Nudge Theory and Behavioral Economics

What is ‘nudge theory’ and why should we care?

The concept is a relatively subtle policy shift that encourages people to make decisions that are in their broad self-interest.

It’s not about penalising people financially if they don’t act in certain way.It’s about making it easier for them to make a certain decision.

“By knowing how people think, we can make it easier for them to choose what is best for them, their families and society,” wrote Richard Thaler and Cass Sunstein in their book Nudge, which was published in 2008.

For example?

A good recent example can be found in UK pension policy.

In order to increase worryingly low pension saving rates among private sector workers the Government mandated employers to establish an 'automatic enrolment' scheme in 2012.

This meant that workers would be automatically placed into a firm’s scheme, and contributions would be deducted from their pay packet, unless they formally requested to be exempted. 

The theory was that many people actually wanted to put more money aside for retirement but they were put off from doing so by the need to make what they feared would be complicated decisions.

The idea was that auto enrolment would make saving the default for employees, and thus make it easier for them to do what they really wanted to do and push up savings rates.

Has it worked?

Very much so.

Since auto enrolment was introduced by the Government in 2012, active membership of private sector pension schemes has jumpedfrom 2.7 million to 7.7 million in 2016.

Anything else?

Organ donation is another example of an area where nudge policy has worked. Spain operates an opt-out system, whereby all citizens are automatically registered for organ donation unless they choose to state otherwise. This is different from the UK where donors have to opt in.

The Spanish opt-out system is one of the reasons Spain is a world leader in organ donation.

France also switched to an opt-out regime this year. Theresa May said at the Tory Party conference that the UK would do the same.

The theory is the same as relates to pensions: deep down most people want to be donors if they die in an accident and their organs could be used to save someone else’s life but for various reasons never get around to registering.

The opt-out system makes it easier for them to do what they really want to do.

However, Mr Thaler actually prefers a system of “prompted choice” on organ donations to opt out.

This would prompt people to register at various points, such as when they apply for, or renew, a driving licence.

Doesn’t this ‘nudging’ infringe civil liberties?

The concept has certainly been criticised as paternalistic.

Yet it’s hard for libertarians to make a persuasive cases against such policy nudges in relation to pensions and organ donation because the opt-out option always remains available for people.

So politicians are all using nudge now?

It is proving increasingly popular.

The previous US president Barack Obama recruited Cass Sunstein as an adviser and exhorted US government departments to adopt behavioural economic concepts such as nudge.

In 2010 the UK Government set up a Behavioural Insights Team, commonly dubbed a “nudge unit”, to develop policies.

Administrations in Denmark, Australia, Canada and the Netherlands have also shown an interest.

Richard Thaler and the economics of how we live

 How do you get people to eat more healthily?

You could construct some powerful arguments about how an obesity epidemic is leading to more diseases such as Type II diabetes and coronary heart conditions.

You could put large red traffic light signs on unhealthy foods and engage in expensive public information campaigns warning that overeating products high in salt, sugar and fat can reduce life expectancy.
Or you could just change where you put the salad boxes on the supermarket shelves.

The last option is an example of nudge theory at work, a theory popularised and developed by Richard Thaler, the University of Chicago economist who was today announced as this year's recipient of the Nobel Prize for Economics.

Prof Thaler's central insight is that we are not the rational beings beloved of more traditional economic theory.

Given two options, we are likely to pick the wrong one even if that means making ourselves less well off.

Lack of thinking time, habit and poor decision making mean that even when presented with a factual analysis (for example on healthy eating) we are still likely to pick burger and chips.

We're hungry, we're in a hurry and burger and chips is what we always buy.

Nudge theory takes account of this, based as it is on the simple premise that people will often choose what is easiest over what is wisest.

Tests have shown that putting healthier foods on a higher shelf increases sales. The food is more likely to be in someone's eye line and therefore "nudge" that person towards the purchase - whether they had any idea about the obesity argument or not.

Such theories, which sit in a big bucket of academic study called "behavioural economics", are what Prof Thaler is famous for.

So famous that the government now has its own Behavioural Insights Team, otherwise known as the "nudge unit".

It helps formulate policies, for example on pensions, to try and make us behave "more rationally" and push us towards better outcomes.

