By Shiv Kampani
Suboptimal decisions by rational humans: Alfred Marshall defined economics as the study of mankind in the ordinary business of life. Although our understanding of this social science has changed with time, a vast majority of the economic theories we use presume that economic problems emerge because of the fallibility of institutions and governments rather than the failures of individuals. In fact, neoclassical economics is built on the premise that individuals are rational agents who act in their self-interest and seek to maximize utility from their economic decisions. This characterisation, aptly termed “homo economicus”, was born from the rational choice theory, proposed by Adam Smith in his masterwork, The Wealth of Nations. But if history has taught us anything about human behaviour, it is that humans are not rational decision makers.
Consider the prisoner’s dilemma, a hypothetical situation where two prisoners must decide whether to confess about their accomplice or remain silent. According to rational choice theory, in a Nash equilibrium (when both prisoners act rationally), both prisoners confess (defect) and receive long sentences. However, experiments have shown that in reality, subjects chose to cooperate 60-75% of the time, which suggests that humans may not always act in their self-interest. Deviating from rationality, as in the case of the prisoner’s dilemma, may reward the decision maker but, in many cases, may also lead to a suboptimal outcome. What is certain is that presumptions that neoclassical economists make about humans do not correspond to real world observations.
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Maximisers vs satisficers
Behavioural economics challenges the notion that individuals are “maximisers”. Instead, it contends that humans are “satisficers” who use their limited rationality and information to make satisfactory decisions. Furthermore, researchers and economists have found that humans behave irrationally in a systematic manner. Through an experimental approach, these economists have discovered the biases that govern the predictable, and more importantly, avoidable mistakes that humans make.
Questioning the limits of rationality is integral to understanding why humans make imperfect decisions. Herbert Simon, psychologist, computer scientist and Nobel Laureate in economics, proposed the concept of bounded rationality, that is, the idea that consumer rationality is limited by the tractability of the problem, cognitive constraints and the amount of available information. Other economists proposed ecological rationality, which is the notion that rationality is contextually dependent.
Building on these ideas, Gerd Gigerenzer suggested that humans are practically rational, which suggests that humans make their decisions quickly and simply, using a set of “fast and frugal” heuristics. Making a decision, according to Gigerenzer, is similar to searching for your keys when you’re late for a meeting. You do not have enough time or energy to search through your entire house, so you go to places where you usually keep your keys. Economists call this the availability heuristic, which states that we tend to use information that we can recall easily. Although different heuristics rely on different “shortcuts” to simplify decisions, what almost all heuristics have in common is their vulnerability to cognitive biases.
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Following intuition
Take for instance, the simple mathematical problem: a baseball and bat cost $1.10. If the bat is exactly $1 more expensive than the ball, what is the price of the ball? This question was posed to thousands of students from prestigious institutions, more than half of whom replied with $0.10 – the incorrect answer. Why does this happen? According to economist Daniel Kahneman, when we have inadequate time to make a decision, we tend to use our intuition or simple mental heuristics to determine our choice. Often, as exemplified by the aforementioned study, our heuristics lead to poor decisions. Individual decision-making has increasingly relied on heuristics which has in turn led to cognitive biases and suboptimal outcomes.
Consider the availability bias which stems from the availability heuristic: when we try to estimate how likely an event is, we try to think of an example of it. If we succeed in doing so, then we assume that the probability that the event occurs is high. This heuristic initially evolved in humans as a survival trait. Prehistoric hunter gatherers, on hearing a rustle in the tall grasses, may have been able to recall past encounters with lions, consequently making them fearful and more cautious. The availability heuristic became a bias due to one major change in our environment: mass media.
Consider the COVID-19 vaccine developed by Pfizer-BioNTech in December 2020, which was reported to work effectively in over 90% of its trials. Those consumers who view the mass media coverage of certain patients who developed severe allergic reactions after taking this vaccine may overestimate the risk that taking this vaccine poses. In this situation, the availability bias causes consumers to develop the misconception that this FDA-approved vaccine may be harmful for them.
