There seem to be countless stories about the times that economists have misjudged the state of an economy or its markets. The 1630s speculative asset bubble in Dutch tulips in which tulips were worth as much as houses (Roos, 2020) or the 2008 financial crisis that nearly collapsed the banking system are examples that spring to mind. Because of such events, it brings into question the effectiveness of the models used within our modern economic system. However, the issue that we experience with these models is not that they do not function. On the contrary, these models can be very useful for modelling outcomes and decision-making, especially that of rational agents. The problem is simple - human beings are not rational economic agents.
A person does not perfectly smooth consumption over the entirety of their life because they are merely credit-constrained (Friedman, 1957), they do so because it is not in their nature. The idea of hyperbolic discounting, or ‘present bias’, highlights the idea that humans are impatient (O'Donoghue & Rabin, 2015). We desire “immediate gratification” and as a result, our choices, and the decisions that we make, are time-inconsistent. Frankly, the future seems too distant to thoroughly consider and plan, resulting in individuals preferring smaller payoffs today over a larger payoff tomorrow. This fundamental part of human behaviour should not be something external to our models. It should not be an exception to the rule that we use to account for variation in our results, and should, instead, be incorporated within its foundations. Ex-Chief Economist for the Bank of England, Andrew Haldane, has said that economics fails in the way that it does not incorporate commonly known irrationalities into “narrow” forecasting models (Giles, et al., 2017; Inman, 2017). This is where we introduce the field of behavioural economics.
Before we can delve into the depths of this field, we must consider what exactly behavioural economics is and why is it so relevant. As one of the forefathers of the field, Professor Richard Thaler, puts it:
“It is still economics, but it is economics done with strong injections of good psychology and other social sciences.” (Thaler, 2015)
The traditional economics models fail to account for the heuristics and biases that are an essential part of human nature. Heuristics (or rules of thumb) come from millennia of evolutionary development that helps to speed up our decision-making processes, but they leave us open to irrational errors and miscalculations. Whilst social heuristics can be useful from an evolutionary standpoint, they cause nightmares for those trying to forecast economic models. Behavioural economics combines psychological insights with the traditional models used by economists to produce more insightful, irrationality-accepting versions.
One of the most common applications of behavioural economics comes from Nudge Theory. Thaler and Sunstein (2008) deliver arguably some of the most influential work in behavioural economics in their book ‘Nudge: Improving Decisions About Health, Wealth and Happiness’. The book is based on the idea that one can use small, ‘liberty-preserving’ approaches that guides decision-making towards a particular choice (Sunstein, 2018). It is key to their approach that the individual’s liberty with regards to decision-making remains unaffected, as it aims to be more liberal in its approach than traditional bans or mandates.
This has been used very effectively across public policy in many countries, with the UK government setting up its own Behavioural Insights Team, or ‘nudge unit’, in 2010 (Behavioural Insights Team, 2022). The UK has introduced automatic enrolment in pensions schemes (UK Government, 2022) to attempt to counteract the effects of present bias, which leads to an under-contribution to pensions. The automatic enrolment uses the notion of ‘status quo bias’, in which most people stick with the default choices to avoid the effort of manually changing out of this default. As a result, “around 90% of eligible workers [have become] enrolled in a workplace pension” (Behavioural Insights Team, 2020), leading to improved long-term financial security. Whilst an automatic enrolment default guides individuals towards increased saving, it is liberty-preserving in its approach.
Behavioural economics is still a relatively new branch of economics, and there remains a long path to integrating behavioural understanding into economic models. A more integrated approach is essential in the development of economics if it wants to maintain its accuracy in predicting and shaping the future of the world’s economy. This article has only touched upon the extent of this field, and for a broader understanding, I would recommend the book ‘Misbehaving: The Making of Behavioural Economics’ by Richard Thaler.
References Behavioural Insights Team, 2020. Nudging young people to engage with pensions. [Online] Available at: https://www.bi.team/blogs/nudging-young-people-to-engage-with-pensions/ [Accessed 20 January 2022]. Behavioural Insights Team, 2022. Who We Are. [Online] Available at: https://www.bi.team/about-us/who-we-are/ [Accessed 20 January 2022]. Friedman, M., 1957. The Permanent Income Hypothesis. In: A Theory of the Consumption Function. s.l.:Princeton University Press, pp. 20-37. [Online] Available at: https://www.nber.org/system/files/chapters/c4405/c4405.pdf Giles, C., Tetlow, G. & Parker, G., 2017. Economists hit back at crisis claims after post-Brexit vote misses. The Financial Times, 6 January. Inman, P., 2017. Chief economist of Bank of England admits errors in Brexit forecasting. The Guardian, 5 January. O'Donoghue, T. & Rabin, M., 2015. Present Bias: Lessons Learned and To Be Learned. The American Economic Review, 105(5), pp. 273-279. Roos, D., 2020. The Real Story Behind the 17th-Century ‘Tulip Mania’ Financial Crash. [Online] Available at: https://www.history.com/news/tulip-mania-financial-crash-holland [Accessed 19 January 2022]. Sunstein, C. R., 2018. Nudging: A Very Short Guide. In: The Handbook of Privacy Studies: An Interdisciplinary Introduction. Amsterdam: Amsterdam University Press, pp. 173-180. Thaler, R., 2015. Misbehaving: The Making of Behavioral Economics. 1st ed. New York: W.W. Norton and Company. Thaler, R. H. & Sunstein, C. R., 2008. Nudge: Improving Decisions About Health, Wealth and Happiness. s.l.:Yale University Press. UK Government, 2022. Workplace Pensions. [Online] Available at: https://www.gov.uk/workplace-pensions/joining-a-workplace-pension [Accessed 21 January 2022]. van den Berg, P. & Wenseleers, T., 2018. Uncertainty about social interactions leads to the evolution of social heuristics. Nature Communications, 9(1), pp. 1-7.