The annual Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, normally known as the Nobel Prize in Economics, has been awarded 49 times since it was founded in 1969. Many well-known economists have been recipients of the award. This year it had been awarded to Richard Thaler for his research in behavioural economics. The award recognises his work in integrating economics with psychology.
Richard H. Thaler has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes.
In total, Richard Thaler’s contributions have built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioural economics, which has had a profound impact on many areas of economic research and policy.
Instead of making the assumption that people are rational maximisers, behavioural economists look at how people actually behave and respond to various incentives.
For example, people may be motivated by concepts of fairness and be prepared to make personal sacrifices for the sake of others. Such concepts of fairness tend to depend on the social context in which choices are made and can be influenced by the way choices are framed.
Also people may not weigh up costs and benefits but use simple rules of thumb, or heuristics, when making decisions. This might be an example of rational behaviour when time or information is limited, but the use of such heuristics often becomes engrained in behaviour and the rules become just habit.
People may also suffer from a lack of willpower or ‘present bias’. They may spend more than they can afford because they cannot resist the temptation to have a product. They may overeat because of the short-term pleasure it brings and ignore the long-term effects on their health.
Understanding how people make choices and the temptations to which they succumb can help policymakers devise incentives to change behaviour to achieve various social goals.
One type of incentive is nudging. A well-known example is people’s choice about whether to become an organ donor in the event of their death. If people are required to opt in to such a scheme, they may never get round to doing so. However, if they are required to opt out if they do not want to participate, many more people would thereby be donors and more organs would become available.
Another form of nudge is making desirable things fun. A well-known experiment here was encouraging people to use the stairs rather than the escalator when exiting a subway by making the stairs like a musical keyboard. See here for more examples.
The UK government set up a Behavioural Insights Team – also known as the Nudge Unit (now independent of government) to find ways of encouraging people to behave in their own or society’s best interests.
But it is not just governments which use the insights of behavioural economists such as Thaler. The advertising and marketing industry is always examining the most effective means of influencing behaviour. A classic example is the loss leader, where consumers are tempted into a shop with a special offer and then end up buying more expensive items there rather than elsewhere.
Firms and advertisers know only too well the gains from tempting people to buy items that give them short-term gratification – such as putting chocolate bars by the tills in supermarkets.
Understanding consumer psychology helps firms to manipulate people’s choices. And such manipulation may not be in our best interests. If we are being persuaded to buy this product or that, are we fully aware of what’s going on and how our tastes are being affected? Would we, by standing back and reflecting, make the same choices as we do on impulse or out of habit?
And governments too can seek to manipulate people in ways that some may find undesirable. Governments may try to influence us to follow their particular political agenda – as may newspapers. Certainly, during election or referendum campaigns, we are being nudged to vote a particular way.
It is important then for us to understand when we are being nudged or otherwise persuaded. Do we really want to behave in that way? Just as it is important, then, for governments and firms to understand individuals’ behaviour, so too it is important for individuals to understand their own behaviour.
Articles
Richard Thaler’s work demonstrates why economics is hard The Economist, RA (11/10/17)
Nobel in Economics Is Awarded to Richard Thaler The New York Times, Binyamin Appelbaum (9/10/17)
The Making of Richard Thaler’s Economics Nobel The New Yorker, John Cassidy (10/10/17)
Nobel prize in economics awarded to Richard Thaler The Guardian, Richard Partington (10/10/17)
Richard Thaler is a controversial Nobel prize winner – but a deserving one The Guardian, Robert Shiller (11/10/17)
What the mainstreaming of behavioural nudges reveals about neoliberal government The Conversation, Rupert Alcock (17/10/17)
This year’s economics Nobel winner invented a tool that’s both brilliant and undemocratic Vox, Henry Farrell (16/10/17)
How a critic of economics became the disciplines Nobel-winning best friend The Guardian, Tiago Mata and Jack Wright (25/10/17)
Podcast
How Richard Thaler changed economics BBC, More of Less, Tim Harford (14/10/17)
Questions
- For what reasons may individuals not always weigh up the costs and benefits of purchasing an item?
