When Psychology Meets Economics

NexGen Economics

[This is Part 2 of the series ‘NexGen Economics’ (NGE). The series will throw light upon how the future or next generation economics would change the way of doing businesses, managing nations and living lives too. Let us enter and try to decode the future.]

In case you have not read the Part 1 of the NGE series, read it here.

Recap

In the first part, we have seen that the classical and neo-classical economists underscored ‘self-interest’ as the only motive behind human decisions. We have also touched upon the fact that at many instances, human behaviour was not rational. Now let us leap forward to the next stage.

Dawn of Behavioural Economics

We are now aware that older theories were based around the egocentric behaviours of human being. Modern economists and psychologists challenged this school of thought by advancing their research on human behaviour. They found that real-life behaviours are rather different from theories. Behaviour varies across time and space, and it is subjected to cognitive biases, emotions and social influences. In various experiments, researchers concluded that most of the decision-making is based on reciprocity, trust, morality and other motives which are assumed absent in classical and neo-classical economic theories. They also concluded that the decisions are made considering context and choices presented to us. They did not rule out rationality; but widened the paradigm of rationality. The field associated with this stream of research and theory is called behavioural economics (BE).

Though behavioural economics gives us an explanation to our irrational nature, the theory is not yet developed to give full-fledged solutions to complex economic scenarios and crisis. It is not a substitute to the mainstream economics but a complementary branch to advance the research and applications. Recently, Richard Thaler was awarded Nobel Prize in economics for his contributions to this field. The future of this branch is very promising as many researchers and professionals are taking active interest in it.

The Philosophy

Nudge philosophy follows libertarian paternalism idea. These words appear contradictory. The ‘libertarian’ aspect lies in the straightforwardness. It follows that people are free to do what they like and what they do not. The paternalistic aspect tries to influences choices of people in order to make them better off. Together, it simply means liberty-preserving idea but with a choice architect. For example, libertarian paternalists will not force people to stop smoking or stop eating junk food but will as Thaler quotes, “self-consciously attempt to move people in directions that will make their lives better. They nudge.” So instead of banning junk food, listing healthy options in front of eyes constitutes a nudge. Let us consider many such examples below to know and understand nudges around us.

BE in Businesses

Every one of us has travelled by Uber. We might have experienced this instance during the travel – before completion of your ride, the driver gets an alert about the next ride in advance. This pre-alert encourages drivers to take more rides and earn more money. Another tactic used by Uber (at least in USA) is by translating messages in terms of dollars like this, “You’re $10 away from making $330 in net earnings. Are you sure you want to go offline?” This is called ‘prospect theory’ which means, “losses hurt more than gains feel good”.

There is a ‘default rule’ also. If something is given to you by default then you might not care about having it or not. But if you are asked before giving, you would start thinking about the same. Generally, all employers enrol their employees in savings plan (say EPF in India) by default. Participation rates are higher in such case as against the one where employers give employees an option to opt-in.

Companies also use ‘negative option marketing’ strategy. For example, the magazine subscription is automatically renewed unless you communicate the withdrawal. This helps companies to earn more money as we tend to forget the renewal date and end up paying for an extra period. However, this strategy becomes beneficial for us when banks use it to auto-renew our fixed deposit receipt.

Have a look at the way various applications and devices speak to us and you would realize that each one of them is the result of human behaviour. Even marketing gimmicks are based on human reactions and behaviours. With the help of machine learning and artificial intelligence, the behavioural sciences are changing business models and strategies to understand consumer behaviour continuously.

It is amusing to learn how some companies have conquered our hearts by giving us amazing experience which makes us forget our rationality. Dan Ariely, Professor at Duke University of Psychology and Behavioural Economics and an author of Irrationally Yours, The (Honest) Truth About Dishonesty, The Upside of Irrationality and Predictably Irrational: The Hidden Forces That Shape Our Decisions writes – “Starbucks did everything in its power to make the experience feel different — so different that we would not use the prices at Dunkin Donuts as an anchor, but instead would be open to the new anchor that Starbucks was preparing for us.” This marked success of Starbucks as our beau ideal. Author has given many such examples which show how our irrational behaviour drives our decision-making; which surprisingly, appears normal to us.

BE in Public Policy

It was interesting to know that Niti Aayog (Government of India’s think tank and erstwhile Planning Commission) has taken a step further to include BE in their policy making strategy. India now joined other nations like USA, UK (Behavioural Insights Team), Australia (NSW Behavioural Insights), Singapore (Behavioural Insights and Design Unit) and the World Bank (Global INsights Initiative) to consider BE tool in planning (commonly called as nudge unit : the name was adopted from Richard Thaler’s book ‘Nudge’)

Policies need to be made and changed according to the behavioural changes as well as behaviours could be changed by implementing or tweaking certain policies.

It is frequently said that when laws are made simpler, we get higher compliance. This statement is based on the psychological costs principles. When an action is perceived as burdensome, there will be lesser number of people taking part in it.

In the UK, people who had declared their taxable income became 5.1% more likely to pay taxes on time when sent the following text: “Nine out of ten people in the UK pay their tax on time. You are currently in the very small minority of people who have not paid us yet”.

In India, for long we used to address the problem of open defecation by building more toilets but never realized the behavioural issue of using toilets. The demographic diversity caused hurdles in sharing toilets due to caste and religious discrimination. Recent government advertisements like shaming a person in public for defecating in open and not marrying a person for not building toilet inside the house address this issue very differently.

Issues like smoking and littering should also be handled differently. The more people behave instantaneously, less they think about the social norm. Imposing fine or punishments make them realize the harm they are doing to the oneself, others and society. To tackle these habits, policy makers must make people aware about the ill effects of people’s habits as well as induce the person change for the better.

Nudges are found everywhere, right from the design of urinal to the design of roads and buildings. The blend of economics and psychology would make businesses more profitable and government policies more effective. Even, further branches like behavioural architecture and behavioural finance are making their way into academics, researches and real life.

Further in our series, we would come across different perspectives on this topic.

– Swapnil Karkare

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