Tag: bounded rationality

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?

The linked article below, by Evan Davis, assesses the state of economics. He argues that economics has had some major successes over the years in providing a framework for understanding how economies function and how to increase incomes and well-being more generally.

Over the last few decades, economists have …had an influence over every aspect of our lives. …And during this era in which economists have reigned, the world has notched up some marked successes. The reduction in the proportion of human beings living in abject poverty over the last thirty years has been extraordinary.

With the development of concepts such as opportunity cost, the prisoners’ dilemma, comparative advantage and the paradox of thrift, economics has helped to shape the way policymakers perceive economic issues and policies.

These concepts are ‘threshold concepts’. Understanding and being able to relate and apply these core economic concepts helps you to ‘think like an economist’ and to relate the different parts of the subject to each other. Both Economics (10th edition) and Essentials of Economics (8th edition) examine 15 of these threshold concepts. Each time a threshold concept is used in the text, a ‘TC’ icon appears in the margin with the appropriate number. By locating them in this way, you can see their use in a variety of contexts.

But despite the insights provided by traditional economics into the various problems that society faces, the discipline of economics has faced criticism, especially since the financial crisis, which most economists did not foresee.

Even Davis identifies two major shortcomings of the discipline – both beginning with ‘C’. ‘One is complexity, the other is community.’

In terms of complexity, the criticism is that economic models are often based on simplistic assumptions, such as ‘rational maximising behaviour’. This might make it easier to express the models mathematically, but mathematical elegance does not necessarily translate into predictive accuracy. Such models do not capture the ‘messiness’ of the real world.

These models have a certain theoretical elegance but there is now an increasing sense that economies do not evolve along a well-defined mathematical path, but in a far more messy way. The individual players within the economy face radical uncertainty; they adapt and learn as they go; they watch what everybody else does. The economy stumbles along in a process of slow discovery, full of feedback loops.

As far as ‘community’ is concerned, people do not just act as self-interested individuals. Their actions are often governed by how other people behave and also by how their own actions will affect other people, such as family, friends, colleagues or society more generally.

And the same applies to firms. They will be influenced by various other firms, such as competitors, trend setters and suppliers and also by a range of stakeholders – not just shareholders, but also workers, customers, local communities, etc. A firm’s aim is thus unlikely to be simple short-term profit maximisation.

And this broader set of interests translates into policy. The neoliberal free-market, laissez-faire approach to policy is challenged by the desire to take account of broader questions of equity, community and social justice. However privately efficient a free market is, it does not take account of the full social and environmental costs and benefits of firms’ and consumers’ actions or a fair distribution of income and wealth.

It would be wrong, however, to say that economics has not responded to these complexities and concerns. The analysis of externalities, income distribution, incentives, herd behaviour, uncertainty, speculation, cumulative causation and institutional values and biases are increasingly embedded in the economics curriculum and in economic research. What is more, behavioural economics is becoming increasingly mainstream in examining the behaviour of consumers, workers, firms and government. We have tried to reflect these developments in successive editions of our four textbooks.

Article

Questions

  1. Write a brief defence of traditional economic analysis (i.e. that based on the assumption of ‘rational economic behaviour’).
  2. What are the shortcomings of traditional economic analysis?
  3. What is meant by ‘behavioural economics’ and how does it address the concerns raised in Evan Davis’ article?
  4. How is herd behaviour relevant to explaining macroeconomic fluctuations?
  5. Identify various stakeholder groups of an energy company. What influence are they likely to have on the company’s behaviour?
  6. In an era of social media, web-based information and e-commerce, why might it be necessary to rethink the concept of GDP and its measurement?
  7. What is meant by an efficient stock market? Why may the stock market not be efficient?

One of the key developments in economics in recent years has been the growing influence of behavioural economics. We considered some of the insights of behavioural economics in a blog in 2016 (A nudge in the right direction?). As the post stated, ‘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.’ The post quoted from a Livemint article (see first linked article below):

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, people use heuristics. A heuristic technique is any approach to problem-solving, such as deciding what to buy, which is practical and sufficient for the purpose, but not necessarily optimal. For example, people may resort to making the best guess, or to drawing on past experiences of similar choices that turned out to be good or bad. On other accasions, when people are likely to face similar choices in the future, they resort to trial and error. They try a product. If they like it, they buy it again; if not, they don’t.

