Will behavioural economics change state policy?

"What other economics is there?"

Sanjit Dhami Professor of Economics at the University of Leicester and a Fellow of CESifo, Munich

The 2017 Nobel Prize for Richard H Thaler is a significant moment in economics. Neo-classical economics assumes unbounded rationality and emotionless deliberation. Behavioural economics uses an explicitly economic framework, yet borrows freely from psychology, sociology and neuroscience. Its explanatory power is vastly superior to any currently available alternative.

Thaler used “loss aversion” (losses bite 2.5 times as compared to the elation from equivalent gains) to explain the following two important puzzles. First, the mere ownership of an object increases the value to the owner (endowment effect); parting with the object triggers loss aversion. This explains why humans and animals fight aggressively to defend their respective territories.

Second, the return on equities relative to bonds is too high, even after accounting for the extra risk on equities (equity premium puzzle). Thaler showed that loss aversion causes the downside movement in fluctuating equity prices to be magnified 2.5 times, requiring a premium relative to bonds. In 1980s, Thaler did experiments with Daniel Kahneman which showed that humans have social preferences that also take account of fairness concerns.

In a set of columns titled “Anomalies” (of the neo-classical model) in the Journal of Economic Perspectives, Thaler popularised behavioural economics. He showed that when people make choices over time, losses are discounted less than gains as are larger outcomes relative to smaller outcomes. He also showed that when bidders bid in auctions for an object with uncertain costs, then the bidder who estimates the lowest cost, bids the highest, but an unpleasant winner’s curse awaits the winner.

In a path breaking idea, Thaler showed that people have mental accounts across which money is not fungible (mental accounting). Further, people are averse to mental accounts going in red (net negative balance). Hence sunk costs, by pushing mental accounts into red can influence behaviour; under neo-classical economics sunk costs don’t matter. Thaler introduced emotions and self-control issues into economic models by modelling human decisions as a game between a long-run planner trying to control a series of short-run doers in his planner-doer framework. This can explain addictions, inadequate savings and procrastination.

Finally, in his most recent work with Cass Sunstein of Harvard, well described in their book Nudge, they have broken new ground in welfare economics. Their idea—libertarian paternalism—gives a gentle nudge to boundedly rational people to improve their welfare, yet has no effect on fully-rational people. Examples of nudges are default options, such as optin or opt-out, which have had a massive effect on savings, pensions, and organ donations.

Thaler’s recognition with the Nobel should finally eclipse the fictional creatures, Econs, in neo-classical economics and, usher a new era of a eclectic and empirically-founded science of economics based on behavi oural economics.

 

"Everything else is not always equal"

Swasti Pachauri A social sector professional. Was a Prime Minister's Rural Development Fellow during 2012-2014

Ceteris Paribus" or "everything else is equal" is the universal assumption in economic theories. For sociologists and psychologists, Thaler’s Nobel is a moment of glory, for it emphasises why economics is becoming more "human" with incorporation of psychological and sociological considerations.

However, does nudging always work in developing countries? Nudge theory presents us with behavioural interventions that are beneficial. Economists argue that people choose the most convenient option than what may be "wisest" to them, thereby succumbing to irrational temptations. This premise may explain the behavioural inertia experienced with Swachh Bharat Mission, where changing mindsets became the recent zeitgeist supplementing making toilets.

However, "a one size fits all" centralised application of nudge may go against the very idea of a bottom up decentralised paradigm, which the nudge espouses—that of enabling individuals.

A case in point to overhauling public policy dissemination was the annulment of the Planning Commission in 2015, and resurrection of decentralised principles of "cooperative federalism" through the NITI Aayog. The think tank was formed with a vision to lend autonomy to states. However, it instituted a "nudge unit" in collaboration with Bill and Melinda Gates Foundation later, to propose solutions to behavioural impediments encountered in government schemes.

"Influencing" behaviour by proposing solutions, so that communities steer towards directed outcomes is not democratic persuasion, rather akin to coercion and manufacturing consent.

Interventions guised as nudging require effective supplementation of efforts with adequate social, cultural and political wherewithal. Such holistic approach attempts at minimising binaries between "planners" and "beneficiaries". Limited application of "libertarian paternalism" where people are not denied a choice, yet nudged in a direction may, however, result in choreographed outcomes to fulfil targets, without any regard for the autonomy of an individual.

