Mar 6, 202114 min read

The Inception of Behavioral Economics

Since time immemorial, there have existed markets, and even if early man was not aware of them, economic principles have governed those markets. However until the 1700s those concepts existed more as vague notions and not as the Laws of Economics as they are known today. Since that time, economics for the most part only existed in the classroom or in small groups where the ideas were discussed. This all changed in the 1970s when economics met psychology and the practical aspects of economics were translated into terms that could be understood by the layperson. It was from this collaboration that a new discipline, named Behavioral Economics, was born. This new discipline has great potential to improve the lives of members of every society on earth. As with any advancement, Behavioral Economics has detractors. These detractors are concerned individuals who fear the damage that could be wrought if the levers of this new machine were controlled by those who seek personal gain, not the advancement of society. While it is still in its infancy, if applied correctly, the principles of Behavioral Economics could play a significant role in the advancement of modern society and the world could reap innumerable benefits.

For all of recorded history, humans have been active participants in markets and have been utilizing economic principles. Scientists have discovered that some animals, and even insects engage in rudimentary forms of trade. Texts dating back thousands of years have been discovered in Asia and Europe showing that thinkers of those times were already developing theories about how the economy works. However, it was not until Adam Smith published his book Causes of the Wealth of Nations in 1776 that economic theory became a more mainstream idea. Since Smith, there have been many theorists who have furthered the study of economics; names like Marx, Keynes and Friedman are familiar to many even if their contributions are not. The reason these names may be familiar and their works are not, is because even for the well educated, economic concepts are difficult to grasp and often even more difficult to apply. Anyone who has taken a high school calculus course has the ability to conduct the mathematical calculations necessary for most economics equations, but how to apply those equations, or even why such equations are important remains a mystery. It is because of this complexity of economic theory, combined with the style of speech and writing found in economic circles that much economic thought has not been translated into everyday applications. Until recently, economic theory had been mainly reserved for the classroom and as an aid to policy makers. It was not until the 1970s, when economists and psychologists began working together to find applications of economic principles for the average person, and began translating the foreign sounding economic principles into terms that could be understood by anyone. This movement has been named Behavioral Economics. It was consolidated into the theory by PHD Economist Richard Thaler and built on the groundbreaking work of PHD Psychologists Daniel Kahneman and Amos Tversky. The theories espoused by Thaler and his collaborators are not necessarily new, but the way in which they have been presented is far different from the theorists who came before. If applied correctly, the principles of Behavioral Economics could provide great benefits to the members of societies around the world. Indeed, there is already some evidence that the early stages of these benefits are already beginning to be realized.

One reason many students, and people in general, struggle with economic theory is because economic models are just that, models. These models rarely account for human nature. The subject is placed in a sterile environment and makes choices according only to the information provided. For most economic applications this works well, especially when trying to make projections about large sample sizes. The disconnect for most people is that these theories are difficult to apply in daily life. In essence, economics treats humans like robots and makes assumptions about how they should behave, not how they actually behave. Is the person hungry, did they have a breakup with their significant other, did they get a bad grade on a midterm, any of these factors can interfere with logical reasoning. Often, in these types of scenarios, people will rely on their intuitive system rather than approaching problems from a cold, rational perspective.

In his groundbreaking book, Thinking, Fast and Slow, Nobel Prize recipient and renown psychologist Daniel Kahneman proposed the idea of two different systems that govern human behavior. He simply calls these “System 1” and “System 2”. As he explains the concepts, System 1 puts almost no strain on mental faculties, whereas System 2 requires concentration and thought. Examples of System 1 could be tying shoelaces or reaching to catch a mug knocked off a desk. System 2 on the other hand is more complicated, solving complicated multiplication problems or trying to remember the name of an acquaintance that has only been introduced once. This is not to say that functions of System 2 cannot become part of System 1. When a child learns to tie their shoes, they are using System 2 processes, however, over time that process becomes automatic and part of System 1.

