Rational Expectations In an Often Irrational World: Behavioral Economics and Public Policy

In public discourse around the world we are faced with something of an ideological standoff. Rather than opening a new era of understanding and dialogue, the wealth of information available through technology and global sourcing appears to have hardened attitudes and beliefs.

What that has often meant is that rational approaches to problem solving are sublimated, emotional positions taking precedence. Meanwhile, demand for public services has, if anything, increased, especially as enterprises and the people who work in them face ever sharper global competition and are looking either for an advantage - or for protection.

The application of behavioral economic theory to public decision-making has, therefore, become something of a salve. Data-driven and results-oriented, it can provide a rational approach, if not always a solution, to societal issues. As the following article explains, this is not necessarily the best or even the preferred answer in many cases, but institutions of varying ideological stripes have embraced it precisely because it seeks to identify pragmatic outcomes based on commonly agreed-upon evidence.

In the end, history is still with us and behavioral economics provides, at its most basic, a common vocabulary as we seek to work our way through an ever-more complex world. JL

Tim Harford reports in the Financial Times:

We treat the possibility of a loss differently from the way we treat the possibility of a gain – and the task of the behavioral economist is to incorporate such ideas without losing the mathematically-solvable nature of the model.

The past decade has been a triumph for behavioural economics, the fashionable cross-breed of psychology and economics. First there was the award in 2002 of the Nobel Memorial Prize in economics to a psychologist, Daniel Kahneman – the man who did as much as anything to create the field of behavioural economics. Bestselling books were launched, most notably by Kahneman himself (Thinking, Fast and Slow , 2011) and by his friend Richard Thaler, co-author of Nudge (2008). Behavioural economics seems far sexier than the ordinary sort, too: when last year’s Nobel was shared three ways, it was the behavioural economist Robert Shiller who grabbed all the headlines.

Behavioural economics is one of the hottest ideas in public policy. The UK government’s Behavioural Insights Team (BIT) uses the discipline to craft better policies, and in February was part-privatised with a mission to advise governments around the world. The White House announced its own behavioural insights team last summer.

So popular is the field that behavioural economics is now often misapplied as a catch-all term to refer to almost anything that’s cool in popular social science, from the storycraft of Malcolm Gladwell, author of The Tipping Point (2000), to the empirical investigations of Steven Levitt, co-author of Freakonomics (2005). Yet, as with any success story, the backlash has begun. Critics argue that the field is overhyped, trivial, unreliable, a smokescreen for bad policy, an intellectual dead-end – or possibly all of the above. Is behavioural economics doomed to reflect the limitations of its intellectual parents, psychology and economics? Or can it build on their strengths and offer a powerful set of tools for policy makers and academics alike?
A recent experiment designed by BIT highlights both the opportunity and the limitations of the new discipline. The trial was designed to encourage people to sign up for the Organ Donor Register. It was huge; more than a million people using the Driver and Vehicle Licensing Agency website were shown a webpage inviting them to become an organ donor. One of eight different messages was displayed at random. One was minimalist, another spoke of the number of people who die while awaiting donations, yet another appealed to the idea of reciprocity – if you needed an organ, wouldn’t you want someone to donate an organ to you?
BIT devoted particular attention to an idea called “social proof”, made famous 30 years ago by psychologist Robert Cialdini’s book Influence. While one might be tempted to say, “Too few people are donating their organs, we desperately need your help to change that”, the theory of social proof says that’s precisely the wrong thing to do. Instead, the persuasive message will suggest: “Every day, thousands of people sign up to be donors, please join them.” Social proof describes our tendency to run with the herd; why else are books marketed as “bestsellers”?
Expecting social proof to be effective, the BIT trial used three different variants of a social proof message, one with a logo, one with a photo of smiling people, and one unadorned. None of these approaches was as successful as the best alternatives at persuading people to sign up as donors. The message with the photograph – for which the teams had high hopes – was a flop, proving worse than no attempt at persuasion at all.

Three points should be made here. The first is that this is exactly why running trials is an excellent idea: had the rival approaches not been tested with an experiment, it would have been easy for well-meaning civil servants acting on authoritative advice to have done serious harm. The trial was inexpensive, and now that the most persuasive message is in use (“If you needed an organ transplant, would you have one? If so, please help others”), roughly 100,000 additional people can be expected to sign up for the donor register each year.
The second point is that there is something unnerving about a discipline in which our discoveries about the past do not easily generalise to the future. Social proof is a widely accepted idea in psychology but, as the donor experiment shows, it does not always apply and it can be hard to predict when or why.
This patchwork of sometimes-fragile psychological results hardly invalidates the whole field but complicates the business of making practical policy. There is a sense that behavioural economics is just regular economics plus common sense – but since psychology isn’t mere common sense either, applying psychological lessons to economics is not a simple task.
The third point is that the organ donor experiment has little or nothing to do with behavioural economics, strictly defined. “The Behavioural Insights Team is widely perceived as doing behavioural economics,” says Daniel Kahneman. “They are actually doing social psychology.”
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The line between behavioural economics and psychology can get a little blurred. Behavioural economics is based on the traditional “neoclassical” model of human behaviour used by economists. This essentially mathematical model says human decisions can usefully be modelled as though our choices were the outcome of solving differential equations. Add psychology into the mix – for example, Kahneman’s insight (with the late Amos Tversky) that we treat the possibility of a loss differently from the way we treat the possibility of a gain – and the task of the behavioural economist is to incorporate such ideas without losing the mathematically-solvable nature of the model.
Why bother with the maths? Consider the example of, say, improving energy efficiency. A psychologist might point out that consumers are impatient, poorly-informed and easily swayed by what their neighbours are doing. It’s the job of the behavioural economist to work out how energy markets might work under such conditions, and what effects we might expect if we introduced policies such as a tax on domestic heating or a subsidy for insulation.
It’s this desire to throw out the hyper-rational bathwater yet keep the mathematically tractable baby that leads to difficult compromises, and not everyone is happy. Economic traditionalists argue that behavioural economics is now hopelessly patched-together; some psychologists claim it’s still attempting to be too systematic.
Nick Chater, a psychologist at Warwick Business School and an adviser to the BIT, is a sympathetic critic of the behavioural economics approach. “The brain is the most rational thing in the universe”, he says, “but the way it solves problems is ad hoc and very local.” That suggests that attempts to formulate general laws of human behaviour may never be more than a rough guide to policy.

