26 Dec 2011

The classical economic model assumes that humans are consistently rational – that they maximise their utility through choices based on a stable set of preferences and an optimal amount of information.

The classical economic model assumes that humans are consistently rational – that they maximise their utility through choices based on a stable set of preferences and an optimal amount of information. Given these assumptions, people’s behaviour can be influenced rather predictably through taxes, penalties and other economic incentives.

Yet empirical inquiry reveals that people often diverge greatly from the behaviour predicted by the model of rational decision-making. At our best, to use Nobel laureate Herbert Simon’s phrase, we are only boundedly rational, lacking the cognitive capacity to reason about the myriad decisions we make every day. Moreover, we are subject to a number of cognitive biases and employ various heuristics – cognitive shortcuts – that work much of the time but sometimes fail us miserably. Not only our cognitive capacity, but our willpower is bounded. Adults often manifest the behaviour of many children who, when offered one sweet now, or two sweets if they waited a few minutes before eating the one placed before them, could not defer gratification.

Can such departures from rational behaviour be systematised and combined with an economic model of decision-making to improve the ways that people go about their everyday lives? This is a central question for the field of behavioural economics, which draws on classical economics, social psychology, and the psychology of judgment and decision-making. Although little progress has been made in improving people’s willpower and capacity to avoid cognitive errors, behavioural economics seeks to mobilise our limitations and biases in order to improve the outcomes of our decisions.

One might think of this approach as psychological jujitsu– a Japanese martial art that uses one’s opponent’s force against himself. By the same token, behavioural economics accepts our cognitive limitations, but builds on their inevitability to try to improve our decision-making.

Consider people’s difficulties in deferring gratification and their pervasive inability to properly discount for the future: Most prefer $100 today over $200 in a year, even though the implied interest rate is unrealistically high. This helps explain why it is so difficult to save money. Yet several programmes have been highly successful in addressing this problem, which is especially devastating for the very poor, for whom even a few pennies spent on non-essential items may have dire economic consequences. The programmes have the common theme of keeping earnings out of reach until needed.

For example, the Savings and Fertilizer Initiative Coupon Programme allows farmers in developing countries to purchase coupons for next season’s fertiliser immediately after being paid for this season’s harvest; participants end up buying 50 per cent more fertiliser as their peers, who spend the money in the intervening period. The Rotating Savings and Credit Association Programme encourages savings by fruit or flower wallahs, by sending around collectors to take daily deposits for a small fee – that is, a small negative interest rate. Yet another programme locks a customer’s savings account until a specified balance has been reached, greatly increasing savings.

While all of these examples involve external interventions, individuals can also engage in personal psychological jujitsu. Consider how we might use our susceptibility to the sunk-cost fallacy to compensate for our bounded willpower – say, our difficulty in adhering to a resolution to go to the gym several times a week to stay healthy.

Rational economic decision-making ignores sunk costs – expenditures already made that cannot be recovered. Yet humans have a strong tendency to throw good money after bad – to avoid acknowledging to themselves or others that they made an error. I have heard many U.S. politicians argue against withdrawing from disastrous foreign military engagements because pulling out would mean that lives were lost in vain. On the individual level, once people have paid for something, they want to realise the benefits of their investment. We are far less likely to walk out of a movie theatre for which we have paid $10 admission than to stop watching the same movie free on television.

So how do we use the sunk-cost fallacy to stay healthy? By purchasing a year’s membership in the gym, and allowing the thought of wasting the fees paid to motivate working out on a morning when we would rather stay in bed. Similar commitment schemes have been developed for goals that can’t provide their own cost sinks. There’s a website that allows people to have their credit cards charged for donations to causes they despise if they fail to achieve goals – e.g. stopping smoking – stated in advance on the site.

Let me turn to another pair of human shortcomings – our limited ability to process statistical information and our limited attention span. Under any plausible moral theory, each person’s life is equally valuable, and one million children dying of starvation in Africa is one million times as bad as one child dying. But which charitable appeal is likely to be more effective? (1) “Food shortages in Mali affect more than 3 million children. You can help some of these starving children;” or (2) “Your donation will help Rokia, a sevenyear- old girl from Mali (showing a photo of Rokia). She is desperately poor and faces the threat of severe hunger or even starvation.” On average, people donated twice as much in the second scenario as in the first.

Stalin remarked: “The death of one man is a tragedy. The death of millions is a statistic.” But it turns out that the phenomenon called “psychic numbing” is true for charitably inclined people as well as tyrants. Large numbers don’t have much meaning for most of us, and the cognitive effort of comprehending them detracts from our empathetic reaction. Unfortunately, the phenomenon manifests itself even with small numbers: people made a smaller net donation when shown photos of both Rokia and another child than when shown only Rokia’s photo.

Non-governmental disaster relief organisations can use their knowledge of this phenomenon in their charitable appeals by forgoing statistics and describing the situation of a single victim. And charities can take advantage of a different psychological phenomenon as well – the fact that we are not very sensitive to a small expenditure bundled together with a larger one in the same transaction. When you check out a $70 bag of groceries at my local supermarket, the credit card display asks if you would care to add $1 for the charity featured this month. Not only is the expenditure insignificant compared to your bill, but the supermarket has made the gift transaction as easy as it could be.

Let me end with another pair of psychological phenomena that can converge to influence people in a powerful way. First, people tend to look to others for cues about how to behave. This phenomenon of “social proof” has been used to promote conservation. Our monthly utility bill compares our family’s electricity usage to our neighbours’ and vividly highlights when our consumption is high. This acts as a strong motivator to be frugal. By the same token, residents who are informed that their neighbours recycle paper and glass products are much more likely to do so themselves.

Second, people are reluctant to change the status quo when the consequences seem uncertain. This is partly due to social proof and partly to our being more averse to possible losses than welcoming equivalent gains. As a result, we tend not to deviate from default positions, even when it only takes a stroke of the pen.

These two phenomena – aided by inattention and inertia – come together in explaining the “stickiness” of default conditions. Consider that when you get a driver’s license in Austria, you automatically consent to donate your organs if you are killed in a crash – unless you opt out; but that in neighbouring Germany, your organs will not be donated unless you opt in. As a result, over 99 per cent of drivers in Austria are enrolled in that country’s organ donation programme, while only 12 per cent of drivers in Germany are enrolled. For another example, in addition to mandated social security, American employees can enrol in a voluntary retirement plan, whose cost is shared by the employer. When enrolment is the default option, many more employees participate than when they need to take affirmative steps to enrol. Also, and a different aspect of the psychology of choice, employees who are offered a relatively small set of retirement plans are more likely to enrol than those offered a large set: many options make the decision seem too complex to handle.

These are just a few examples of how behavioural economics offers a valuable complement to classical economics to improve people’s behaviour for their own benefit and that of society at large. Behavioural economics also has its limitations. For example, because the effects of climate change seem remote, because of poor feedback loops, problems in deferring gratification, and extravagant future discounting, it is difficult to induce people to take action now to prevent catastrophic global warming. But behavioural economics is still a very young field, with the potential to address problems that seem intractable at the moment.

Paul Brest is President of the William and Flora Hewlett Foundation and Dean Emeritus of Stanford Law School. David Hoffert also contributed to this article.