There has been some push back against Kahneman’s System theory. An oft cited example of a high level intuitive function is the firefighter example, “A fire broke out in the kitchen of a house in Chicago, Illinois. A team of firefighters kicked down the door of the house. They stood in the living room as they sprayed water at the fire in the kitchen. Strangely, the fire would not go out. One of the firefighters had a feeling that something was very wrong. ‘Get out, now!’ he ordered. The team ran out of the house. Moments later, the floor they had been standing on in the living room collapsed” (1). This example was used by Malcom Gladwell in his book Blink, and also by Kahneman. As the example goes, there was no obvious, rational reason for the firefighter to pull his team. Gladwell argues that it was intuition, trained through years of experience both in practical application as well as in the classroom. Furthermore, Gladwell has argued that these high level intuitive responses are to be found often in high performers, from fighter pilots to big wave surfers. He has shown instances where complex, sometimes life or death decisions are made in an instant, without conscious thought. In fact, throughout his book, Gladwell points to example after example where if the subject had stopped to think about what was happening or to try to formulate a calculated response, the end result often would have been death. Rather than disagreeing with Gladwell’s assessment, Kahneman seems to agree and puts these examples into the category of a System 1 function. After the incident the firefighter could not explain how he knew that the source of the fire was below where they were standing (he did not know that there was a basement in the house), or that their lives were all in imminent danger, something just did not feel right. For Kahneman, this is an example of System 2 processes that have been trained and refined to the point where they become automatic, System 1. For a less experienced individual, the situation would likely have resulted in tragedy. If examined carefully, everyone could make a list of things they do automatically that had to be trained. For a child in kindergarten, 2+2 does not intuitively equal 4, but this process requires no thought for the same child a couple of years later. In the same way the chess master can walk by a casual chess game and at a glance, say with certainty, “Checkmate in 4 moves”, even if neither player can see the necessary moves. But what does any of this have to do with behavioral economics?

Economists and psychologists often work at cross purposes with each other. Economists focus on how people should make decisions, psychologists strive to learn why people make decisions. The goal of Behavioral Economics is to combine the two disciplines; to understand why people do not make optimal choices, then to simplify the decision making process as much as possible in order to help, but not force, people to make better decisions. This process is complicated, in their perfect world, economists would have everyone carefully weigh the consequences of every choice by collecting and analyzing all available data before making their final decision. This, obviously, is not realistic. To help differentiate between models and real human beings, those who focus on behavioral science have come up with terms to differentiate the two groups; Econs and Humans. In a paper titled Econs vs. Humans, Scott Niederjohn and Kim Holder describe the two groups, “Econs, could be described as being analytical, reflective, effortful, deliberate and patient. Humans might sometimes be described as emotional, reflexive, effortless, impulsive, and short-sighted” (2). At a glance it seems obvious that these two groups are not compatible, and could not be contained within one individual. Kanehman believes that the two are not mutually exclusive, they are just functions of different systems.

Over the years, Kahneman and Tversky ran countless tests and experiments to better understand how the mind works. As they refined the process, they began developing theories to explain the choices that people make. One of these theories crystalized into what became known as a Conjunction Fallacy. The most famous test that they developed was known as the ‘Linda the Bank Teller’ case. Some of the data they used in this case has become rather dated and would probably not produce quite the same results today as when they conducted the experiment in the 1980s. For a similar example that has better stood the test of time, consider Steve, “An individual has been described by a neighbor as follows: ‘Steve is very shy and withdrawn, invariably helpful but with very little interest in people or in the world of reality. A meek and tidy soul, he has a need for order and structure, and a passion for detail.’ Is Steve more likely to be a librarian or a farmer?” (3). In the context of a discussion about behavioral economics, the correct answer is more likely to be given than if it were in a clinical setting. The usual answer given by respondents is that Steve is more likely to be a librarian. Given the description of Steve, it seems obvious that his personality lends itself more readily to the occupation of a librarian than a farmer. There is however, a problem with this answer; another name for the Conjunction Fallacy is the Base Rate Fallacy. The Decision Lab defines the Base Rate Fallacy as, “When provided with both individuating information, which is specific to a certain person or event, and base rate information, which is objective, statistical information, we tend to assign greater value to the specific information and often ignore the base rate information altogether.” (4). This can also be referred to as Base Rate Neglect. A quick Google search shows that there are about 2 million farmers in the United States and about 125,000 librarians. The disparity grows wider when considering the likely gender of librarians and farmers. Given the relevant data, the correct answer is obvious. Steve is far more likely to be a farmer than a librarian.

