Psychology of economics
Colin Camerer, a behavioural economist, predicted that the Economics Nobel for 2017, would be awarded to his fellow behavioural economist Richard H Thaler. In response, after the prediction was proven correct, Thaler tweeted that sometimes behavioural economists do make good predictions. The recognition of Thaler's contribution, nevertheless, came late. Governments around the world have realised the importance of behavioural economics and such economists have thus formed an important aspect of the policy-making establishments.
The behavioural insight team, created by the British Prime Minister David Cameron, was the world's first government institution dedicated to the application of behavioural sciences. The objectives had been to make public services more cost-effective and easier for citizens to utilise; to improve outcomes by introducing a more realistic model of the interaction between human behaviour and policy; and wherever possible, to enable people to make 'better choices for themselves'. The last objective could be found in Thaler's popular book 'Nudge', written jointly with Cass R Sunstein.
Thaler is not the first behavioural economist to receive the economics Nobel. Much before, in 2002, Daniel Kahneman won the Nobel memorial prize in economics. The American Psychological Association proudly announced, "Psychologist wins Nobel prize." In between, in 2013, Robert Shiller shared the Nobel honour with two others. Since Shiller worked on the financial markets where the behaviour of participants was acknowledged as critical, his recognition did not evoke screaming headlines on the triumph of behavioural economics. But the case of Thaler has been different – he is out and out a behavioural economist, clearly a recognition, perhaps late, by the Nobel Prize authorities that behavioural economics cannot be whisked away as some kind of an imaginative cocktail.
Pareto, the Italian economist, said in 1906, "the foundation of the political economy and, in general, every social science is evidently psychology.'' Behavioural economics, however, has more critics than followers. Despite the immense popularity of books like, Thinking fast and slow (Kahneman), Nudge (Thaler and Sunstein), and Misbehaving (Thaler), critics felt that the field is overhyped. Behavioural economists feel that often BE is used by the political class to confuse and delay decision making.
Some feel that Cameroon was wrong when he said that the best way to persuade people to consume less electricity was to cite the example of a neighbour and his low electricity bill. In other words, to nudge him into following the thrifty neighbour. Economists think that is rubbish. The best way to reduce consumption is to raise the cost. Politically this is inconvenient. Hence, behavioural economics comes as a fig leaf for a reluctant political administration.
The core concept of mainstream economics is the assumption that people optimise. They make purchases rationally and act rationally in making economic decisions, by taking into account their preferences and the information at their disposal. Thaler explains in his book, Misbehaving, the standard economic approach suffers from the fact that humans are not what he terms 'Econs': they don't, or can't, optimise at all points of time. A glaring example could be the Brexit vote in UK. The majority vote to exit the European Union was more sentimental than economically well-rationalised. In India, fuel prices kept changing daily. Few noticed that, in effect, the cost of fuel rose even when global prices of crude did not change. The late realisation and the resultant criticism forced the hand of the ruling party which finally led to the reduction in duties by the centre and a few BJP-ruled states. Whether one goes by the behavioural economic model or not, there are umpteen occasions when the consumer, accepted as rational 'Econs', are fooled.
Even Thaler recalled how difficult it is to push for the right reforms, citing an experience of his co-author Sunstein. Sunstein had spent four years as a regulatory tsar in the Obama White House. Thaler wrote, "Cass wanted a tax on petrol, but he couldn't get one, so he pushed for higher fuel economy standards. We all know that is not as efficient as raising the tax on petrol – but that would be lucky to get a single positive vote in the Congress."
Take the case of Delhi Metro Rail fare hike. The 4th Fare Fixation Committee (FFC) had recommended in May to hike the fares in two phases. Had it been raised in one shot there would have been a stiff protest. By raising the fares in two tranches, Delhi Metro avoided the trouble of public protest and also caught the political authorities on the wrong foot. The FFC had representatives from both the Centre and the State, who failed to notice the sharp rise of fares between May and October. Had the commuters of the Delhi Metro been 'Econs', they would have realised that to travel a similar distance with the frills offered, would have turned unaffordable for them. They would have accepted the hike without much protest. In any case, the commuters did and continued to travel by metro. The conclusion, therefore, would be that commuters are largely 'Econs' not 'humans' as defined by Thaler. The other point one cannot wink at is that the FFC members are well aware of the psychology of the commuters. In sum, behavioural economics is in full play with or without any help from the Nobel laureates.
Most people affected by a Government decision tend to behave like matured 'Econs', as could be seen in India during the period of demonetisation of two high-value notes, just a year before. Initially, everyone was stunned, but actions to convert the cash in hand into bank deposits and new currency notes or some other assets, started forthwith. In the end, nearly the entire stock of money came back into circulation. Clearly, even when people initially seemed to be 'humans', they graduated into 'econs' in no time. The thin Lakshman Rekha between 'econs' and 'humans' takes no time to get erased.
Professor Thaler and other proponents of behavioural economics have made economic theory more practical than the mainstream economists who believe in optimisation. Humans are not 'Econs': they don't, or can't, optimise all the time. The decision makers know that well. They use the nudging tricks they can think of while adopting favourable or unfavourable decisions. By honouring Professor Thaler, the Nobel Prize committee acknowledged the incontrovertible fact that economics is not about rigid assumptions and complex mathematical functions but instead, it deals with human beings who do not act as per a scripted formula. The political masters knew this much before the behavioural economists observed the same.
(The views expressed are strictly personal.)