On other occasions, they may use various rules of thumb: buying what their friends do, or buying products on offer or buying trusted brands. These rules of thumb can lead to estimates that are reasonably close to the utility people will actually get and can save on time and effort. However, they sometimes lead to systematic and predictable misjudgements about the likelihood of certain events occurring.

In traditional models of consumer choice, individuals aim to maximise their utility when choosing between goods, or bundles of goods. The context in which the choices are offered is not considered.

Yet, in real life, we see that context is important; people will often make different choices when they are presented, or framed, in different ways. For example, people will buy more of a good when it is flagged up as a special offer than they would if there is no mention of an offer, even though the price is the same.

The recognition that framing is important to choices has led to the development of nudge theory. Indeed, it underpins many marketing techniques. These seek to persuade people to make a particular choice by framing it in an optimistic way or presenting it in a way that makes it easy to decide.

Governments too use nudge theory. In the UK, the Coalition government (2010–15) established the Behavioural Insights Team (BIT) (also unofficially known as the Nudge Unit) in the Cabinet Office in 2010. A major objective of this team is to use ideas from behavioural economics to design policies that enable people to make better choices for themselves.

The podcast linked below, looks at the use of nudge theory. The presenter, Mary Ann Sieghart looks at how we are being encouraged to change our behaviour. She also looks at the work of UCL’s Love Lab which researches the way we make decisions. As the programme notes state:

Mary Ann is grilled in UCL’s Love Lab to find out how she makes decisions; she finds taking the pound signs off the menu in a restaurant encourages her spend more and adding adjectives to the food really makes it taste better.

Walking through the Nudge Unit, she hears how powerful a tiny tweak on a form or text can get be, from getting people back to work to creating a more diverse police force. Popular with the political left and right, it has been embraced around the world; from Guatemala to Rwanda, Singapore to India it is used to reduce energy consumption, encourage organ donation, combat corruption and even stop civil wars.

But the podcast also looks at some of the darker sides of nudging. Just as we can be nudged into doing things in our interests, so too we can be nudged to do things that are not so. Politicians and businesses may seek to manipulate people to get them to behave in ways that suit the government or the business, rather than the electorate or the consumer. The dark arts of persuasion are also something that behavioural economists study.

The articles below explore some of the areas where nudge theory is used to devise policy to influence our behaviour – for good or bad.

Podcast

Video

Articles

Questions

  1. Explain what are meant by ‘bounded rationality’ and ‘heuristics’.
  2. How may populist politicians use nudge theory in their campaigning?
  3. Give some examples from your own behaviour of decisions made using rules of thumb.
  4. Should we abandon models based on the assumption of rational maximising behaviour (e.g. attempts to maximise consumer surplus or to maximise profit)?
  5. 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.
  6. How might we be nudged into using less plastic?
  7. How might people be nudged to eat more healthily or to give up smoking?
  8. To what extent can financial incentives, such as taxes, fines, grants or subsidies be regarded as nudging? Explain.
  9. Would you advise all GP surgeries and hospital outpatient departments to text reminders to people about appointments? What should such reminders say? Explain.

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

  1. Explain what is meant by bounded rationality.
  2. Give some examples from your own behaviour of decisions made using rules of thumb.
  3. Should we abandon models based on the assumption of rational maximising behaviour (e.g. attempts to maximise consumer surplus or to maximise profit)?
  4. 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.
  5. How might people be nudged to eat more healthily or to give up smoking?
  6. To what extent can financial incentives, such as taxes, fines, grants or subsidies be regarded nudging? Explain.
  7. 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?

Australia is a rich country. It is one of the few to have avoided a recession. This has been the result partly of successful macroeconomic policies, but largely of the huge mining boom, with Australia exporting minerals to China and other fast growing Asian economies.

