It turns out that you aren’t as rational as you may have thought. So, traditional economic theories that assume you are, are… well, flawed. We need an approach that accounts for self-interest and lazy mental short-cuts. Enter Behavioural Economics.
We’ve already told the foundation story of Behavioural Economics in our Management Thinkers series. There we looked at the two men who received Nobel Prizes in Economics for their work in the field:
Arguably, behavioural economics is Richard Thaler’s baby. And an important baby it is too, being part of an essential late twentieth century trend. At last, economists – spurred on by psychologists and social scientists, stopped seeing people as ‘rational units of intelligent decision making’ and started seeing us as part rational and part irrational bundles of ideas, knowledge, feelings, desires and biases.
It is with these filters, rather than pure rationality, that we make decisions. And that insight was an essential correction to classical economics. It won the psychologist, Daniel Kahneman, a Nobel Prize in economics. His collaborator and mentee, economist Richard Thaler, then led the development of the ideas.
Writing with University of Chicago colleague, Cass Sunstein, they together produced the massive selling book, Nudge. But why is co-authorship enough to justify Sunstein’s place in a management thinker pair, when Thaler led the charge on behavioural economics? The answer lies in Sunstein’s contribution: he’s a constitutional and administrative lawyer with a strong interest in social policy. His thinking helped bring behavioural insights out of the classroom, ad agency, and boardroom, and into public policy.
It’s not just in the supermarket that we get nudged to buy stuff, but when we interact with Government too. And between them, Thaler and Sunstein’s conception of liberal paternalism inspired a number of benign behaviour changes, with no whiff of compulsion. Their ideas were picked up by governments all over the world, including the US, where Sunstein (a former colleague) served in Barack Obama’s administration, and here in the UK, where Prime Minister David Cameron established a Nudge Unit within Government.
Richard Thaler was born in 1945 in New Jersey. He studied at Case Western Reserve University, gaining his BA in 1967. From there, he went to the University of Rochester, for his MA (1970) and PhD (1974).
In his PhD, Thaler started the work that still occupies him today, investigating the economic value of a life. What he found was a huge disparity in people’s evaluation of the worth of one week of their life. When asked to put a value on a week lost, or on a week gained, people needed a high payment to be prepared to give up a week of life. Yet they would be prepared to pay far less to gain an extra week.
This imbalance is, of course, irrational. And that interested psychologists Daniel Kahneman and Amos Tversky. They researched all sorts of biases and shortcuts in our thinking. Thaler became a long term collaborator with the pair.
Thaler stayed in the academic world, holding teaching and research positions at many institutions. His permanent academic homes were the Universities of Rochester (1974-8), Cornell (1978-95) and then Chicago, from 1995 to the present day. It was at Chicago that Thaler met Cass Sunstein.
Cass Sunstein was born in Massachusetts, in 1954. He gained his BA at Harvard College in 1975 and his JD from Harvard law School in 1978. Before returning to academia, Sunstein clerked for justices in the Massachusetts and US Supreme Courts, and served in the Justice department from 1980-1981.
In 1981, he became an Assistant Professor at the University of Chicago, becoming a full Professor in 1985. He remained at Chicago until 2008, when he formally moved to a post at Harvard Law School. However, having become friends with another Chicago Law School professor, Barack Obama, he headed up the Whitehouse Office of Information and Regulatory Affairs from 2009 to 2012.
In 2008, after working together on the ideas in the book for five years, and having known each other for ten, Thaler and Sunstein published a best-selling book, Nudge: Improving Decisions About Health, Wealth and Happiness. This brought the ideas of behavioural economics to a wide audience, and introduced many of us to the term ‘choice architecture’.
Choice architecture is a beautifully simple idea. By framing choices in a certain way, we can make it easier – physically, cognitively, psychologically – for people to make one choice rather than another. It’s how supermarkets channel customers and how governments secure compliance.
Choice architects study the heuristics people use to make decisions. These are the mental shortcuts we apply, that save us from having to think too carefully, expend too much effort, and take time over mundane choices. Except these heuristics effectively hard-wire biases into the way we make decisions. These are the biases that choice architects can exploit.
A ‘Nudge’ is simply a selection of how to frame (or architect) a choice, so that people can more easily make a choice that will satisfy them. Setting up nudges that satisfy you, at the cost of the chooser is manipulation. If you can avoid forcing your outcomes upon anyone, but make it easy for them to make a choice that suits them, Thaler and Sunstein refer to this as ‘libertarian paternalism’.
The tools that choice architects use are:
Setting the right defaults, so the easy choice is the best one
Anticipating errors, and therefore making correct behaviour easier
Setting up complex choices to highlight the right ones
Creating positive incentives for beneficial behaviour
The Behavioural Economics Context
Choice architecture is a subset of behavioural economics. This is the study of how real humans (not the artificial idealised, wholly-rational ‘econs’ of earlier economic theory) behave. Given economic choices, we are not wholly rational. This distorts markets and creates dynamics that do not conform to rational economic theory. This may seem like an obvious observation, but to economists through most of the twentieth century, it was not obvious at all. Year after year, new models and theories worn prestigious prizes. All were based on the myth of the ‘rational actor’.