- Give some examples of the use of heuristics in making consumption decisions?
- Is the use of heuristics irrational?
- Explain how people considering that they have behaved fairly is influenced by the social context of their behaviour?
- Find out what is meant by the Dictator Game and how it can challenge the assumption that people behave selfishly. How is the ‘dictator’s’ behaviour affected by the possible payoffs?
- Thaler suggested that Brexit could be an example of behavioural economics in action. Find out what he meant by this. Do you agree?
- Give some examples of ways in which the government can nudge people to persuade them to behave in socially or individually desirable ways.
- Find out what is meant by the ‘endowment effect’ and how it influences people’s valuation of items they own.
- Why may nudging by governments be undemocratic?
Is too much expected of economists? When economic forecasts turn out to be wrong, as they often are, economists are criticised for having inaccurate or unrealistic models. But is this a fair criticism?
The following article by Richard Whittle from Manchester Metropolitan University looks at what economists can and cannot do. The article highlights two key problems for economic forecasting.
The first concerns human behaviour, which is influenced by a whole range of factors and can change very rapidly in response to changing circumstances. Moods of optimism or pessimism can quickly spread in response to a news item, such as measures announced by Donald Trump or latest data on growth or the housing market.
The second concerns the whole range of possible economic shocks. Such shocks, by their very nature, are hard to predict and can quickly make forecasts wrong. They could be a surprise election result, a surprise government policy change, a natural disaster, a war or a series of terrorist attacks. And these shocks, in turn, affect human behaviour. Consumption and investment may rise or fall as the events affect confidence and herd behaviour.
But is it a fair criticism of economics that it cannot foretell the future? Do economists, as the article says, throw up their hands and curse economics as a futile endeavour? Not surprisingly, the answer given is no! The author gives an analogy with medicine.
A doctor cannot definitely prevent illness, but can offer advice on prevention and hopefully offer a cure if you do get ill. This is the same for the work economists do.
Economists can offer advice on preventing crises or slowdowns but cannot definitively prevent them from happening. Economists can also offer robust advice on restoring growth, although when the advice is that the economy has grown too fast and should slow, it is often not welcomed by policy makers.
Helping understanding the various drivers in an economy and how humans are likely to respond to various incentives is a key part of what economists do. But making predictions with 100% certainty is asking too much of economists.
And just as medical professionals can predict that if you smoke, eat unhealthy food or take no exercise you are likely to be less healthy and die younger, but cannot say precisely when an individual will die, so too economists can predict that certain policy measures are likely to increase or decrease GDP or employment or inflation, but they cannot say precisely how much they will be affected.
As the article says, “the true value of the economist lies not in mystical fortune telling, but in achieving a better understanding of the nature of the economies in which we live and work.”
Article
How to be an economist in 2017 The Conversation, Richard Whittle (24/1/17)
Questions
- For what reasons has economics been ‘in crisis’? What is the solution to this crisis?
- Look at some macroeconomic forecasts for a country of your choice made two years ago for today (see, for example, forecasts made by the IMF, OECD or a central bank). How accurate were they? Explain any inaccuracies.
- To what extent is economic forecasting like weather forecasting?
- What is meant by cumulative causation? Give some examples. Why does cumulative causation make economic forecasting difficult?
- How is the increased usage of contactless card payments likely to affect spending patterns? Explain why.
- Why is it difficult to forecast the effects of Brexit?
- How can economic advisors help governments in designing policy?
- Why do people tend to overweight high probabilities and underweight low ones?
Can behavioural economics be applied to the case of Sweden? The Swedish government is trying this out by changing government policy in a way that may encourage its residents to change their behaviour.
People in many countries in the world live in what is often called a ‘throwaway society’. If something breaks, it’s often easier and cheaper simply to get rid of it and buy a new one. But with changes in government policy, including VAT cuts on repairs to white goods, the objective is to encourage consumers to repair their goods, rather than buying new ones. This is also contributing towards the wider objective of sustainable consumption, which is being promoted by the Swedish government.
