the formulas and the math incorporated are not the problem. In fact, behavioral economics needs these foundations; but the riff is with the assumptions preceding these formulas; that every individual in a society, will act predictably and completely in compliance with these formulas and assumptions.

Behavioral economists advocate a more realistic approach to the concepts of economics. 

Ever wonder why economists are so bad at predicting important events, such as financial crises, down-turns, stock market movements, etc? The answer may lie in the models they use.

Data shows that from 1988 to February of 2020 (before the Covid pandemic hit), there has been 469 downturns in total, all around the world, and only 4 of those economic declines were predicted at least a year in advance by economists employed at IMF. It clearly shows that the economists are completely incompetent when it comes to predicting recessions! (I chose the word ‘incompetent’, instead of my first rough draft phrasing: “economists kinda suck at this!”)

It means they are accurate less than 1 percent of the time! (Only 0.85%). But these scientists and seasoned economists are not imbeciles or idiots. The fact of the matter is that predicting human behavior is quite hard and sometimes impossible, which attributes to the volatility we see every day, either in the stock market, housing prices, bitcoin’s value, or other situations.

According to the rational agent models, the way a question is asked or a phrase is conducted, would not (and should not) affect the answer or the behavior of an Econ toward it. But in reality, the empirical evidence and lots of experiments done by Psychologists and also economists shows that we may choose differently among two options, solely based on how a question is asked.

We also may have a negative or positive attitude toward an idea or a person, only by irrational reasons such as their name (the “halo effect”). The way a policy is named can, and does make people react differently to it. This fact has not been unnoticed by savvy politicians and political operatives, and even some unscrupulous marketers. For instance, Frank Luntz, a Republican consultant and operative, has coined the term “Climate Change” and convinced other Republicans to use this term instead of “Global Warming”. He did this after the rise of concern and collective attention to the environment and the negative effects of the modern industrialization.

It was part of an elaborate scheme constructed by Mr. Luntz, ahead of 2004 presidential election. He sent a memo to the President Bush’ administration and other Republicans and instructed them to abandon the term “global warming” and also “continue to make the lack of scientific certainty a primary issue in the debate.”

If we were all Econs, change of a word would not affect either we support an idea or not. However, the ‘Climate Change’ in fact seemed more benign and not as dangerous or urgent as ‘Global Warming’; I think maybe it’s because people instantly would think of changing of seasons and temperatures; so it would seem natural or even healthy to have “Climate Change”! It shows that we are dealing with Humans.

Luntz’ way of messaging and talking points have helped his fellow Republicans to evade the environmental issues such as rise of concern over fossil fuel and fracking. (As a neutral by-stander, I must admit I do not have much knowledge about fracking and its consequences. I am writing this with utmost impartiality, and only want to focus on the way this issue has been talked about, not how it has been handled.)

Another example is the “Death Tax”. This term was also adopted by Republicans to substitute the more neutral-sounding “inheritance tax”. So, ‘Death tax’ is just another name for ‘inheritance tax’, but it is designed to make people think of it as unfair and unjust. If we were in fact Econs, we would understand that the name should not have an impact on how we feel about the percentage level of a tax bill. But, since we are humans, we may perceive it as rather unjust for the government to expand its authority and power over our lives and lives of our descendants and heirs even after our death.

These are the clear examples of ‘Framing Trap’, showing that in spite of what we have been told about the rationality of agents, they can be persuaded by trivial and apparently non-important factors such as the framing of a sentence or the mere name of a policy.

Behavioral economics

Endowment Effect

Behavioral economists such as Richard Thaler, professor of Behavioral Science and Economics at the Chicago University, has long been advocating for a change in the field. He first came across some inconsistencies in the way that the agents ‘should’ operate and make decisions versus how he people actually ‘do’ make decisions. Thaler closely paid attention to others, even some of his professors and their actions and conducts, and saw that they regularly breach the rational model hypothesis and act as the opposite of ‘Econ’s. He was taught the classical theorems at the university and saw the opposite of those theories happening outside, in the real world.

He encountered one professor who exhibited violations of supply and demand theory, which states that the in a free market, buyers and sellers would agree on a price that will leave both of them happy, with highest utility which will result in an efficient market. That professor, who was a wine enthusiast, had a collection of wines from around the world. When asked whether he prefers to sell one bottle of wine with a price of the market or keep it, he chose the idea of keeping it. Even when the hypothetical price went up, he still declared that he would keep his good wine and consume it rather than sell it to someone else; which is a clear violation of basic economical axioms. His dear bottles were obviously worth too much to him. But why??

If we follow the classic economic theory of willingness to pay and willingness to sell and if this axiom always prevailed in a free market, the owner would have to be willing to sell his bottle the same price as it is worth in the market. But the owner, refused to sell even higher than that price. This brings us to the Endowment Effect.

Endowment Effect states that the negative-utility (dissatisfaction) we feel when we lose something, is not as much as the utility we get when we acquire that thing, but it is twice more! In other words, we feel the loss twice more than gain. A loss of an object that we own will give us more dis-pleasure and sadness than the happiness we would get if we got the same thing. That’s why we, as humans, hate losing. This also helps explain risk-taking behavior of some people.