The Steve example demonstrates a number of Kahnamen and Tversky’s theories. The most relevant is System 1 and System 2, furthermore it exemplifies another one of their ideas, “What You See Is All There Is”. System 1 is excellent at processing and responding to stimuli. The information given about Steve sounds like it would describe a librarian better than a farmer, therefore System 1 says, “Well, Steve is probably a librarian”. Given the base rate information, System 2 which (for most people) has lain dormant during this process, activates. At this point, System 2 processes the information, runs some simple calculations, and produces the correct answer. If the question had simply been “Is Steve more likely to be a librarian or a farmer?”, with no further information, most people would have their System 2 activate, and give the correct answer. It is only when given additional (in this instance, worthless, if not misleading) information that System 1 takes over and gives the wrong answer. It was through years of similar tests that Kanhamen and Tversky came to the simple conclusion, “Human beings are surprisingly bad statisticians”. Following this logic, they began wondering “If people are so easily misled on simple questions, what happens when the stakes are higher, or when the problem is more complex?”.

Everyday, people around the world encounter far more complex questions than “Is Steve a farmer or a librarian”. These questions can be as simple as “what should I have for breakfast”, or as complex as deciding whether or not to go to war; the consequences of these decisions span a range as vast as the distance between those two questions. An interesting discovery during the testing performed by Kahneman and Tversky was that trained economists and statisticians fared little better (sometimes worse) than the average college student or indeed, the average person. By this point, Kahneman and Tversky had compiled massive amounts of data about how, and why people make their choices but they also had a problem, what were they supposed to do with the information they had been gathering? So far, they knew that people were generally bad at making decisions, and they also understood to some extent, why people struggle to make the right choice even if that choice is in their best interest. Of course, they wrote and published academic papers and books on the subject, but the interest in their findings was not exactly overwhelming. Even less so was enthusiasm for the adaptation of what they had learned into practical applications or policy to benefit the very people who they had been studying. It was around this time that a young, unknown economist named Richard Thaler made the acquaintance of Kanheman.

Today, Richard Thaler is known as the Father of Behavioral Economics and for his contributions was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2017, but when he met Kahneman the idea of such a prestigious title coupled with a Nobel Prize would have been laughable. As Thaler recalled during an interview, “I certainly wasn’t a great student. And I don’t think I was a great economist, in the way economists are usually judged, in the sense that I wasn’t a great mathematician and my econometrics skills were not super. And so what I really ended up having to do to survive, was to figure out a kind of way of doing economics that would be something I was good at.” (5). During this meeting of Thaler and Kahnamen that the bud that would eventually grow into the branch of economic thought known as Behavioral Economics first appeared. Kahneman and Thaler had been pursuing the same idea from two different starting points. Thaler knew that people were generally bad at making decisions and understood what the optimal choice would be in many situations. Kahneman understood why, or how people made their decisions. The two began developing a theory; that if people making complicated decisions were given some gentle guidance to help them arrive at what was usually the most optimal decision, that they were more likely to make the choice that in the long run would be in their best interest. They named this idea Nudge Theory.