Per Bolund, who is one of Sweden’s six Green Ministers, spoke about this policy commenting that:
“Consumers are quite active in changing both what they buy and how they buy in Sweden … We believe that getting lower costs for labour is a big part in making it more rational to repair rather than just to buy cheap and throw away …If we don’t change the economic incentives the change will never come.”
Whether or not this policy works will take some time to see, but it’s certainly an interesting test of how changing incentives affect consumer behaviour. You can read about other examples of nudging in the following blog A nudge in the right direction?.
Articles
Waste not want not: Sweden to give tax breaks for repairs The Guardian, Richard Orange (19/9/16)
Can Sweden tackle the throwaway society? BBC News (20/9/16)
Trendy now, trash tomorrow Huffington Post, Kirsten Brodde (29/9/16)
Hong Kong needs a strategy quickly for dealing with waste South China Morning Post (27/9/16)
Questions
- If VAT on repairs falls, how will this affect consumer behaviour?
- Do you think there would be an income and a substitution effect from this change in government policy? What would they be?
- How is the Swedish government using incentives to change consumer behaviour?
- If it is cheaper to buy a new white good, then is it rational to buy a new one rather than repair an existing one?
- How effective do you think this policy would be in encouraging consumers to change their behaviour?
- Find some other examples of how people might be nudged to behave in ways that are in their own interest or that of society.
Behavioural economists study how people’s buying, selling and other behaviour responds to various incentives and social situations. They don’t accept the simplistic notion that people are always rational maximisers. As the Livemint article below states, “According to behavioural economists, the human brain neither has the time nor the ability to process all the information involved in decision making, as assumed by the rational model.” Instead, rationality is bounded: people use simple rules of thumb in making decisions – rules they have developed over time in the light of experience.
So can people’s behaviour be altered by understanding their limited rationality? Advertisers are only too well aware of a number of psychological ‘tricks’ to change people’s purchasing behaviour. For example, wanting to be approved of by your friends is used by advertisers to sell various fashion products and toiletries. Often, people need only a relatively small ‘nudge’ to change the way they behave.
And it is not just advertisers who are using the insights of behavioural economics. Governments are increasingly trying to find ways of nudging people to behave in ways that are better for themselves or for society.
In 2010, David Cameron set up a ‘Nudge Unit’, formally know as ‘The Behavioural Insights Team‘. It has produced a number of academic papers on topics as diverse as tax compliance, incentives for university attendance, charitable giving in the workplace and using SMS reminders to reduce missed hospital appointments. The academic evidence can then be use as the basis for policy.
Another nudge unit has been set up in Australia (see second article below). The USA, Singapore and various other countries are increasingly using the insights of behavioural economics to devise policy to affect human behaviour.
Two recent pieces of work by the UK team concern ways of discouraging doctors from over-prescribing antibiotics and using encouraging text messages to FE students to reduce dropout rates. Another nudge has been used by the tax authorities (HMRC) who have been sending out texts to remind people to pay their taxes on time and to make them aware that they are being monitored. The message read, “Most people pay on time to avoid penalties”.
The articles below look at these recent initiatives and how human behaviour can be changed in a relatively low-cost way. In most cases this involves a simple nudge.
Articles
Nudge-unit trials reveal best ways to prod people Sydney Morning Herald, Nick Miller (29/8/15)
Government ‘nudge unit’ to attempt to change people’s behaviours Sydney Morning Herald, Nick Miller (15/9/16)
New frontiers of human behaviour Livemint, Biju Dominic (15/9/16)
Doctors ‘nudged’ into prescribing far fewer antibiotics New Scientist (15/9/16)
GPs handing out fewer antibiotics after warning of over-prescribing, says study BT (15/9/16)
Study of colleges shows ‘encouraging’ texts dramatically cut dropout rates FE Week, Paul Offord (22/7/15)
The text messages getting teenagers better grades BBC Today Programme, David Halpern and Fiona Morey (15/9/16)
Ping! Pay your tax now or face a penalty. HMRC sends out ‘threatening’ SMS texts to taxpayers The Telegraph, Christopher Hope (15/9/16)
Publications of Behavioural Insights Team
Publications list BIT
The Behavioural Insights Team’s Update Report: 2015–16: overview BIT (15/9/16)
The Behavioural Insights Team’s Update Report: 2015–16 BIT (15/9/16)
Blog BIT
Questions
- Explain what is meant by bounded rationality.
