Behavioral economics; or What I've been reading (vol. 4)

Today's book review is all about behavioral economics. This relatively new branch of economics (originated in the 70s, reached prominence in the past few decades), has been a complete eye-opener for many. It changed the way many academic economists think about the concept of rationality (although it hasn't yet persuaded the majority, I'm afraid), and it performed the ultimate merger between the fields of economics and psychology. 

I am proud to admit that after having read Kahneman's masterpiece, it has changed/shifted/(nudged?) my perspectives as well. Ever since first reading about it a few years ago (it was Ariely's Predictably Irrational and Caplan's Myth of the Rational Voter that got me started), I came to see myself attracted to the notion of abandoning the standard rationality assumption, even though, as a person with a standard academic training in mainstream economics, I was finding that rather difficult to do. I liked the mathematical precision of economic models, and was not overly enthusiastic about attempting to empirically test any of them. In hindsight, how silly of me! 

However, after having completed the classics, I admit that I too have become infected by this new and exciting field. I haven't changed my worldview after reading a few books. I'm still a political economist and an institutionalist, with public choice theory being the forefront of my research interests and efforts, but now I'm more inclined to give all of it it a behavioral flavor (after all, having clear institutional rules at the forefront of a democratic society coincide well with the "nudge", libertarian paternalism perspective - it's all about mechanism design anyway). 

So behavioral economics is definitely a research worth pursuing. At least it can serve as an eye opener to many economists still enslaved in formal modelling (as I was). Without further ado (we got a long read in front of us), let's start with Kahneman's classic.

Kahneman, Daniel (2011) Thinking, fast and slow. Allen Lane.

In what is arguably one of the best books ever written on the psychology of decision-making, Nobel prize winner Daniel Kahneman offers a slightly autobiographical insight into how our mind works and how we tend to be absorbed by heuristics which prevent us from being the rational decision maker (the homo economicus) the field of economics set out to define. Kahneman won the Nobel prize in economics in 2002 for laying the foundation of an entirely new field of research (behavioral economics), and he would certainly have shared it with his long-time friend and collaborator Amos Tversky who unfortunately died 6 years before the prize was awarded to Kahneman (who btw shared it with another brilliant scientist, the father of experimental economics, Vernon Smith). This book is therefore a detailed overview of all the work Kahenman and Tversky did in their career, from the time they met at the Hebrew University of Jerusalem back in 1969, to their time in Eugene, Oregon and Stanford’s Center for Advanced Study in the Behavioral Sciences. This includes a wide variety of topics from the workings of System 1 and System 2 (the basic idea behind the title itself, System 1 is fast thinking, System 2 is slow thinking), to heuristics and biases, to prospect theory.

Their arguably most important finding is how people deviate from rational behavior, even though most of the time their thinking (and decisions) are sound. So in general they are rational, but there is a number of scenarios where emotions such as fear or affection take over. They found systematic errors in the thinking of normal people, however they linked these errors to cognition rather than emotion (e.g. availability heuristic – people evaluate relative importance of issues by the ease they can be retrieved from memory which is largely determined by relative media coverage; explains why some issues become salient in the public discourse, and how it can easily lead to populism in politics - the so called availability cascade).

The reason why their research turned out to be so successful is because their simple examples showed people how they can fail in rational thinking (e.g. experienced academics, when they read a study result, tend to attribute judgment errors to the typical, average participant of the study – usually a student. It’s easy to distance yourself from the research findings this way; but when they themselves got caught up in the same biases, they started changing their minds).

The book is separated into several parts. The first one, concerning the workings of System 1 and System 2, sets the framework (and the tone) for the rest of the book where Kahneman dissects judgement heuristics and explores why is it difficult for us to think statistically, what makes us overconfident in our beliefs, how we make choices and what is prospect theory, challenges the assumption of economic rationality, and finally presents the distinction between the two selves of the human mind, the experiencing and the remembering self. 