For example, the sudden change induced by declaring 86 per cent currency null and void last November, to gravitate towards a cashless society, while penalising those with unaccountable cash, caused grave discomfort to rural and tribal populations.

While the intent of this scheme was noble, a sudden expectation in behavioural change resulted in a complete breakdown of ecosystems. "Digitising behaviour," by encouraging people to use "e-money", required deeper empathy with people’s agonies; understanding the elderly’s plight, differently-abled’s hardships and poor’s marginalisation. Effective implementation in this case first required creation of critical infrastructure and awareness on use of digital payments. Such "Indianisation of nudge" resulted in a catastrophe with ripple effects paralysing the unorganised sector that accounts for over 90 per cent of our workforce.

A successful example of nudge by the government is PM Ujjwala Yojana through which BPL households switch from firewood to clean LPG, which is a behavioural, cultural and social shift empowering women. In this case, accessibility of affordable cylinder refilling option to BPL households (a challenge in rural areas) may be considered as a feasible nudge.

 

"The ethics of nudge"

Chiranjib Sen Economist and a Professor in Azim Premji University, Bengaluru

Behavioural economics is a sub-discipline that attempts to ground economic analysis in a more realistic characterisation of human psychology. This approach shakes the foundations on which modern economics has been constructed—namely that human beings act as self-seeking, utility maximising rational individuals. Thaler’s work is based on the idea that human ability to act rationally is bounded. Human decision-making processes are prone to errors of different kinds, so that we are unable in many situations to make choices that are rational. Many wrong choices are made, for example, on diet and health. Thaler and colleagues work towards a new theory of choice, which recognises that human choices are prone to systematic errors. This includes bias, unrealistic optimism and choice inertia due to which the status quo situation is preferred to improvement. This behavioural approach is certainly more scientific as it is based on empirical observation and experimentation. It has identified different human cognitive processes such as the “automatic system” and the “reflective system”. The latter is more geared to rational decision-making. However, humans very often use the more spontaneous automatic system.

Criticism regarding the unrealism of traditional economic analysis of choice is not new. However, mainstream economics has been generally hostile. The core reason for this hostility is that the whole body of welfare economics rests on the tenet of rationality. It is on this basis that economists argue that perfectly competitive market outcomes are the most socially efficient economic arrangements possible. Rationality (i.e. “individuals know best what is good for them and choose accordingly”) is at the root of the ideological basis of market-based policy.

Thaler’s application of the behavioural economic idea is the suggestion that policy makers make use of its insights in order to improve social welfare. He calls this approach "nudge". It is well-known that the private sector commonly uses subtle methods of persuasion to market products and influence behaviour. However, the idea that governments should also use comparable tactics has been controversial in countries like the US since it smacks of government manipulation and control. Thaler has sought to avoid such criticism by characterising his policy stance as “libertarian paternalism”.

By this he means that there should be no attempt to nudge citizens by pressuring them—the idea is not to infringe on their freedom of choice. Ultimately, let the consumers choose. It is their exercise of economic freedom. Hence, his recommendation is libertarian. However, since we know that citizens’ capacity for rational choice is limited, it should be possible to shape the “choice architecture” (i.e. the context in which people choose) so that they are better aware of the “good” choice alternative than they otherwise might be.

The instruments through which nudge works to shape the choice architecture include creating incentives, setting beneficial “default option” in choice so that lazy decision-makers choose the good option, giving feedback about decisions, structuring of complex decisions to make it easier and so on. The general direction of these recommendations is in the direction of making the choice process simpler, more comprehensible and relevant. But also of course to embed the socially better alternative in the choice set in a manner such that it will not go unnoticed.

However, one should note that as far as government policy is concerned, this approach is capable of being misused. Hence, there ought to be some check on the ethics of such manipulation. This should be done through continuing public debate on the major issues, and through legislative checks.

Also, we need to recognise that there are limits to the scope and efficacy of libertarian paternalism. Most importantly, it may be necessary for government to take strong positions and implement them through traditional means that includes some degree of coercion. Governments need not stop at libertarianism—crises may require coercive actions. At the same time, paternalism should not be pushed too far in a democratic society. There is, therefore, a need for balance.

 

(This debate was first published in the 1-15th November issue of Down To Earth).