- Give some examples from your own behaviour of decisions made using rules of thumb.
- Should we abandon models based on the assumption of rational maximising behaviour (e.g. attempts to maximise consumer surplus or to maximise profit)?
- Find out some other examples of how people might be nudged to behave in ways that are in their own interest or that of society.
- How might people be nudged to eat more healthily or to give up smoking?
- To what extent can financial incentives, such as taxes, fines, grants or subsidies be regarded nudging? Explain.
- Why, do you think, the message by an Australian hospital, “if you attend, the hospital will not lose the $125 we lose when a patient does not turn up” was successful in reducing missed appointments by 20%, while the message, “if you do not attend, the hospital loses $125” was not as effective?
Tax avoidance has been in the news since the publication of the Panama papers, which show the use of offshore tax havens by rich individuals and companies, partly for tax avoidance, partly for money laundering and other criminal activities – some by corrupt politicians and their associates – and partly to take advantage of lower regulation of financial dealing.
There are many tax havens around the world, including Switzerland, Hong Kong, British overseas territories (such as the British Virgin Islands, the Cayman Islands and Bermuda), Jersey, Singapore and certain US states 
(such as Arizona, Delaware, Nevada and Wyoming).
Here we focus on tax avoidance. This is the management of tax affairs by individuals or firms so as to avoid or minimise the payment of taxes. Tax avoidance is legal, unlike tax evasion, which is the practice of not declaring taxable income.
In a statement from the White House, directly after the publication of the Panama papers, President Obama spoke about the huge international scale of tax evasion and tax avoidance:
“A lot of it is legal, but that’s exactly the problem. It’s not that [people are] breaking the laws, it’s that the laws are so poorly designed that they allow people, if they’ve got enough lawyers and enough accountants, to wiggle out of responsibilities that ordinary citizens are having to abide by.
Here in the United States, there are loopholes that only wealthy individuals and powerful corporations have access to. They have access to offshore accounts, and they are gaming the system. Middle-class families are not in the same position to do this. In fact, a lot of these loopholes come at the expense of middle-class families, because that lost revenue has to be made up somewhere. Alternatively, it means that we’re not investing as much as we should in schools, in making college more affordable, in putting people back to work rebuilding our roads, our bridges, our infrastructure, creating more opportunities for our children.”
Tax avoidance, whether in tax havens, or through exploiting loopholes in the tax system may be legal. But is it fair?
Various principles of a tax system can be identified. These include:
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Horizontal equity |
People in the same situation should be treated equally. For example, people earning the same level of income and with the same personal circumstances (e.g. number and type of dependants, size of mortgage, etc.) should pay the same level of income tax. |
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Vertical equity |
Taxes should be ‘fairly’ apportioned between rich and poor. The rich should pay proportionately more taxes than the poor. |
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Equity between recipients of government services |
Under the ‘benefit principle’, it is argued that those who receive the most benefits from government expenditure ought to pay the most in taxes. For example, it can be argued that roads should be paid for from fuel tax. |
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Difficulty of evasion and possibly of avoidance |
If it is desirable to have a given tax, people should not be able to escape paying. |
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Non-distortion |
Taxes alter market signals: taxes on goods and services alter market prices; taxes on income alter wages. They should not do this in an undesirable direction. |
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Convenience to the taxpayer |
Taxes should be certain and clearly understood by taxpayers so that they can calculate their tax liabilities. The method of payment should be straightforward. |
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Convenience to the government |
Tax rates should be simple to adjust and as cheap to collect as possible. |
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Minimal disincentive effects |
Taxes may discourage people from working longer or harder, from saving, from investing or from taking initiative. It is desirable that these disincentives should be kept to a minimum. |
Of course, not all these requirements can be met at the same time. One of the most serious conflicts is between vertical equity and the need to keep disincentives to a minimum. The more steeply the rich are taxed, it is argued, the more serious are the disincentive effects on them likely to be (see the blog post from 2012, The 50p income tax rate and the Laffer curve). Another is between vertical equity and equity between recipients of services. Some of the people most in need of government support are the poorest and hence pay the least taxes.
