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Imagine that you are at a casino by the roulette table and black comes up for, say, 20 times in a row. Is there a growing probability that the ball will hit red? Or imagine that you have recently been hired for a new job. What should you compare your salary with – the paycheck of your colleagues or the market average? Would the benchmark change after a year? Would you prefer 10,000 rubles today or 11,000 rubles in a week’s time? And what would be your choice if the delay is 4-5 weeks? Answers to these questions make up behavioral economics.
Books about this branch of economics are probably the most fascinating and easy among books on this science. This is probably due to the fact that they are devoted to people themselves, give us a chance to reflect on the nature of our mistakes and laugh at them. “It seems to be a long Jewish tradition to pass on history and wisdom from one generation to another not through lectures and textbooks, but through anecdotes, funny stories and jokes on the topic.” Amos Tversky, one of the fathers of modern behavioral economics, wrote this in a note a few days before his death.
Behavioral economics in some ways resembles this wisdom thanks to its anecdotes about “fictional creatures that populate economic models” (Richard Thaler, winner of the Nobel Prize in Economics for his contributions to behavioral economics), a calculator-man that maximizes profit and minimizes loss. It helps to understand the nature of the choices we make in the environment of uncertainty, the causes of our mistakes, of market “bubbles” and crashes; it shows how we can be irrational and how we can be pushed to make rational decisions. The achievements of this branch – the systematization of cognitive distortions – are used in marketing, finance, politics, management, etc. In a certain sense, it refers to the fundamentals of economic thought. Adam Smith, in his Theory of Moral Sentiments, actually formulated the principle of avoiding loss which has become one of the core principles of behavioral economics.
“We don’t have to stop inventing abstract models that describe the behavior of imaginary Econs. We do, however, have to stop assuming that those models are accurate descriptions of behavior,” Richard Thaler says. Behavioral economics does not try to deny the neoclassical theory, but complements it with psychology, showing that a person does not always act according to a model. Therefore, 1000 rubles is not always an equally valuable amount; the restriction of choice pleases us; we treat business as “jam tomorrow”; the magic of round numbers acts on us; etc. Psychology helps us understand why we do not save for retirement, how market optimism takes hold of us, and then panic begins, why we sell winning stocks early and hold losing ones for long. This behavior is very different from the actions of a rational person who clearly knows what he or she wants, strives to get the maximum profit with minimal costs, and in a situation of uncertainty is able to estimate the probability of various events based on all available information. A rational will not choke and finish the paid dinner without being hungry, a rational does not understand the meaning of gifts, and the best gift for him or her is cash, Thaler explains.
Cognitive distortions prevent us from making rational decisions. It was a human who was missing in the models used for forecasting before the global financial crisis, the legendary head of the Federal Reserve Alan Greenspan says in the book The Map and the Territory: Risk, Human Nature, and the Future of Forecasting. After all, many people hold him responsible for that catastrophe.
It is, of course, difficult to distinguish between a rational choice and an irrational one. In 1953, the French economist Maurice Allais published an article The behaviour of the rational man in the face of risk – critique of the postulates and axioms of the American school, where he formulated the so-called “Allais Paradox”: people prefer smaller, but guaranteed remuneration compared to a larger, but not guaranteed one. In behavioral economics, this is called risk avoidance. But it was this choice that Allais considered rational: simply put, a bird in the hand is worth two in the bush.
In their reading lists, NES professors and alumni have many books about the relationship between our behavior and economics. The number of Nobel Prize winners among their authors and the extensive application of their ideas confirm their recognized status. However, any theory should be treated with the same level of criticism that behavioral economists themselves suggest for the theories and models that assume the absolute rationality of economic agents.
An answer to this question can be found in the book Thinking, Fast and Slow (recommended by Professor Evgeny Yakovlev) by the Nobel Prize winner in Economics Daniel Kahneman, who dedicated this work to his colleague Amos Tversky. We live in the time of quick decisions that we have to make ever more often. Technology has increased the intensity of communication, we have been hit by a flood of information, and often we don't have time to think. However, we should never grudge the time for doing this.