This shift to radical incrementalism is so much more important than some of the grand proposals out there

The most well-known critique of behavioural economics comes from a psychologist, Gerd Gigerenzer of the Max Planck Institute for Human Development. Gigerenzer argues that it is pointless to keep adding frills to a mathematical account of human behaviour that, in the end, has nothing to do with real cognitive processes.
I put this critique to David Laibson, a behavioural economist at Harvard University. He concedes that Gigerenzer has a point but adds: “Gerd’s models of heuristic decision-making are great in the specific domains for which they are designed but they are not general models of behaviour.” In other words, you’re not going to be able to use them to figure out how people should, or do, budget for Christmas or nurse their credit card limit through a spell of joblessness.
Richard Thaler of the University of Chicago, who with Kahneman and Tversky is the founding father of behavioural economics, agrees. To discard the basic neoclassical framework of economics means “throwing away a lot of stuff that’s useful”.
For some economists, though, behavioural economics has already conceded too much to the patchwork of psychology. David K Levine, an economist at Washington University in St Louis, and author of Is Behavioral Economics Doomed? (2012), says: “There is a tendency to propose some new theory to explain each new fact. The world doesn’t need a thousand different theories to explain a thousand different facts. At some point there needs to be a discipline of trying to explain many facts with one theory.”
The challenge for behavioural economics is to elaborate on the neoclassical model to deliver psychological realism without collapsing into a mess of special cases. Some say that the most successful special case comes from Harvard’s David Laibson. It is a mathematical tweak designed to represent the particular brand of short-termism that leads us to sign up for the gym yet somehow never quite get around to exercising. It’s called “hyperbolic discounting”, a name that refers to a mathematical curve, and which says much about the way behavioural economists represent human psychology.
The question is, how many special cases can behavioural economics sustain before it becomes arbitrary and unwieldy? Not more than one or two at a time, says Kahneman. “You might be able to do it with two but certainly not with many factors.” Like Kahneman, Thaler believes that a small number of made-for-purpose behavioural economics models have proved their worth already. He argues that trying to unify every psychological idea in a single model is pointless. “I’ve always said that if you want one unifying theory of economic behaviour, you won’t do better than the neoclassical model, which is not particularly good at describing actual decision making.”
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Meanwhile, the policy wonks plug away at the rather different challenge of running rigorous experiments with public policy. There is something faintly unsatisfying about how these policy trials have often confirmed what should have been obvious. One trial, for example, showed that text message reminders increase the proportion of people who pay legal fines. This saves everyone the trouble of calling in the bailiffs. Other trials have shown that clearly-written letters with bullet-point summaries provoke higher response rates.
None of this requires the sophistication of a mathematical model of hyperbolic discounting or loss aversion. It is obvious stuff. Unfortunately it is obvious stuff that is often neglected by the civil service. It is hard to object to inexpensive trials that demonstrate a better way. Nick Chater calls the idea “a complete no-brainer”, while Kahneman says “you can get modest gains at essentially zero cost”.
David Halpern, a Downing Street adviser under Tony Blair, was appointed by the UK coalition government in 2010 to establish the BIT. He says that the idea of running randomised trials in government has now picked up steam. The Financial Conduct Authority has also used randomisation to develop more effective letters to people who may have been missold financial products. “This shift to radical incrementalism is so much more important than some of the grand proposals out there,” says Halpern.

Not everyone agrees. In 2010, behavioural economists George Loewenstein and Peter Ubel wrote in The New York Times that “behavioural economics is being used as a political expedient, allowing policy makers to avoid painful but more effective solutions rooted in traditional economics.”
For example, in May 2010, just before David Cameron came to power, he sang the praises of behavioural economics in a TED talk. “The best way to get someone to cut their electricity bill,” he said, “is to show them their own spending, to show them what their neighbours are spending, and then show what an energy-conscious neighbour is spending.”
But Cameron was mistaken. The single best way to promote energy efficiency is, almost certainly, to raise the price of energy. A carbon tax would be even better, because it not only encourages people to save energy but to switch to lower-carbon sources of energy. The appeal of a behavioural approach is not that it is more effective but that it is less unpopular.
Thaler points to the experience of Cass Sunstein, his Nudge co-author, who spent four years as regulatory tsar in the Obama White House. “Cass wanted a tax on petrol but he couldn’t get one, so he pushed for higher fuel economy standards. We all know that’s not as efficient as raising the tax on petrol – but that would be lucky to get a single positive vote in Congress.”
Should we be trying for something more ambitious than behavioural economics? “I don’t know if we know enough yet to be more ambitious,” says Kahneman, “But the knowledge that currently exists in psychology is being put to very good use.”
Small steps have taken behavioural economics a long way, says Laibson, citing savings policy in the US. “Every dimension of that environment is now behaviourally tweaked.” The UK has followed suit, with the new auto-enrolment pensions, directly inspired by Thaler’s work.
Laibson says behavioural economics has only just begun to extend its influence over public policy. “The glass is only five per cent full but there’s no reason to believe the glass isn’t going to completely fill up.”