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Column: Behavioural economics holds a mirror to the human mind

Conventional economics assumes people can easily and dispassionately calculate the pros and cons of their decisions, but most of us fall somewhere between Mr Spock and Homer Simpson when it comes to logical thinking.

Kevin Denny

ECONOMISTS GET a bad rap at the best of times. This is partly because it often falls to them to deliver the bad news – whether it’s that the economic outlook is sometimes bleak, that there is no such thing as a free lunch, or that governments may need cut expenditure.

None of these get you on people’s Christmas card list. However, economists have come in for particular criticism since the onset of the recent worldwide economic crisis.

It is worth knowing that to some extent, perhaps not enough, economics has taken this criticism on board. One of the most exciting developments in recent decades is Behavioural Economics, which is all about making our models of how people make decisions more realistic.

The problem with conventional economics

In conventional economics it is assumed that people can effortlessly calculate the pros and cons of all the decisions they face, calmly choose the right one and then stick with it. If this doesn’t sound like you, congratulations, you’re normal. In fact it sounds rather like Star Trek’s Mr Spock.

At the other extreme you could imagine a person who isn’t all-knowing, who can sometimes be quite emotional or have limited willpower and is sometimes downright irrational. Think Homer Simpson. The starting point of behavioural economics is that most of us are somewhere in between Spock and Homer.

Once we realise this, the stage is set for a much more nuanced picture of how people go about their business. The “grandfather” of behavioural economics is the Israeli psychologist Daniel Kahneman author of the best-selling book Thinking Fast and Slow. One of the things he showed is how people’s estimates of some variable could be unconsciously influenced by the environment.

Bias and decision-making

For example, ask someone to write down the last three digits of a phone number. Now ask them how many houses were sold in Dublin last month. You will find on average that people who wrote down high digits from the phone number gave a significantly higher estimate for the second question, even though they are completely unrelated. This is an example of the ‘anchoring effect’.

Kahneman also showed that people often use mental shortcuts or “heuristics” to save us having to think through problems over and over. This can sometimes lead to biases in how we decide. Assuming a doctor knows best is a heuristic which is usually, but not always, correct.

One of the best known biases that he documented is the Planning Fallacy, our tendency to seriously underestimate the time and money necessary to complete projects. Here the PPARS project, budgeted for €9 million, ended up costing the taxpayer €131 million, for example. This is a very common phenomenon. Understanding it could save governments many billions and years of frustration.

Choice architecture

Arguably the father of Behavioural Economics is the American economist Richard Thaler. He is best known for his work with Cass Sunstein on “Nudges”: this is about how small change in how decisions are presented to us – what is called ‘Choice architecture’ – can lead us to make better decisions.

It recognises that people have limited willpower and although we intend to do the right thing we often fail to do so, preferring to procrastinate. By changing default settings we can help ourselves achieve our objectives, whether it is to start saving for retirement, commit to an exercise programme or make those healthy food choices.

Governments, starting with the UK, have taken to this idea with enthusiasm. An example is that the Irish government is planning to switch to an “opt-out” model for organ donation so one is a donor by default – this has been shown to increase the supply of organs for transplantation. Here the Revenue Commissioners have also drawn on behavioural economics to improve revenue compliance while businesses too have found that behavioural economics can be profitable.

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Irrational behaviour

One of the best known thinkers in this field is another Israeli, Dan Ariely. He has written several best-sellers about people’s irrational behaviour. His engaging TED talks have been viewed online over six million times.

Traditional economics focuses on the power of incentives particularly financial ones. Given the controversies about bonuses paid to bankers, Ariely and colleagues asked what do bonuses actually do? In a series of experiments they found the bonuses elicit better performance only when the task is boring and repetitive. For more mentally challenging tasks, bonuses and performance related pay didn’t work and could even be counter-productive.

Ariely will be visiting Ireland soon for Kilkenomics, the festival of economics in Kilkenny November 7th-10th, where he will talking about his new book, The Honest Truth About Dishonesty: How We Lie To Everyone – Especially Ourselves, where he documents the extent of dishonesty and its consequences.

Ironically, he discovered that in the weeks after it was published it was illegally downloaded over 20,000 times.

Dr Kevin Denny is an economist at the UCD School of Economics and the Geary Institute. He blogs about behavioural economics and other topics at Economics More-or-Less . His twitter handle is @KevinDenny.

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