Kahneman suggests a simple experiment consisting of doing two things: looking at a photo and solving a multiplication problem. This is the starting point of his story about two systems of thinking – intuitive and analytical. The former works faster than the latter, being a kind of biological reaction to a threat when there is no time to analyze the situation. Meanwhile, we often make hasty and wrong decisions relying on intuition, Kahneman shows and gives recommendations that help to avoid mistakes. The main one is to doubt that you are always right. Shakespeare’s “modest doubt is called the beacon of the wise” could become an epigraph to Kahneman’s book.
But what if a person, a group of people or the whole society needs help to make a rational choice? For example, to save for retirement or take care of one’s own health. This is often a matter of state policy, because empty pension accounts are a social, economic, and political problem. Should the authorities force the population to act? Behavioral economists say “not at all”: they can push us (in a certain sense, manipulating our choices) in the style of libertarian paternalism. This is discussed in two works by Richard Thaler: Misbehaving: The Making of Behavioral Economics and Nudge: Improving Decisions About Health, Wealth, and Happiness (co-authored by Cass Sunstein), recommended by Professor Evgeny Yakovlev.
40 years ago, Thaler wrote an article in which he came to the conclusion that data on irrational behavior can help guide people in a rational direction. In the book Nudge he tells how society and the state can help us make the right choice – between French fries and salad, buying here and now and replenishing the pension account, the desire to go over the speed limit and comply with traffic rules. Importantly, their help should not restrict people’s freedom of choice: it should be a nudge, not a compulsion. The book is full of similar examples. One of the most famous ones is nudging people to make savings in their retirement accounts. Richard Thaler, together with economist Shlomo Bernartzi, developed the “Save More Tomorrow” solution, which became the best confirmation of the effectiveness of nudging. People do not want to save money for the future because they procrastinate, try to avoid uncertainty and possible losses, etc. Thaler and Bernartzi suggested several ways to encourage employees to take care of their retirement savings: for example, they are asked by default to agree to a pension program, but, importantly, with the possibility to opt out.
“We need an enriched approach to doing economic research, one that acknowledges the existence and relevance of Humans,” Thaler urges in the Misbehaving. And at the beginning of the book, he gives readers advice: “My only advice for reading the book is stop reading when it is no longer fun. To do otherwise is to demonstrate yet another example of ‘irrational’ behavior.”
NES alumnae Anna Shchetkina recommends a set of books by Dan Ariely, including Predictably Irrational: The Hidden Forces That Shape Our Decisions, The Upside of Irrationality: The Unexpected Benefits of Defying Logic, and The Honest Truth About Dishonesty: How We Lie to Everyone – Especially Ourselves. They are worth reading if you want to learn more about your own cognitive mistakes and how to deal with them, and maybe about better organizing your business. From the book Predictably Irrational you can learn, for example, about the role of social norms: participants of an experiment perform their task more willingly if you ask them for a favor or offer a Snickers bar rather than give them a small amount of money. The Upside of Irrationality talks about why we value our crookedly assembled Ikea cabinets so much, and how this strange effect is associated with soaring sales of dry mixes for cakes.
The Honest Truth About Dishonesty describes a funny experiment to determine the boundaries of human ethics. Dan Ariely and his co-authors left a few cans of coke and a few dollars in the refrigerator in a student dormitory, and came back to check them a week later.
An alternative view of the relationship between rational and irrational is offered in Passions Within Reason: The Strategic Role of the Emotions by Robert Frank (also recommended by Anna Shchetkina). And what if being irrational is rational (see also below)? The author takes people’s emotions for granted, embeds them in the (traditional for economists) concept of utility maximization and game theory, and then demonstrates how the model outcomes change. Suddenly it turns out that love is a solution to the commitment problem, and a vindictive character is a good protection from exploitation. This book will also be an excellent introduction to evolutionary game theory, an interesting topic at the intersection of economics and biology.