Now, we know for sure that this rational actor is an ideal at best and a mythical creature at worst, we can start to do messier, but more realistic economics. That’s behavioural economics or, as Richard Thaler points out, Behavioral Economics: ‘why do the British need a superfluous u?‘, he asks. Because we are not rational, I suppose.
Richard Thaler on Nudge
A lot of great content, though edited with some disconcerting cuts.
Daniel Kahneman has won many awards and honours, but none more surprising, perhaps, than a Nobel Prize. Why is this surprising? Kahneman is, after all, one the most eminent and influential psychologists of his time. It is surprising because there is no Nobel Prize for psychology: Kahneman was co-recipient of the 2002 Nobel Prize in Economics ‘for having integrated insights from psychological research into economic science, especially concerning human judgement and decision making under uncertainty’.
In short, what Kahneman taught us was that, before he and his co-worker, Amos Tversky (who sadly died six years before the Nobel Committee considered this prize and so was not eligible), had started to study human decision making, all economic theories were based on the same, false assumption. Kahneman and Tversky taught us that human beings are not rational agents when we make economic decisions: we are instinctive, intuitive, biased decision makers.
And, if that sounds pretty obvious to us now, then we have Kahneman and Tversky, and their long walks together, to thank.
Daniel Kahneman was born in 1934 to Lithuanian emigré parents living in Paris (although he was born when they were visiting family members in Tel Aviv). When Nazi Germany occupied France, the family went on the run, ending up after the war in what was then (1948) Palestine under the British Mandate, shortly before the formation of the State of Israel.
In 1954 he gained his BSc from the Hebrew University, in Psychology and Maths, and joined the psychology department of the Israeli Defence Forces, helping with officer selection. Four years later, he went to the University of California, Berkeley, where he was awarded a PhD in 1961. He returned to the Hebrew University in 1961.
It was in 1968, while hosting a seminar, that he met Amos Tversky. They started collaborating shortly afterwards. Their fertile discussions often involved thought experiments about how we make decisions and judgements, uncovering in themselves a series of heuristics – or thinking shortcuts – which they went on to observe in controlled laboratory experiments. Their collaboration continued until Tversky’s death in 1996.
In that time, they collaborated with other researchers, most notably, Paul Slovic and economists Richard Thaler and Jack Knetsch. Their many insights into how we make judgements and the application to economic decision-making eventually led to the Nobel Committee recognising Kahneman with the 2002 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
Kahneman’s 2011 book, Thinking, Fast and Slow is a summary of a remarkable life’s work. If the ideas are new to you, they may well rock your world. It is not an easy read, but it is remarkably well-written for an intelligent lay audience. Even if Kahneman’s work is familiar to you, this book will repay close reading.
There is far too much in Kahneman’s work to even begin to summarise it, so I want to focus on three biases that he discovered, which have a profound impact on the choices we make; often leading us far astray.
The Anchoring Bias
The first information we get biases any subsequent choices we make. Your father was right, or your mother or anyone else who told you at a young age that first impressions count. Systematically, the human brain takes the first information it receives, and creates an interpretation of everything else that is anchored in the inferences it draws from that first impression. In management terms, this accounts for the horns and halo effect, that biases us to seek and spot confirming evidence for our pre-existing assessment.
The Representativeness Bias
Who is a more likely person to find working in a car repair shop, changing your brakes? Is it A: a young woman with blond hair and pink eyeliner, or B: a young woman with blond hair and pink eyeliner, whose father owns the car repair shop?
If you think B, you have fallen for representativeness bias. The story makes more sense in our experience, doesn’t it? A young woman with blond hair and pink eyeliner is not a person you’d expect to see in that environment. But a young woman with blond hair and pink eyeliner, whose father owns the car repair shop, may feel right at home. But statistically, this is rubbish. For every young woman with blond hair and pink eyeliner, only a small proportion will also have fathers who own a car repair shop.
The Availability Bias
Recent events bias our perception of risk. They are more available to recall and hence have a stronger impact on our intuition than do counter examples. The classic example is perceptions of risk of train travel, after a train crash. Trains are safe: they rarely crash. Cars crash a lot: there are many accidents every day. But they are rarely reported, so we have no immediate intuitive sense of the statistics.
The Impact of Kahneman’s Work
Kahneman’s work has had a huge impact. Decision theory existed before he came along, but he and Tversky revolutionised it. But it was Kahneman, along with Tversky, Knetsch and Thaler who pretty much invented the discipline of behavioural economics – and perhaps the relationship that drove that development was the friendship between Thaler and Kahneman.
Now Behavioural Economics infuses much of public policy and social influence that corporations try to exert over us. Thaler’s book, Nudge (with Cass Sunstein) is a best seller and Thaler and Sunstein both advise Prime Ministers and Presidents. Next time you get a document from Government, or go into a store, and you find yourself complying with their wishes without thinking, there is a chance that you have been ‘nudged’. And the roots of these ‘choice architectures’? The roots are in understanding our heuristics and biases. And that was Kahneman’s contribution.
Kahneman at TED
Here is Daniel Kahneman, talking about how we perceive happiness and discomfort.