So what are System 1 and System 2? Metaphors for intuitive, fast thinking (System 1) and slow, deliberate, and effortful thinking (System 2). System 1 operates automatically and quickly with little effort and without any voluntary control. E.g. recognizing a facial expression, recognizing objects, orienting attention, detecting distance, detecting hostility, read words on billboards, answering 2+2, driving a car on an empty road (given some experience), any type of automative work, understanding simple sentences, succumbing to stereotypes, etc. Everything that has to do with effortlessly maintaining impressions and feelings. Its mental actions are involuntary and it cannot be turned off. System 2 on the other hand allocates attention to an effortful mental activity that demands complex computation and deeper thinking. It is slower, deliberate, and orderly. It makes explicit and deliberate choices and decisions. E.g. focus attention to specific details, focus on the voice (and conversation) with one person in a crowded room, look for a specific person, search memory to identify a song, walk faster than usual, count letters in a text, tell someone your phone number, park in a narrow space, compare stuff, check the validity of an argument, etc.. It’s about paying attention, which is why it’s difficult (almost impossible) to do several System 2 things at the same time (you can’t do math while driving, but you can drive “normally” and talk to someone).

Because of this fact, that we can’t simultaneously perform two (not to mention more) System 2 tasks at the same time, we tend to be vulnerable to cognitive biases and heuristics (e.g. Invisible gorilla experiment). We tend to be blind to the obvious and even more so – blind to our blindness. The problem is that our System 1 generates suggestions for System 2, like impressions, intuitions and feelings. If these become endorsed by System 2 (without modification), they turn into beliefs, and subsequently voluntary actions. This is usually fine and perfectly normal, but it is also what’s causing our cognitive illusions. System 2 will only take over when things get too difficult or when an event happens that violates your model of the world (e.g. an accident, a terrorist attack, or seeing a Black Swan). The division is however important as it minimizes effort and optimizes performance. We use System 1 most of the time, because most of the time it works very well. BUT, System 1 is prone to biases and illusions which easily turn into systematic errors of judgment that are applied and stored by System 2. 

From this discrepancy our heuristics arise (NOTE: heuristics are simple, mental rules people use to make judgments). We fail to account for basic statistical laws and patterns (like regression to the mean) and neglect statistical base-rate information altogether, we are overconfident in our decisions (90% of us believe they are better drivers than the average), unable to understand the difference between correlation and causality (illusion of causality - having the need to find causal connections where there really aren't any), fall victim to confirmation bias (deliberative search for confirming evidence), fall victims to framing effects (90% fat-free is the same as 10% fat), fall victim to availability heuristics (buying insurance after an earthquake), anchoring, representatives, hindsight bias (the - I knew it all along effect), illusion of validity (we cannot predict, but this doesn't prevent us from doing so), entrepreneurial delusions (even though only 35% of start-ups survive the first five years, almost 90% of entrepreneurs don't think this will happen to them - this is actually a good one, as over-excessive risk-taking among start-ups drives innovation), etc, etc. The examples are so many. 

Basically, the conflict between the two Systems in our brain results in our blindness to uncertainty (recall Taleb), and our blindness to the obvious. After having read this book it becomes much clearer as to why certain people tend to believe that, for example, vaccinations cause autism, or that the earth is flat (yes, this is an actual "debate", believe it or not). People really don't make rational decisions even if they are "smart". Intelligence, actually, has nothing to do with it. When performing automatic tasks we are guided by our intuitions, not by our reason. But what we can improve in our thinking is to know when, in the decision-making process, is it necessary to neglect the biases generated by System 1, and operate only on System 2.

It's really an insightful book, and I fully recommend it. As you walk through the examples you barely notice its length. Maybe because you start to think that everything he writes about is important! Is that a heuristic as well? Did Kahneman exploit our System 1 during the reading process? Perhaps he did. Perhaps he did...

Thaler, Richard and Sunstein, Cass (2008) Nudge: Improving decisions about health, wealth, and happiness. Yale University Press.

The next step after Kahneman was surely this book, containing the very essence of behavioral economics, its application to policy and, as the title says, our "health, wealth and happiness". The authors, Richard Thaler, behavioral economist, and Cass Sunstein, legal scholar and expert in constitutional law (both from University of Chicago at time of writing; Sunstein is now at Harvard), also start with abandoning the general economic assumptions behind human rationality (distinguishing between the perfect Econs and the imperfect Humans) and utilize some of the very same examples as in Kahneman's classic (although Nudge came out three years earlier. Nevertheless, the examples they all use are common knowledge in psychology and are very widespread when teaching this stuff to people). Instead of System 1 and System 2 they use the more formal Automatic System (i.e. "1") and Reflective System (i.e. "2"). They too draw attention to the same biases arising from the conflict between the two systems, like anchoring, availability heuristic, representatives heuristic, status quo bias, heard behavior, etc. 

