Published 26 August 2022 by Benjamin Skuse
Economics Embracing our Warts and All Selves
Mainstream economics can be regarded as the study of what people should do, whereas behavioural economics – the application of psychological insights to explain economic decision-making – is more about what we actually do in real life. Perhaps worryingly, there is an uncomfortable and wide chasm between the two. This divide was probed deeply by three Laureates of the Nobel Memorial Prize in Economic Sciences during the 7th Lindau Meeting on Economic Sciences.
“Mainstream economics is based on the premise that people behave rationally,” began Robert Aumann in his Lecture ‘Behavioral Economics and Mainstream Economics’ on Wednesday 24 August. This means economic agents – people, firms, banks, governments – attempt to maximise their expected individual rewards.
Traditionally implied in this statement is that individuals (economic agents) act perfectly: they are given perfect information and have the ability to calculate and weigh up the consequences of each available choice before reaching a logical conclusion and acting to promote their best interest. “That’s not what people do,” Aumann explained. “People act by rules of thumb.”
But those rules of thumb, Aumann argued, evolved, biologically or culturally. “How does evolution work?,” he asked. “Evolution works by survival of the fittest. The rules that don’t benefit the users will not survive… These rules of thumb are almost always beneficial because they evolved.”
Using a number of entertaining and vivid examples, Aumann proceeded to rip apart long-established notions of irrational behaviour to either show it to be rational or beneficial in most scenarios, or reveal the example to be overly contrived, and therefore irrelevant to economics.
“I say that… if the rules of thumb actually do promote the goals of their users, then behavioural economics and mainstream economics are entirely consistent … Behavioural economics is what makes mainstream economics work!”
Not so Irrelevant Factors
Given Aumann’s Lecture provided examples of seemingly irrational economic decision-making almost exclusively from Richard Thaler’s findings in behavioural economics, audience members were excited to attend Thaler’s own Lecture on Thursday 25 August titled ‘The Importance of Seemingly Irrelevant Factors in Guiding Economic Policies’.
Like Aumann before him, Thaler focused on bridging mainstream economics’ characterisation of what people should do and behavioural economics’ description of what people actually do. But instead of attempting to convince the audience of their consistency, Thaler instead focused on where mainstream economics gets it wrong in disregarding some factors as irrelevant noise.
Why are agent optimisation problems never qualified by the problem’s difficulty? Why is no attention given to how a given problem is worded (framed)? And shouldn’t all the ‘sludge’, i.e frustrating barriers to arriving at a beneficial outcome, like long-winded forms or protracted application processes, be factored into the economic analysis? “I call all things like this ‘supposedly irrelevant factors’ [which] economists say have a coefficient of zero,” said Thaler. “And that’s wrong, they’re not irrelevant.”
Thaler made his case with several examples where supposedly irrelevant factors turned out to be the most important ones in delivering the desired outcome. Perhaps the most impactful was a retirement saving plan called ‘Save More Tomorrow’ introduced by Thaler and Shlomo Benartzi in the noughties to nudge employees into increasing their retirement fund contribution rates. Under this plan, workers are offered the option to increase their savings rate over time until it reaches some cap or the worker opts out. “In the first company that we got to try this, we tripled saving rates in three years,” said Thaler. It has since been rolled out in companies around the world.
“If you want people to do something, make it easy,” he concluded. “But we don’t know what makes an economics problem hard. And if we knew more about that, then we could make some progress.”
Are you Paying Attention?
Daniel McFadden’s Lecture ‘Choice: What Can Go Wrong?’, delivered on the same day, attempted to do just that, analysing how negative online marketing practices are making it difficult for consumers to make decision that promote their best economic interests.
“What is new is the volume of information facing consumers in the digital age, the replacement of personal association by digital influencers as curators of information, and the introduction of marketing tools that use consumer choice history, cognitive psychology and discrete choice analysis to design and promote products that attract consumers,” said McFadden, before launching into examples of modern marketing practices that can harm consumers and degrade market efficiency.
One that most attendees will have comes across is subscription autorenewal to online news platforms, dating sites, entertainment streaming services, etc. Often offered at a low introductory rate, many service providers exploit the consumer’s poverty of attention for profit, shrouding their regular rate from view and/or making cancellation or disabling autorenewal difficult, and designing their products, processing and marketing to avoid or distract the consumer’s attention.
McFadden has researched inattention in this context in detail using Medicare Part D, an administered market offering prescription drug and drug insurance for seniors. Enrollees have a yearly option to choose among about 50 plans, and the US Government provides an internet resource called Plan Finder to help them choose. However, ~90% of enrollees stay with their current plan each year even if there are substantial changes to their medical needs and plan costs.
McFadden’s team broke down the overall decision process into a number of stages and introduced a personal characteristic termed ‘acuity’, which they defined as decision making ability and opportunity cost. They then modelled the process, with interesting results: “Overall, we find the costs of inattention are substantial, about 20% higher costs for prescription drugs,” McFadden revealed. “And for low-income seniors, overspending equals about 10% income.”
McFadden concluded that policies that increase attention, such as messaging consumers that they have a choice and giving them individualised information on alternative plans, substantially increase enrollee wellbeing and reduce government costs, suggesting at least one route to tackling inattention.
Harking back to Aumann’s argument that seemingly irrational behaviour – like inattention around autorenewal – evolves biologically or culturally, McFadden concluded by saying that such behaviours largely stem from how we process information and form perceptions. “This can and should be studied and quantified and built into our understanding of economic consumer behaviour… putting us in a better position to design remedies and assess their efficacy.”