Behavioral economics

Mug Experiments

Thaler tested this hypothesis by doing a lab experiment. He asked 20 students to volunteer for this, then bought 10 coffee mugs and then 10 pens and at the end assigned these items to each student randomly. He then told them to look at the item they have, completely inspect it and then if they want, trade it with the other good. So if a student got a mug, he was able to trade with another person willing to trade his pen with a mug. In theory this random assignment would result in 50 percent trade. Meaning, at least 5 students who value a mug more than a pen (a mug was just slightly more expensive than the pen, and the pen had the price tag on it), would be willing to trade with the other 5 who wanted a pen more than a mug. This would mean 10 out of 20 students conducted a trade. So, 50 percent.

But this isn’t what happened. The percentage of actual trade was way lower. Students were sticking to what they have been assigned to. They didn’t want to lose what they had in their hands, which didn’t make sense because a) it was randomly assigned b) the mug was even a little more pricy.

This is also called a status quo bias, or loss aversion.

This experiment was done in another format as well. In this version, after the random assignment of mugs and pens, the students were asked to evaluate the items. If they got a mug they could see also other people’s pens and then they had to write down the amount of money up to 5 dollars, that they are willing to give to purchase that item. For instance if they had a mug and wanted to acquire a pen as well, they could write down the maximum amount they are willing to pay and also the minimum amount they are willing to sell their own item (in this case the mug).

In both groups, the average value that the mug owners gave to their mug was much higher than the average value the pen owners gave to the mugs. Symmetrically, the median price of pens declared by pen owners was way higher than how mug holders estimated them. In other words, the mug owners estimated their mugs so much higher than how pen owners valued the mugs.

There is an obvious discrepancy in the valuation. The owners overvalued their own items.

This clearly shows that the willingness to pay and willingness to sell prices do not match when the owners of goods want to sell their own items. The participants show severe case of status quo bias and endowment effect.

These particular experiments have been replicated over the years by many different researchers, and they all yield the same results. The same experiment, albeit with modest modifications such as changing the pen to chocolate or other goods. However, the results always affirm the endowment effect theory and status quo bias, and show that we hate to give up the goods which we already have in our hands.

Behavioral economics

Empirical Evidence

In the conventional economics, the utility function of a consumer shows the set of goods that a consumer is able to afford, which would give them the highest utility (satisfaction). The higher the curve, the better; more satisfaction. And that curve also will show us the trade-off between two or multiple goods.

Based on empirical studies done, we can see that due to endowment effect, when people are faced with two options, which depict a sure loss or a potential bigger loss, they opt for the potential one. For example, imagine a hypothetical case like this: if someone was given an option of losing 200 Euros for sure, or 50 percent chance of losing 400 euros, they will use the second option. However, if we take the classical economics rout, the utility function formula would tell us that a rational and neutral agent will be indifferent to these two options because both of them would yield negative 200 utility.

U (1) = -200
U (2) = (1/2) × (-400) = -200

Behavioral economics

The Father of Economics

When Adam Smith’s name is brought up, the first things that comes to mind are ‘The father of Economics’; and “the Wealth of a Nation”, which laid the ground work for Capitalism and the basis of almost all the western economies.

However, we might need to take another look at his other book “The theory of moral sentiments”, which he published decades before the wealth of Nation. In this book he writes about the fundamental “human nature” and the ever-lasting conflicts of our “passions” and our inner “impartial spectator”. He argues that by evaluating our own behavior and curbing our passions and animalistic desires, we employ this inner “impartial spectator” that is the source of, as he put it “self-denial, of self-government, of that command of the passions which subjects all the movements of our nature to what our own dignity and honour, and the propriety of our own conduct, require”.

Human nature and the sources of behavior (and misbehavior) were not alien to Smith. He was well aware of our irrational, self-serving and passion-seeking side. He did not believe we’re all rational, informed Econs, always making the best decisions or judgments.

We should bear in mind that Smith was also a philosopher, and that is why behavior and the nature of Humans have not passed his sight un-noticed.

Behavioral economics

Conclusion

‘Behavioral Economics’ sprang from the great works done by two tireless and brilliant Israeli psychologists Amos Tversky and Daniel Kahneman, which were the first inspiration to Richard Thaler to pursue this line of research. Their findings and inquiries into the minds of humans and our decision-making process have had an enormous impact on the fields of Economics, Finance and the unlikely alliance between the so-called ‘dismal science’ (i.e. Economics) and field of Psychology. Kahneman and Tversky’s novel way of psychoanalysis and data-driven approach has truly revolutionized the way we think about rationality and decision-making in general.

Nonetheless, behavioral economic aficionados do not call for complete abandonment of all the foundations of Economics, and the classical theories. But what they try to do, is achieving accuracy by injecting some reality into the old hypotheses, and taking into account the human side of us. We have to come to terms with the fact that we are humans and easily susceptible to biases and irrationality. Not Econs; who master the art of rational thinking and optimizing.

Behavioral economics

[References:

Thinking, Fast and Slow”, by Daniel Kahnemann

Misbehaving”, by Richard Thaler

The Theory of Moral Sentiments”, by Adam Smith

Nudge”, by Richard Thaler and Cass Sunstein]


Maryam Rahmani

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