The next two bestsellers are devoted to irrationality, booms and busts. Irrational Exuberance by the Nobel Prize winner in Economics Robert Shiller can be considered a prophetic book: in a certain sense, it predicted the global financial crisis. Alan Greenspan was the first to speak about irrational exuberance in 1996. It was the psychological basis of the speculative “bubble.” Shiller writes about the situation in which news about stock price spurs investor enthusiasm, spreading like an infection from person to person, and increasingly exaggerating the stories that justify further price increases. As a result, new investors come to the market, being attracted, despite their doubts about the real price of the investment asset, partly by envy of other people’s gains, and partly by the gambler’s excitement. In the book, he examines many factors that lead to the formation of a “bubble” – media, technology, as well as psychological factors, such as herd behavior. Shiller refutes many axioms, for example, that “the ‘fact’ of the superiority of stocks over bonds is not a fact at all.”
His other work, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, co-authored by the Nobel Prize winner George Akerlof (recommended by Professor Evgeny Yakovlev), can be called one of the most famous books about the nature of booms and busts. The authors turn to the ideas of the great John Maynard Keynes about human irrationality and the impact of this irrationality on markets and the economy.
Keynes recognized that in the area of economic activity a person is mostly rational, that is, not always. This irrational feature is the main reason for economic fluctuations (“markets can stay irrational longer than you can stay solvent”). Therefore, to understand economics, one has to figure out how it is driven by irrationality, Akerlof and Shiller write. The book examines five manifestations of irrationality and their impact on the economy: trust, justice, abuse and dishonesty, monetary illusion and how our ideas about reality are intertwined with stories from our lives. The authors show how these five manifestations of irrationality impact the start of economic depressions, people’s inability to find jobs and being careless about savings, etc.
They are convinced that in quiet times, the state need not actively interfere in a free market economy, even though it is far from perfect. But everything changes when a crisis sets in: then the state must stabilize the economy and help it return to equilibrium. In this difficult period, we have to pay special attention to economic justice.
Behavioral economists have been criticized a lot by representatives of the mainstream. Examples of irrational behavior, they pointed out, are very useful, but do not help to build a model of economic processes.
A well-known Russian economist Rostislav Kapelyushnikov wrote several interesting works about rational and irrational choice, and about criticism of behavioral economics: Around Behavioral Economics: A Few Comments on Rationality and Irrationality and Behavioral Economics and New Paternalism.
Kapelyushnikov asks a simple question: if decisions guided by intuition and heuristics had not formed an internally consistent system, how would humanity have passed natural selection and survived? He sees risks in devotion to behavioral economics: “Its discovery of ‘market failures’ conditioned by behavior has opened the door to a wide range of paternalistic interventions.” However, the fact that people often make mistakes does not mean that they need state paternalism. By making our own choice, without being pushed from outside, we can achieve higher levels of utility. And on the contrary, pushing people to make a certain choice can lead to the situation when a significant part of society will be at a disadvantage. For example, by default, people will save more for retirement without an obvious need, and these savings will be redundant for them. “In fact, we have here yet another attempt to exploit our limited cognitive abilities (let’s admit – an attempt that turned out to be extremely successful),” Kapelyushnikov writes.
He describes an alternative approach: ecological rationality rather than logic, which requires continuous adaptation instead of maximization. This was, in particular, suggested by the works of the German psychologist Gerd Gigerenzer. For him, heuristics are an evolutionary way to avoid losses in moments of uncertainty when there is no time to build an optimal model (and here we can recall the quick thinking that Kahneman wrote about).
To sum up, after reading all these books, one can come to the conclusion that human behavior cannot be definitely explained by any single model. Therefore, the Nobel Prize winner Milton Friedman was right: “A theory or its ‘assumptions’ cannot possibly be thoroughly ‘realistic’ in the immediate descriptive sense so often assigned to this term.”