The crucial question is what is regarded as ‘fair’. What is vertically equitable? According to the second article below, people’s preferred tax rates depend on how information is presented. If information is presented on how much tax is paid by the rich, people generally feel that the rich pay too much. If, however, information is presented on how much income people are left with after paying tax, people feel that the rich still have too much and ought to pay more tax.
The majority of people in the UK feel that tax avoidance, although legal, is morally wrong. According to the results of an HMRC survey in 2015, “the majority (63%) of respondents felt that the use of tax avoidance schemes was widespread. However, the majority (61%) also responded that it was never acceptable to use a tax avoidance scheme. The most frequent reason given as to why it was unacceptable was that ‘it is unfair on others who pay their taxes’.”
In making judgements about the fairness of tax, people generally have inaccurate knowledge about the distribution of income, believing that it is more equal than it really is, and about the progressiveness of the tax system, believing that it is more progressive than it really is. Despite this, they want post-tax income distribution to be more equal.
What is more, although people generally disapprove of tax avoidance, it is the system that allows the avoidance of taxes that they want changing. As long as it is possible to avoid taxes, such as giving gifts to children to avoid inheritance tax (as long as the gift is made more than seven years before the person’s death), most people see no reason why they should not do so themselves.
The following articles look at tax avoidance and people’s attitudes towards it. They are all drawn from The Conversation, “an independent source of news and views, sourced from the academic and research community and delivered direct to the public.”.
Articles
Explainer: what are ‘tax havens’? The Conversation, Tommaso Faccio (5/4/16)
When it comes to tax, how do we decide what’s fair? The Conversation, Stian Reimers (8/4/16)
Six things a tax haven expert learned from the Panama Papers The Conversation, Ronen Palan (6/4/16)
Documents
The Panama Papers The International Consortium of Investigative Journalists
Exploring public attitudes to tax avoidance in 2015: HM Revenue and Customs Research Report 401 HMRC, Preena Shah (February 2016)
2010 to 2015 government policy: tax evasion and avoidance HMRC/HM Treasury (8/5/15)
Questions
- Distinguish between tax avoidance and tax evasion.
- Give some examples of tax avoidance.
- Look through the various principles of a tax system and identify any conflicts.
- What problems are there in having a highly progressive tax system?
- What is a ‘shell company’? How can it be used to avoid and evade taxes?
- What are bearer shares and bonds? Why were they abolished in the UK in 2015?
- What legitimate reasons may there be for a company or individual using a tax haven?
- To what extent might increased transparency in tax affairs discourage individuals and companies from engaging in aggressive tax avoidance?
- What light does/can behavioural economics shed on people’s perceptions of fairness?
- How might the use of absolute amounts or percentages influence people’s thinking about the fairness of a tax system? What implications does this have for politicians in framing tax policy?
- In the principal–agent problem, where the principals are the tax authorities and the agents are taxpayers, why does asymmetric information arise and why is it a problem? How do the tax authorities seek to reduce this problem?
The annual Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, normally known as the Nobel Prize in Economics, has been awarded 49 times since it was founded in 1969. Many well-known economists have been recipients of the award. This year it had been awarded to Richard Thaler for his research in behavioural economics. The award recognises his work in integrating economics with psychology.
Understanding how people make choices and the temptations to which they succumb can help policymakers devise incentives to change behaviour to achieve various social goals.
Understanding consumer psychology helps firms to manipulate people’s choices. And such manipulation may not be in our best interests. If we are being persuaded to buy this product or that, are we fully aware of what’s going on and how our tastes are being affected? Would we, by standing back and reflecting, make the same choices as we do on impulse or out of habit?
