The Era of Behavioural Economics

By Barry Childs

2017 saw the Nobel prize in Economics awarded to Richard H. Thaler for his wide-ranging work in the area of behavioural economics. While he is not the first to receive the award for work in this field, his writings and contribution to making behavioural economics more accessible have done us all a great service.

It has been clear for some time that the simplistic mathematically tractable models used in traditional economics do not accurately represent how people make certain types of decisions. There is a vast body of evidence of cognitive biases that affect the way we perceive and interact with the world around us. Around 1974, Prospect Theory developed by Amos Tversky and Daniel Kahneman (also Nobel prize winners in the field) presented a more nuanced view of how individuals make decisions when faced with risk and uncertainty. Their early rule of thumb that people react twice as strongly to potential losses as potential gains remains true today.

Mental accounting is a cognitive bias that affects our everyday lives, as we separate our funds into artificial buckets resulting in us having money for some things and not others without a proper prioritisation mechanism for allocation. Overconfidence is a bias that affects the way we think about our own abilities and results in a high proportion of people considering themselves better than average. Hyperbolic discounting is a bias that results in us heavily discounting future events which have a material impact on the way people save for retirement. From a healthcare perspective, we underestimate the cumulative effect of minor regular behaviours, and so prolonged bad habits, poor nutrition and inadequate exercise compound over time to yield an unhealthy state. Conversely, we need to put in consistent effort over a protracted period of time to improve our state of health. These forces explain a large part of why it can be difficult to stick to our budgets, to save properly for retirement and to keep ourselves healthy. There are many other examples and if the topic is something you’re interested there a host of great books to read. We also put together a cheat sheet of 20 common cognitive biases – send us an email if you’d like a copy of the poster.

So, what can we do empowered with this better understanding of how people behave? Richard Thaler has some great pointers in his highly publicised book Nudge. He advocates an approach he calls neoliberal paternalism. People should of course be free to make their own choices, but they can make better choices with some help, with some nudging. This may take the form of smart defaults on choices presented to consumers, framing choices in a particular way to solicit positive behaviours, and designing products with the right incentives built in to optimise decision making for prosperity and health. Those of us involved in product design and policy making owe it to our constituents to ensure we use the best possible information and skill sets. This includes the application of behavioral economics principles. Look out for our upcoming series of blogs on this theme.

For your reading pleasure here is our suggested starter book list on the topic of behavioural economics. 

Nudge, Richard ThalerCass Sunstein, 2008

Misbehaving, Richard Thaler, 2015

Predictably Irrational, Dan Ariely, 2008

The upside of irrationality, Dan Ariely, 2010

The honest truth about dishonesty, Dan Ariely, 2012

The Why Axis, Uri Gneezy and John A-List, 2013

Thinking fast and slow, Daniel Kahneman, 2011

Judgement under Uncertainty: Heuristics and Biases, Amos Tversky and Daniel Kahneman, 1974