Edited By: Siya Kohli
In the realm of traditional neoclassical economics, human decisions have long been rooted in mathematical models, employing complex differential equations to arrive at optimal choices that maximise utility. These models presume that people diligently utilise all available information, strive to maximise satisfaction, make independent choices, and maintain stable preferences to make ‘rational’ decisions.
However, the emergence of behavioural economics challenges these entrenched assumptions of rationality in mainstream economic thinking. This captivating field delves into the intriguing interplay of money, mind, and decisions, taking into account the very cognitive limitations that shape human behaviour. Richard Thaler, father of behavioural economics, brilliantly captures the reality of human fallibility when he observes, “Real people have trouble with long division if they don’t have a calculator, sometimes forget their spouse’s birthday, and have a hangover on New Year’s Day. They are not Homoeconomicus; they are Homo sapiens.”
Herbert Simon, a pioneering economist, introduced the concept of ‘bounded rationality’, recognizing that in the real world, humans confront an array of constraints in knowledge and computation. These limitations of cognitive abilities make it difficult for them to approximate predictions and arrive at optimal decisions. Building upon Simon’s bounded rationality, psychologist and economist Daniel Kahneman and cognitive and mathematical psychologist Amos Tversky uncovered ‘heuristics and biases’. In order to arrive at a decision under these cognitive constraints, humans resort to ‘heuristics’ when faced with limited information using a very practical approach. Within their research, three main heuristics emerged: the 'representativeness' heuristic, where people rely on stereotypes over statistical data to assess the probability; the 'availability' heuristic, in which likelihood estimation is influenced by readily available examples; and the 'anchoring' heuristic, where initial reference points significantly shape decisions. Their illuminating work sheds light on the usefulness of providing fast, close to optimal answers under limited cognitive capabilities, while also highlighting the risky nature that can lead to significant and systematic errors associated with these mental shortcuts. This impacts the quality of decision-making as biases can skew judgements and result in suboptimal choices.
Following this body of heuristic-bias literature, Richard Thaler conducted a series of experiments to explore the other limitations of the rational choice theory. In particular, he focused on anomalies in decision-making, building upon the foundational work of Kahneman and Tversky. One intriguing anomaly he investigated was the ‘endowment effect’, wherein individuals tend to ascribe higher value to items they already possess compared to those they do not own. This phenomenon has been examined by the study by Thaler, Kahneman and Jack Knetsch involving equally valued mugs and pens. Participants were asked to engage in trading these items. The findings revealed a significant shift in perceived value based on ownership status. Those who were already owners of a mug demanded compensation twice as much as those who were potential acquirers of the same mug. This observation underscored the impact of ownership status on individuals' valuation of objects. Another anomaly popularised by Richard Thaler is ‘status quo bias’ considered to be causing systematic errors to a great extent in the decision making. The status quo bias or inertia leads people to favour maintaining the current state by either taking no action or sticking to a prior decision. This bias becomes a hindrance when the potential benefits of making a change, even if the associated costs are relatively small, outweigh the rewards of sticking with the existing situation. The cognitive limitations that result in status-quo bias includes loss aversion, sunk cost fallacy and commitments.
Behavioural economics seeks to address these cognitive shortcomings to enhance the quality of life. Richard Thaler and Cass Sunstein introduced the idea of ‘softer policies’, where governments can shape the decision-making environment to nudge individuals towards more rational choices. This innovative concept, known as ‘choice architecture’, transcends cognitive limitations by subtly guiding people towards beneficial decisions without restricting their freedom of choice. The choice architecture mitigates the influence of bias-inducing heuristics. One of the examples of the effective choice architecture is in relation to the retirement savings. Individuals often grapple with weakness of will, loss aversion, and status quo bias, hindering them from making optimal saving decisions. To tackle this challenge, Thaler and Sunstein devised the ‘Save More Tomorrow’ program, which nudges individuals towards participating in a contractual saving scheme. In this policy, individuals are automatically enrolled in the savings plan with an initially low contribution rate to address loss aversion. Over time, the contribution percentage gradually increases, overcoming status quo bias and empowering individuals to build a more secure financial future. Similarly, the nudge has been incorporated in policies like Organ Donor Registration wherein individuals have to opt in instead of opting out of the registration. The European countries that have adopted this scheme, over 90% individuals are in the organ donation list.
Thus, through behavioural economics, policy makers can intervene in the behaviour of their target agents to ensure that they can make choices that are comparable to, or at least more aligned with decisions they would make if they were not influenced by cognitive biases making their life healthier and happier.
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