Prof Thaler also gave us the concept of "mental accounting" - that we will tend to divide our expenditure into separate blocks even though they come from the same source.

For example, we will spend more on a credit or debit card in a food shop compared with cash even though all the money ultimately comes from our earnings.

Having just received news of the award, Prof Thaler told me that his job was to "add human beings" to economic theory.

And today he has been rewarded, both via the recognition of the Nobel Prize and by the not inconsiderable sum of £845,000 in prize money. 

Asked how he would spend the money Prof Thaler gave a succinct answer. "Irrationally."

What is 'Behavioral Economics'

Behavioral Economics is the study of psychology as it relates to the economic decision-making processes of individuals and institutions. The two most important questions in this field are:

1. Are economists' assumptions of utility or profit maximization good approximations of real people's behavior?

2. Do individuals maximize subjective expected utility?

BREAKING DOWN 'Behavioral Economics'

In an ideal world, people would always make optimal decisions that provide them with the greatest benefit and satisfaction. In economics, rational choice theory states that when humans are presented with various options under the conditions of scarcity, they would choose the option that maximizes their individual satisfaction. This theory assumes that people, given their preferences and constraints, are capable of making rational decisions by effectively weighing the costs and benefits of each option available to them. The final decision made will be the best choice for the individual. The rational person has self-control and is unmoved by emotions and external factors and, hence, knows what is best for himself. Alas behavioral economics explains that humans are not rational and are incapable of making good decisions.

Behavioral economics draws on psychology and economics to explore why people sometimes make irrational decisions, and why and how their behavior does not follow the predictions of economic models. Decisions such as how much to pay for a cup of coffee, whether to go to graduate school, whether to pursue a healthy lifestyle, how much to contribute towards retirement, etc. are the sorts of decisions that most people make at some point in their lives. Behavioral economics seeks to explain why an individual decided to go for choice A, instead of choice B.

Because humans are emotional and easily distracted beings, they make decisions that are not in their self-interest. For example, according to the rational choice theory, if Charles wants to lose weight and is equipped with information about the number of calories available in each edible product, he will opt only for the food products with minimal calories. Behavioral economics states that even if Charles wants to lose weight and sets his mind on eating healthy food going forward, his end behavior will be subject to cognitive bias, emotions, and social influences. If a commercial on TV advertises a brand of ice cream at an attractive price and quotes that all human beings need 2,000 calories a day to function effectively after all, the mouth-watering ice cream image, price, and seemingly valid statistics may lead Charles to fall into the sweet temptation and fall out of the weight loss bandwagon, showing his lack of self-control.

Applications

One application of behavioral economics is heuristics, which is the use of rules of thumb or mental shortcuts to make a quick decision. However, when the decision made leads to error, heuristics can lead to cognitive bias. Behavioral game theory, an emergent class of game theory, can also be applied to behavioral economics as game theory runs experiments and analyzes people’s decisions to make irrational choices. Another field in which behavioral economics can be applied to is behavioral finance, which seeks to explain why investors make rash decisions when trading in the capital markets.

Companies are increasingly incorporating behavioral economics to increase sales of their products. In 2007, the price of the 8GB iPhone was introduced for $600 and quickly reduced to $400. What if the intrinsic value of the phone was $400 anyway? If Apple introduced the phone for $400, the initial reaction to the price in the smartphone market might have been negative as the phone might be thought to be too pricey. But by introducing the phone at a higher price and bringing it down to $400, consumers believed they were getting a pretty good deal and sales surged for Apple. Also, consider a soap manufacturer who produces the same soap but markets them in two different packages to appeal to multiple target groups. One package advertises the soap for all soap users, the other for consumers with sensitive skin. The latter target would not have purchased the product if the package did not specify that the soap was for sensitive skin. They opt for the soap with the sensitive skin label even though it’s the exact same product in the general package.

As companies begin to understand that their consumers are irrational, an effective way to embed behavioral economics in the company’s decision-making policies that concern its internal and external stakeholders may prove to be worthwhile if done properly.

Notable individuals in the study of behavioral economics are Nobel laureates Gary Becker (motives, consumer mistakes; 1992), Herbert Simon (bounded rationality; 1978), Daniel Kahneman (illusion of validity, anchoring bias; 2002) and George Akerlof (procrastination; 2001).

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