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Social conformity bias
From herding at supermarkets to the hoarding of toilet paper, the pandemic has caused some unusual changes in our consumption decisions. When it comes to explaining this behaviour, most economic theories, which assume that humans are self interested agents unbiased by the decisions of others, fall short. As consumers, as humans, as members of an ever-changing society, our desire to fit in is fundamental to our nature. Behavioural economists try to explain this innate desire through the social conformity bias. Often called the “bandwagon effect”, social conformity is another heuristic that we use to make satisfactory decisions within the limits of our bounded rationality. Imitating or following others saves us cognitive effort.
In cases where information is limited, following the herd is particularly useful because other members of the herd may have more information than we do. Our reputation is of great importance to us; imitating the herd’s decision helps us safeguard this reputation. These reasons have made our decisions over-reliant on this heuristic. A study by social psychologist Solomon Asch found that participants tended to change their answers from correct to obviously incorrect choices, just to conform with the group’s decision.
Corollaries of this bias are evident in supermarkets, where consumers rush to purchase hand sanitizers and toilet paper simply because other consumers are doing so. In India, consumers began to hoard hydroxychloroquine, an arthritis medication, because they assumed that it could be used to treat COVID-19. This “bandwagon effect” also explains the herds of migrant workers who returned to native villages from Indian cities during the pandemic. Their complete disregard for lockdown protocols and social distancing was reinforced by the identical behaviour of the other members of the migrating herd.
It goes without saying that the decisions that result from these cognitive biases lead to negative externalities of consumption. For instance, when consumers decide not to take a COVID-19 vaccine due to an availability bias, they put society and their community at risk. Migrating labourers can carry COVID-19 across different states. The hoarding of hydroxychloroquine and N95 masks in India creates a shortage, or excess demand, of these goods, consequently triggering what a recent IMF report describes as inflation in the prices of essentials in emerging market economies. Consumers with budget constraints and patients who require hydroxychloroquine to treat conditions such as rheumatoid arthritis may be priced out of the market entirely.
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Such negative implications can only be addressed by government intervention. Apart from conventional policy instruments such as legislation, taxes or price controls, governments can subtly take advantage of consumers’ cognitive biases and “nudge” them into making choices that are in the interest of society at large. The aptly named “nudge theory” describes a form of liberal paternalism, through which choices presented to consumers are altered so that certain alternatives stand out among others. In the Government of India’s campaign, “Give It Up”, behavioural economics was used to “nudge” above-poverty line households to forgo their LPG subsidy.
The inertia bias suggests that consumers have a strong tendency to stay with the status quo and select default options. By changing the default option from opt-in to opt-out for this subsidy, this campaign managed to “nudge” over 10 million households into giving up their subsidy. The framing bias states that the way information is presented plays an important role in our decisions. When state governments in India presented gain-framed health messages to the public (for example, “vaccinate yourself to keep your friends and family happy and safe”), studies found that consumers were more likely to adhere to these instructions as opposed to when messages were loss-framed (for example, “if you don’t vaccinate, your friends and family are at risk”).
In conclusion, researching consumer behaviour certainly has merits. Nevertheless, applying the results of these studies to subtly influence consumer decisions may raise ethical concerns. While behavioural economics and nudge theory may be contentious topics, I believe that research in these areas will broaden the scope of economics from a study of institutions to a study of mankind, from a study of markets to a study of the ordinary business of life.
(Shiv Kampani is a 17-year-old student who is fascinated by how and why humans make sub-optimal economic decisions. Interested in behavioural economics, he enjoys reading about how these sub-optimal decisions can be predicted and prevented through the use of nudge theory.)
References
Smith, Adam. The Wealth of Nations. Random House USA, 2020.
Blink, Jocelyn, and Ian Dorton. Economics: Course Companion. 3rd ed. Oxford: Oxford
University Press, 2020.
Baddeley, Michelle. Behavioural Economics: a Very Short Introduction. Oxford, United
Kingdom: Oxford University Press, 2017.
Thaler, Richard H., and Cass R. Sunstein. Nudge: Improving Decisions Using the Architecture of
Choice. New Haven, CT: Yale University Press, 2008.
Wansink, Brian, and Lizzy Pope. “When Do Gain-Framed Health Messages Work Better than
Fear Appeals?” OUP Academic. Oxford University Press, December 16, 2014.
Economic Survey. Ministry of Finance, Government of India.