Behavioral Economics

Try and think back to the very brief "Economics 101" lesson that was part of the explanation for externalities. If you recall, I noted that most economic decisions are based on weighing private benefit against private cost in an effort to maximize private benefit (remember the thrift store table?). This effectively summarizes the neoclassical economic model we've been using in the Western World for the past 150+ years, and it has changed very little in that time.  When economics models people's decisions in this manner, the generic person in the model often referred to as "Economic Man" or "homo economicus," the latter of which is an obvious play on the term homo sapiens. Economic Man was described by Craig Lambert in Harvard Magazine thusly:

Economic Man makes logical, rational, self-interested decisions that weigh costs against benefits and maximize value and profit to himself. Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings.

As Lambert says, this is the "standard model...that classical and neoclassical economics have used as a foundation for decades, if not centuries."  If you recall, I noted in the externalities lesson that these conditions required for the behavior of what you now know as Economic Man "is generally not a reasonable set of assumptions, but that is a story for another day." Well, that other day has arrived, my friends! Most economics models are based on this assumed behavior, but there is at least one major problem with this. Lambert sums up the problem concisely: "But Economic Man has one fatal flaw: he does not exist." 

So what does he mean by this? Well, for starters, the world is littered with irrational behavior. Some are relatively harmless like making an impulse buy of something you don't need (come on, admit it - we've all been there!), but some are more serious, like engaging in potentially life-changing or -threatening behavior such as heavy drug use or risky sexual activity. And of course, we don't always act in self-interest, for example donating to charity, making decisions such as water conservation that benefit the "greater good," and so forth. (Though it should be stated that some of this behavior can be at least partially driven by selfish consideration because it makes the decision-maker feel good.) There are many more examples, as you will read below. But the question is, how do we include this type of irrational behavior into economic models? In a more general sense, it begs the question: "How can we explain such behaviors?" Enter Behavioral Economics. Some of the principles of Behavioral Economics is described below by Alain Samson in the Behavioral Economics Guide 2015. (I added the emphasis in bold.)

In last year's BE Guide, I described Behavioral Economics (BE) as the study of cognitive, social, and emotional influences on people's observable economic behavior. BE research uses psychological experimentation to develop theories about human decision making and has identified a range of biases. The field is trying to change the way economists think about people’s perceptions of value and expressed preferences. According to BE, people are not always self-interested, cost-benefit-calculating individuals with stable preferences, and many of our choices are not the result of careful deliberation. Instead, our thinking tends to be subject to insufficient knowledge, feedback, and processing capability, which often involves uncertainty and is affected by the context in which we make decisions. We are unconsciously influenced by readily available information in memory, automatically generated feelings, and salient information in the environment, and we also live in the moment, in that we tend to resist change, be poor predictors of future preferences, be subject to distorted memory, and be affected by physiological and emotional states. Finally, we are social animals with social preferences, such as those expressed in trust, altruism, reciprocity, and fairness, and we have a desire for self-consistency and a regard for social norms

It's worth noting that the 2017 Nobel Prize in Economics was awarded to Richard Thaler, who is considered one of the fathers of Behavioral Economics. Here is an article from The Atlantic ("Richard Thaler Wins the Nobel in Economics for Killing Homo Economicus") that explains some of his theories, if you are so inclined. These theories are starting to hit the mainstream!

The Behavioral Economics Guide provides an excellent introduction to this topic, but the following sums it up pretty well (I added the emphases in bold): 

• "...if people were simply perfectly rational creatures, life would be wonderful and simple. We would just have to give people the information they need to make good decisions, and they would immediately make the right decisions. People eat too much? Just give them calorie information and all will be well. People don’t save, just give them a retirement calculator and they will start saving at the appropriate rate. People text and drive? Just let them know how dangerous it is. Kids drop out of school; doctors don’t wash their hands before checking their patients. Just explain to the kids why they should stay in school and tell the doctors why they should wash their hands. Sadly, life is not that simple and most of the problems we have in modern life are not due to lack of information, which is why our repeated attempts to improve behavior by providing additional information does little (at best) to make things better.
• There are lots of biases, and lots of ways we make mistakes, but two of the blind spots that surprise me most are the continuous belief in the rationality of people and of the markets. This surprises me particularly because even the people who seem to believe that rationality is a good way to describe individuals, societies and markets, feel very differently when you ask them specific questions about the people and institutions they know very well. On one hand, they can state all kinds of high order beliefs about the rationality of people, corporations, and societies, but then they share very different sentiments about their significant other, their mother-in-law (and I am sure that their significant other and mother-in-law also have crazy stories to share about them), and the organizations they work at. Somehow when we look at a particular example of life up close, the illusion of sensible behavior fades almost instantly. And the more we look at the small details of our own life, the more our bad decisions seem to multiply.

The main thing Ariely is trying to get at here is that people make decisions that are irrational and/or are not good for their own well-being all of the time, and if you ask them they admit it. Yet, modern economic models assume that people always act rationally and in their own self-interest. He provides a lot of examples of this, including texting while driving, overconsumption of alcohol, overindulging in social media, over-eating and more. You may find it enlightening to go through the exercise he provides on p. viii. In it, he asks the reader to indicate how many times (really think about it and put a number behind it) in the past 30 days you've done things such as texting while driving, reading email while driving, mismanaged your time, drank too much, procrastinated, said something inappropriate then regretted it, stayed up too late and did not sleep well, and lied. (I know that I was surprised, okay, horrified when I went through the exercise!) The point is that there are a lot of damaging behaviors that people engage in despite "knowing better." This is indicative of something being amiss in economic models.

The Greenwashing Connection

You may be wondering how this all fits into this week's lesson. Okay, here goes: As it turns out, though the field of Behavioral Economics is only recently gaining steam in academics, and to a lesser extent public policy, advertisers have known about irrational behavior for decades. Though they did not call it Behavioral Economics, they have been using its principles to sell stuff to people. And if you ask the right person, they will openly acknowledge this.

Lucky for you, the good folks at Freakonomics Radio have interviewed such a person, and some others familiar with this topic in a recent show. [Despite the funny-sounding name, Freakonomics Radio delivers a lot of legitimate, insightful commentary on modern economics. It is the brainchild of Dr. Steven D. Levitt, William B. Ogden Distinguished Service Professor of Economics at the University of Chicago (how's that for ethos?!) and author, journalist, and TV and radio personality Stephen J. Dubner.] In a more general sense, Behavioral Economics provides insight into how people can be influenced to act irrationally, and even against their own interests. The applications go well beyond advertising! I'm looking at you, in particular, politics.

Hopefully, next time you are looking at advertisements, listening to politicians, or even just listening to others speak, you will pick up on techniques like social norming, loss aversion, positivity, and perception of scarcity.

One final note: Always keep in mind that the only goal of advertising (other than public service announcements) is to get you to buy things. And it works, otherwise it would not be a multi-billion dollar industry! Do not believe everything you see or hear in ads.