Behavioural Economics: How Far Has It Come & What's Next?

When I first came to St Andrews my degree was Economics & Psychology and when asked to explain such an unusual choice, I would often say ‘I like behavioural economics’. Up until December 2017, many non-Economics students would have told me that they had heard of Daniel Kahneman but not anybody else in this field. But in December 2017 the Nobel Prize was awarded to Richard Thaler, another behavioural economist. As Robert Shiller, a 2013 Nobel laureate in Economics put it, ‘Thaler is a controversial winner but a deserving one’. While Kahneman was awarded the prize for ‘laying the foundation for a new field of research’ (Nobel Prize, 2002); Thaler was credited for ‘moving economics towards a more realistic understanding of human behaviour, and for using the resulting insights to improve public policies’ (The Committee for the Prize in Economic Sciences, 2017). This practical implementation of his ideas as well as his best-seller Nudge: Improving Decisions about Health, Wealth, and Happiness quickly brought him and behavioural economics their well-deserved fame. Even among my friends, less people were completely puzzled when they heard the expression ‘behavioural economics’, especially when they recalled the scene in The Big Short with Thaler and Selena Gomez. In this article I would like to address the recent history of behavioural economics, its current state and its future implications.

Daniel Kahneman & the Prospect Theory

The real fame of behavioral economics started with Daniel Kahneman, a Psychology and Public Affairs professor at Princeton, receiving the Nobel Prize for Economics in 2002. One of his biggest contributions is the development of the Prospect Theory with Amos Tversky, his long-term collaborator, that shows how people decide between alternatives that involve risk and uncertainty. The theory demonstrates that people evaluate options based on certain reference points and that they are loss-averse - they dislike losses more than equivalent gains. Consequently, individuals are more willing to take risks in order to avoid a loss, than to secure a gain (Tversky & Kahneman, 1991).

Despite being decades-old, the Prospect Theory is still of interest to researchers in economics and other disciplines with new theories being developed and older theories gaining further evidence. For instance, a recent natural field experiment based on trading observations from over 864,000 price realizations (Larson et al., 2016) supports the behavioural economics’ explanation of the equity premium puzzle. This phenomenon refers to the inability of classical economic models to explain the premium of a well-diversified U.S. equity portfolio over U.S. Treasury Bills observed over the past century. The behavioural explanation is based on myopic loss aversion (a common tendency to over focus on the short term and react too negatively to recent losses often at the expense of long-term benefits) (Thaler et al., 1997). Before the 2016 field experiment, this theory had only been tested in laboratory experiments. Thus, until recently it was unknown to what extent these preferences underlie traders’ behaviour in their natural domain.

The popularity of the Prospect Theory is attributable not only to its empirical success, but also to its unique nature merging economics and psychology. On the one hand, it is ‘a psychologically informed cognitive process model’. On the other hand, it is one of the ‘utility maximization models’ which are a core class of models in classical microeconomics (Heukelom, 2015). In other words, it is one of the first theories to incorporate insights from cognitive psychology into the economic choice models.

Behavioural Economics in practice

Following Kahneman’s award in 2002, the gap between academia and real-life applications of behavioural economics started diminishing. In 2006 the US Congress passed the Pension Protection Act which incorporated many elements of Thaler’s and Benartzi’s (2004) the Save More Tomorrow programme (the SMarT programme). Contrary to the traditional sign-up or ‘opt-in’ approach, the SMarT plan is based on the ‘opt-out’ principle, meaning that a person’s pension contribution increases with each pay raise unless they opt out.  Another feature of this programme is that an increase in pension contributions happens when a person gets their next pay-raise. This helps to overcome the loss-aversion bias since this way people are more likely to experience a decrease in future gains rather than the loss in pay. Similar programs are used by employers in the UK, Australia and New Zealand (Jenks, 2017).

Behavioural economics has also attracted the interest of policy-makers across the Atlantic. In 2010 the UK government established the Behavioural Insights Team which is the world’s first government institution dedicated to the application of behavioural sciences to achieve policy goals. The team has grown from a seven-person unit to a global social purpose company with offices around the world. Its projects span from tackling tuberculosis in Moldova to boosting early tax returns in Indonesia. On an international scale, in 2014 the UN set up the Development Program Innovation Facility, while in 2017 Rare launched the Center for Behaviour & the Environment.

Richard Thaler & the Nudge

In 2017 behavioural economics received more attention as Richard Thaler was awarded the Nobel Prize in Economics. Perhaps there was some connection between him and Kahneman as the later famously noted ‘Richard was the first person I called when I won’ (2017). Thaler says his research started with ‘observing real life stories’ that seemed inconsistent with the economic theory on human behaviour. He continued recording this ‘collection of anecdotes’ at the same time trying to find explanations for these often-paradoxical accounts of our behaviour (Thaler, 2018). One of his greatest contributions is the development of the Nudge theory with Cass Sunstein, a Harvard law professor and the former Administrator of the White House Office of Information and Regulatory Affairs. The nudge is a ‘relatively subtle policy shift that encourages people to make decisions that are in their broad self-interest’ (Chu, 2017). A simple example of a nudge is the following: adding a photo on the speed ticket increases the fine payment rate because it amplifies our feelings of guilt (Thaler & Sunstein, 2009). These policy shifts have the potential to replace some incentives – the standard tools in policy-making – that do not work when people ‘do not notice or do not understand them’ (Chetty et al., 2009). According to Thaler (2018), he and Sunstein ‘did not invent a nudge, but rather gave it a word’ as people have been nudging as long as they have been trying to influence others.

What is next for Behavioural Economics?

To conclude, behavioural economics and in broader terms behavioural sciences are entering the real world at an impressive pace. Robert Shiller even argues that apart from Kahneman and Thaler, other Nobel Prize winners can be classified as behavioural economists, namely George Akerlof, Robert Fogel, Elinor Ostrom, and himself. Whether this classification is valid or not is up to these Nobel Prize winners themselves. However, an achievement of behavioural economics that is very hard to deny is that it is no longer ‘a radical departure from the mainstream’. Instead, it could be considered ‘a friendly détente with the mainstream’ (Darling, 2019).

The potential for future academic development of the field is unquestionable as Behavioural Economics departments are being set up in top institutions such as LSE, Harvard, Princeton and many others. At the same time, the practical applications of behavioural economics look very promising in both private and public sectors. The popularity of the Behavioural Exchange Conference is a case in point – the world’s leading behavioural science conference which brings together academics, policy makers and entrepreneurs is almost sold out 4 months prior to its launch.

One of the reasons why behavioural economics is advancing so quickly is that history has shown that the costs of dismissing a human factor in economics are very high. Just think about the 2008 Financial crisis and how many mainstream economists considered it unimaginable right before it started! (King, 2009). This rapid development of behavioural economics makes me wonder if the distinction between behavioural and classical economics will remain for a long time. Richard Thaler (2017) does not give a specific time frame but is convinced that ‘behavioural economics will eventually disappear from our lexicon’ and ‘all economics will be as behavioural as the topic requires’.

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