But has this growth brought happiness? Are Australians having to work harder and harder to pay for their high standard of living? Indeed, do higher incomes generally result in greater happiness? The following articles explore this issue, both in an Australian context and more broadly. They look at some recent evidence.

For example, in one study, Canadian, Chinese, Indian, and Japanese university students were asked what they held to be most important for assessing the worth of their lives. The crucial finding was that although higher incomes may be a contributing factor to increased happiness and well-being, especially for poorer people, other factors are more important. These include developing fulfilling personal relationships, whether with partners, family members or friends; gaining knowledge and wisdom; having enjoyable hobbies; having financial security (as opposed to higher incomes); having a worthwhile career; living a moral life; helping other people.

The question then arises whether our economic systems and incentives are geared towards achieving these outcomes. Or are we encouraged to consume more and more and to seek higher and higher incomes to feed our addiction to consumption?

Is there an information problem here? Do many individuals perceive that money will buy them happiness, whereas, in reality, money can’t buy them love?

Articles

Australia: Where the good life comes at a price BBC News Magazine, Madeleine Morris (24/2/13)
Australia has the know-how to boost wellbeing Sydney Morning Herald, Matt Wade (8/9/12)
Money can’t buy you the good life Independent, Roger Dobson (24/2/13)
The 10 Things Economics Can Tell Us About Happiness The Atlantic, Derek Thompson (31/5/12)
Yes, Money Does Buy Happiness: 6 Lessons from the Newest Research on Income and Well-Being The Atlantic, Derek Thompson (10/1/13)
The fact is, the richer you are, the happier you are The Telegraph, Allister Heath (5/2/13)
Money buys happiness? I wouldn’t bank on it The Telegraph, Christopher Howse (6/2/13)
Who Says Wealth Doesn’t Buy Happiness? The Wealthy Do CNBC, Robert Frank (4/2/13)
More Proof That Money Can’t Buy Happiness Business Insider, Aimee Groth (28/1/13)
Money Changes Everything The New York Times, Adam Davidson (5/2/13)
Why are the Chinese so sad? Maclean’s (Canada), Mitch Moxley (4/2/13)

Reports

First World Happiness Report Launched at the United Nations The Earth Institute, Columbia University (2/4/12)
World Happiness Report The Earth Institute, Columbia University, John Helliwell, Richard Layard and Jeffrey Sachs (eds.) (2/4/12)
Well-being evidence for policy: A review New Economics Foundation, Laura Stoll, Juliet Michaelson and Charles Seaford (3/4/12)

Questions

  1. Distinguish between necessary and sufficient conditions. Is higher income a necessary or sufficient condition (or both or neither) for an increase in happiness? Does a person’s circumstances affect the answer to this question?
  2. Explain what is meant by ‘rational behaviour’ at the margin in the traditional economic sense?
  3. If a person always behaved rationally, would they be happier than if they did not? Explain.
  4. Explain how information asymmetry between the two or more parties involved in a transaction may make people worse off, rather than better off, even though they were behaving rationally.
  5. Explain what is meant by diminishing returns to income.Do richer countries get happier as they get richer?
  6. How would you set about measuring happiness?
  7. What do you understand by the term ‘hedonic elevation and decline’? Does this provide an accurate description of you own purchasing behaviour? If so, explain whether or not you would like to change this behaviour.
  8. When people make economic decisions, these are normally made with bounded rationality. How may this affect the desirability of the outcomes of the decisions?
  9. In explaining bankers’ behaviour, Christopher Howse (author of the second Telegraph article above) states: ‘It’s the power game that keeps them happy, not the money itself. When I say “keeps them happy” I mean “feeds their addiction”. It is a negative kind of satisfaction. A morning spent without the distraction of making big bucks is a morning left exposed to the empty horror of being a little rational animal on the bare surface of the Earth lost in space.’ Do you agree? Explain why or why not.
  10. When people are addicted to something, would doing more of it be classed as irrational? Explain.
  11. Why are the Chinese so sad?