But their basic underlying idea is policy-oriented. In the book they define and introduce a new policy-making concept - libertarian paternalism. Some might call it an oxymoron, but the authors are adamant that it isn't. They reject the traditional coercive nature of paternalism, and embrace its choice architecture approach in trying to help people make better decisions. The libertarian part refers to having the freedom to choose among any choice that you wish (so it's based on our voluntary decisions, there's no forcing anyone to do anything). Combining the two implies nudging a person towards one choice, even though that person has the full freedom not to accept it and go for something else. What they're exploiting in this concept is human inertia - the unwillingness to be detached from the default. For example, the decision to become an organ donor after an accident. Making this the default option significantly increases the amount of people who agree to become donors. Asking the people to tick a box in order to become a donor is not the same as asking them to tick a box to remove them from the potential donor list. The same thing is with savings (for retirement) decisions - having the default option a given savings rate (say 6%) which can be changed and abandoned if anyone wants is not the same as asking the people to choose their own savings plan. In the first case someone (the employer) has made the choice for you, which you are free to alter, while in the second you have to choose for yourself from scratch, which results in the fact that most people simply choose not to. For example, the opt-in scheme (where you have to tick a box to enroll) has savings participation rates around 60%, whereas the identical opt-out (where you have to tick a box to withdraw) has participation rates between 90 and 95%. A huge and important difference. Automatic enrollment solves the inertia problem (an example exploiting inertia are magazine subscriptions - they get you to sign up for the discount version, and after it ends, the default option is usually to extend the subscription under the normal price - most people simply forget to cancel it). 

In essence their idea is to become the next hit book for policy-makers, an effort they've succeeded at (read the next review). They present a multitude of examples on how to improve policy-making, how to help achieve better outcomes in public health (e.g. how we choose our food in the cafeteria), environment, schools, marriage, finance, retirement plans, reducing energy use (putting a smiley face on bills goes a long way, believe it or not), and even improve the precision of men to pee in public urinals (give us a urinal target, seriously - it can have politicians' faces on it). 

Upon careful inspection, some policy proposals they advocate are better suited as being described as soft paternalism, since the libertarian perspective puts the free to choose argument in its core. Personally, I don't feel the idea is too threatening towards free will, since it merely solve the laziness problem. Even if we know what's good for us, we can be too lazy to achieve it. Their examples and proposals are seemingly trivial, but can actually improve outcomes. Having a smiley or frowny face on your utility bills doesn't hurt anyone, nor does it impede on free will. It just helps us put things in perspective. It lowers our informational asymmetry. And that is always a good thing. 

Thaler, Richard (2015) Misbehaving. The Making of Behavioural Economics. Allen Lane, UK

After having read the first two books, Thaler's latest volume on how the field of behavioral economics originated and catapulted itself into the mainstream paradigm was a must. Although many of the stories are the same as in the first two books (particularly in Nudge, obviously), the book is still a refreshing and easy read. However I do suggest that any reader anxious to learning more about the field of behavioral economics takes a few months between reading each of these - you'll be reminded of the major concepts once again and yet some of the the examples will sound new. 

Misbehaving is an autobiographical book about behavioral economics and one of its key founders Richard Thaler. Thaler paints an encompassing picture of how this once narrow field, whose advocates were treated as renegades among mainstream economists at the time (particularly in finance), came not only to the fore of mainstream economics, but is also threatening to overtake it completely. He describes in detail all the wrong assumptions economists make (e.g. perfectly rational agents which are not overconfident, nor are they befuddled with biases, and can solve optimization problems easily) featured with a multitude of examples (some new, some from Nudge - but mostly new and interesting). Mental accounting and self-control seem to be the two things economists stay blind to. For example, people being responsive to bargains and rip-offs (raising the price of shovels after a snowstorm may be good economics, but it's certainly bad for business, at least in the medium run), or the acknowledgment of sunk costs (which is economically unsound - paying money for an event we end up not going does hurt us), or the fact that we find it hard to contain ourselves from eating a bowl of cashew nuts standing in front of us while waiting for dinner. And so on (there's even an example of a Prisoner's Dilemma game from the show Golden Balls, an example I always use in my class when introducing this concept - watch it, the title is "the weirdest split or steal ever".)