When discussing Nudge Theory and Behavioral Economics, Thaler explained that “People aren’t dumb. The world is hard” (5), and it is the goal of behavioral scientists to make the world a little less hard. The applications for Nudge Theory are wide and diverse and over the past decade over 200 Nudge Units have been established around the world. These units focus on implementing behavioral economic theory that they have labeled “choice architecture”. To better show how these nudges are implemented, Apolitical states “From 96,000 more people a year in the UK registering as organ donors, to increasing the share of female musicians in top US orchestras from 5%-35%, simple design tweaks have had very powerful impacts — often at very low cost.” (6). These nudges by design are subtle, changing the default option for organ donation from “opt out” to “opt in” could significantly increase the organ donor pool. Likewise, next year England (as part of a program to combat high rates of obesity), will implement a law in which “Supermarkets in England are to be barred from displaying unhealthy food and drinks at checkouts or using them in buy one, get one free offers” (7). Still other organizations are investigating how nudges could be used to increase voter enrollment or contributions to retirement funds. For behavioral economists and scientists, the potential applications of choice architecture and nudge theory are endless. However the rosy view of a world in which everyone is gently pushed to make the right decisions is not shared by all.

Browsing Google briefly turns up many contrarian viewpoints, mostly centered around the idea of “when does a nudge turn into a shove”. In an ever growing, interconnected world in which Big Data is ever more prevalent, the information about preferences and personal views is readily available to companies and organizations that have the ability to exploit that data. Opponents of Nudge Theory are not opposed to the idea itself, their concern is that the principles espoused by behavioral science could be easily turned to nefarious purposes. In a recent article by Henrik Skaug Sætra, the potential negative application of Nudge Theory is laid out succinctly, “Imagine that I could make you do what I wanted you to do without you realising that I was even involved. All I would have to do is to rearrange the information around you in ways I know would lead you in the direction I desired. I could change the sequence of the choices you have to make, and use my knowledge of your susceptibilities and weaknesses to choose the appropriate time and method of delivering my nudge” (8). A consequence of living in the internet era is that news stories about leaks of personal information and hacking incidents where large amounts of consumer data is stolen, are commonplace. One Google search, or (some speculate) just a conversation about a product will result with web browsers and social media accounts being filled with ads for a certain product or a political candidate. As the power of big data grows the risk of choice architecture being exploited by those interested in personal gain, not the betterment of society, grows. Targeted advertising is an example of how companies are using personal data to nudge consumers to purchase products that they may have never considered buying before being inundated with clever marketing campaigns. For the most part, these types of relatively innocent nudges are not what concerns the opponents of Nudge Theory. They are more concerned with how the choice architecture system could be abused, “The abusers could be criminals, or perhaps foreign powers nudging people politically, for example in order to interfere with elections. It could also be hidden government activity – activity that is not desired or approved of by the people.” (8). The detractors of Nudge Theory certainly have a valid argument to be made against the adoption of such a system, but whether the potential benefits are outweighed by the potential costs is uncertain.

When the first manmade object was launched into space, a new frontier of technological advancement was unlocked, and with it, the potential for a global armageddon by intercontinental nuclear war was also made possible. Without question there is potential for the ideas espoused by Behavioral Scientists to be used by those with ill intentions. However if there is a possibility that the implementation choice architecture could leave citizens of countries around the world healthier, wealthier and happier, it should be explored. If every advancement of civilization were to be stopped because of potential negative externalities, mankind would still be living in caves, hunting with sticks and afraid of fire because it possesses destructive qualities. Behavioral Economics may be the key needed to unlock future human potential through the creation of better societies. That is not to say that pioneers should push blindly forward regardless of the negative consequences that could come with progress, but there are already indications that Nudge Units are able to increase the quality of life for people around the world in countless ways. In the scope of economic theory, behavioral economics is still in its infancy, it should be nurtured and allowed to grow. As the discipline grows, new applications and potential uses may be discovered; to stop now would be a disservice to modern society. Eventually, the marginal costs and benefits of behavioral economics will be studied and calculated. For now, the choice architects in Nudge Units around the world should focus on maximizing the social benefits that have been made possible through the development of behavioral economics, and if the citizens of the world can be made happier and healthier, then the initial goal of people like Thaler and Kahneman will have been achieved, and society will be better for their efforts.