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 the 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 is 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." Most economic 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 smoking 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.

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 are 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: 

• "...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 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.

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. 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. 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. If you have time, I strongly suggest listening to or reading the podcast in the box below. It's done in a really engaging way and is full of good information.

In the podcast, Dubner interviews Rory Sutherland, vice chairman in the U.K. of Ogilvy and Maher, a global marketing and advertising firm. Sutherland is an avowed proponent of behavioral economics (BE) and makes it clear that the advertising agency has been using BE principles for decades, though they never had a specific name for it. The following are a few important elements from the podcast. (There is a LOT more good information, by the way!):

• "Sutherland: The problem with economics is that it’s designed for the perfectly rational, perfectly informed person possessed of infinite calculating ability. It isn’t really designed for the human brain as it is currently evolved...The fact is that those conditions exist in the real world somewhere between very rarely and never.
• They go over some examples of how BE has been applied in advertising and other business functions, and include descriptions of the following strategies. Note that for these strategies to work, people must only perceive that they are true:
  • Social norming is basically peer pressure. People tend to want to do things that they perceive that others are doing. Advertisers can use phrases such as "many people like you" or portray "everyday" people in their advertising to help accomplish this.
  • Loss aversion refers to the fact that "we generally experience more pain with loss than we experience pleasure with a commensurate gain. Meaning: we hate to give up what we have even if what we have isn’t all that valuable to us." People don't want to give things up, even if they don't need it.
  • Perception of scarcity refers to making people believe that if they don't act now (or soon) that they may miss out on an opportunity. "For a limited time!" and "Labor Day sale!" "One day only!" are all examples of this.

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.