Thaler is, above all, a great storyteller. Even more amusing than Kahneman, he writes with a distinguishable wit, self-criticism, and a sense for entertainment. From what I read in the three books, I understand he's like that as person as well: humorous, observant and intelligent (and lazy apparently - as Kahneman reportedly said, "he would only work on questions that are intriguing enough to overcome the default tendency to avoid work"). So a typical Human, rather than a perfectly rational Econ, as he himself would put it. 

In the book he takes us through a journey of how behavioral economics, himself in the center of it all along with the dynamic duo Kahneman-Tversky, came to existence, how it survived the harsh academic debates with mainstream economists, and eventually triumphed and started to be used as a policy-making tool around the world. The Nudge Unit in the UK (officially Behavioural Insights Team) set up under Cameron's administration, and the White House Social and Behavioral Science Team set up under the Obama administration, are the two most famous examples, but as Thaler informs us, over 50 countries in the world have set up similar teams designated at helping design better policies aimed at improving our well-being. 

The most interesting thing for me, apart from the stories, experiments, and anecdotes, were all the famous economists he interacted with during the creation of the field. Both as adversaries and proponents, and enemies and enemies turned advocates. He mentions the creme de la creme of the economics profession of the 1970s, 80s, 90s. From the Chicago boys Eugene Fama, Merton Miller, Robert Lucas (all Nobel laureates, N.L. henceforth), and judge Richard Posner, to Robert Shiller (N.L.), Vernon Smith (N.L.), Charles Plott, Alvin Roth (N.L.), Kenneth Arrow (N.L.), Robert Barro, Tomas Scheling (N.L.), Andrei Shleifer, Michael Jensen, Orley Ashenfelter, etc. (to name only a few) (btw, you can guess which of these were his friends based on which of them he refers to by their first name at some point in the book). Having to confront and persuade (future or current) Nobel laureates in the field had to have been an exciting experience.

Anyway, the success of the field, from its infancy during the long working hours in Stanford in early 1970s, to its profound impact on policy in the current decade, is impressive to say the least. I don't recall any scientific field developing so quickly in terms of having an immediate impact on "the real world". And particularly a field that went against the dominant assumptions of its science at the time (the Samuelson mathematical economics revolution of the 50s, the origination of the efficient market hypothesis in the 60s, and the emergence of new classical macroeconomics in the 70s and the 80s, to mention only a few obstacles). To withheld such powerful opposition means that behavioral econ really is that good. All it takes for it now is to penetrate the principles of economics textbooks (a bold endeavor), and to finally improve decision-making in macroeconomics (something that Thaler predicts/hopes to be the next step). This will be its most difficult task. Unlike health or education economics, or savings and taxation, or finance for that matter, fiscal and monetary policy are difficult to test, and, as Thaler correctly pointed out, its theories/hypotheses are difficult to falsify (in many cases since they appear too vague, plus there's not enough data to begin with). If behavioral economics does to macro what it did to finance, it will be its ultimate triumph. 

Addendum 

These three books are just the beginning, and are nowhere near the exhaustive list of must reads on behavioral economics. In addition to a multitude of papers (Kahneman reprints two of his papers co-written with Tversky at the end of Thinking, fast and slow), there are other books I would like to recommend: 

• Kahneman and Tversky (eds): Choices, Values and Frames
• Kahneman, Slovic, and Tversky (eds): Judgement under Uncertainty: Heuristics and Biases
• Sunstein, Cass: Why Nudge. The Politics of Libertarian Paternalism (his own perspective, I assume similar to Thaler's Misbehaving)
• Halpern, David: Inside the Nudge Unit: How small changes can make a big difference (the Nudge Unit CEO examining their policy outcomes)
• Ariely, Dan: Predictably Irrational
• Ariely, Dan: The Upside of Irrationality
• Samson, Alain (ed) The Behavioral Economics Guide 2014 (pdf)

Gladwell's and Taleb's books are also somewhere in that category. Many others exist as well. Have fun!