12 Dec How can behavioural economics inform better business decisions?
Words:Dan Ariely, Duke University
The science of economics was built on the assumption that as human beings we are rational beings. There was just one problem: the assumption was wrong. Professor of Psychology and Behavioral Economics at Duke University, Dan Ariely, discusses what came next.
Economics is a bit like a religion. Believe in it in a strong way and there’s very little that can be done to shake that. But what if economics can be shaken? It can. In 2008, an earthquake reduced the financial world to rubble. The perceived self-interests of organisations – especially financial institutions – was the epicentre: it was a myth. The American stock market looked out of hand for a long time before the crash, in all manner of ways. And yet economists would explain that the behaviour of the markets was actually perfectly rational, even if difficult to understand. They assumed rationality from the beginning.
Later, and somewhat reluctantly, economists admitted that even if people themselves are irrational by nature, it’s enough that there are some big players in the market who are rational. In other words, the rational players and organisations were responsible for taking money out of the hands of the irrational, and eventually the markets would reflect the perfect pricing.
But they didn’t. The failings of the deregulated market; the fact that companies had no idea what they were entering into; the fact that the employees of those companies kept all of their pensions in doomed bank funds – all of this was crucial in unearthing the reality that ultimate rationality doesn’t exist. As humans, we are inherently fallible – and nowhere is this more evident than when it comes to making economic decisions. Have all economists been convinced? Of course not. Will they ever be? Of course not. But the public discussion around the matter has changed considerably.
Defining ‘behavioural economics’
‘Behaviour’ is not just an outcome of people’s preferences, but of the environment in which people are placed. One hundred years ago, roughly 10% of human mortality was caused by bad decision-making. That figure is now about 45%. Why the rise? Because as we’ve developed as a society, we’ve effectively created more ways to kill ourselves. Think about texting and driving. As we develop more technology, we are creating more situations to test our frailty, our character.
Of course, this is an extreme example. But what about the kind of food we expose ourselves to? The lifestyles? The payment systems? Regulators wield an enormous amount of power in their ability to design an environment compatible with human frailties – or not, as is so often the case. If we put people in a compatible environment, there’s a good chance they’ll make better decisions; if we put them in an incompatible environment, there’s a good chance they’ll make worse decisions. This covers ‘behaviour’, but what of ‘economics’? Since its inception as a science, economics has become more mathematically inclined; economists became increasingly interested in things like game theory and complex mathematics – constructs far removed from Adam Smith’s Theory of Moral Sentiments, which is in essence a book of psychology, written by the founding father of economics.
But in order for such mathematical constructs to be solved, some simplifying assumptions were needed. The most comfortable was the assumption of rationality – so comfortable that economists eventually forgot it was an assumption. As a result, economics became more interesting in many ways, but also more wrong. And given the fact that economics is a prescriptive study (i.e. not just concerned with describing the world but with stating how it should be), it also became more dangerous.
Every perspective has its value. Society can be explained through the eyes of the philosopher, the sociologist, the anthropologist, the psychologist. But when it comes to dictating how society works – how tax systems are created, how the education system should be run, how people should be punished and so forth – then we require a more realistic approach. The economist who informs public policy while assuming human rationality would be akin to the engineer with an incomplete knowledge of building bridges.
When people spend money and feel the act (e.g. when handing over cash or signing a cheque), they commonly experience what’s known as the ‘pain of paying’
The irrationality of humanity
So what exactly do we mean when we say that as humans we are essentially ‘irrational’? Consider the act of texting while driving. Nobody says that their goal for next year is to text and drive. In fact, I’ve never met a single person who said that texting while driving is not an incredibly irresponsible thing to do. But what happens when your phone vibrates while you’re driving? You become curious and interested. Your sense of long-term safety and the safety of others goes down, and you check your phone.
Helping others – isn’t that an irrational form of behaviour? Sometimes people equate rationality with good and irrationality with bad, but if a stranger asked you to help them move a sofa, what would your incentive to help them be? Rationally speaking you would be wasting your time. If you were a good, rational economist, you would state your price and offer the stranger a take-it-or-leave-it deal.
Procrastination is another example. It’s a terrible thing we do. Ask someone whether they spend too little or too much time on social media and they will probably admit to the latter – but they don’t necessarily make a change. Likewise, many people say they are at their most productive in the first two hours of the day – but they admit that while they recognise that those hours are productive, they don’t actually use that time to do work that demands a high level of cognitive function.
There are lots of things that we do that are not in line with rationality. In fact, if you think about most of our actions, they are probably not in line with perfect rationality. Some of them are, but most of them fall short of the ideal.
Bad (economic) behaviour
Irrational habits are written into the human condition, and I don’t believe that will ever change. We’ll never be able to turn off our emotions or always think in the long term.
Take something commonplace that we do every day: spending money. When people spend money and feel the act (e.g. when handing over cash or signing a cheque), they commonly experience what’s known as the ‘pain of paying’. However, when we’re not aware of money leaving our wallets and purses, we don’t feel so bad. Think about the old-fashioned utility meters that took coins versus today’s direct billing options. Payment systems for smartphones and watches are similarly conducive to what we might call ‘bad’ economic behaviour. In getting us to think less about our money, they encourage us to spend more of it. Likewise, trading platforms routinely present us with past performance reports when we know for a fact that past performance is no reflection of how stocks will perform in the future.
Money is an interesting animal, to be thought of in terms of ‘opportunity cost’. Every time you spend a dollar on something, that’s a dollar less for you to spend on something else. But what exactly is this something else? Where is it coming from? It’s very hard to think about money in any real degree of clarity because of the existence of such dilemmas.
Imagine a world in which I gave you $20 a day on the provision that this is your daily allowance – no more, no less. You would realise very quickly what you can and cannot afford, and how best to deal with the money. If I gave you a weekly allowance on Monday, you’d not recognise a constraint then or on Tuesday. However, by Thursday you’d start to feel it, and then it would be too late.
Mortgages are another good example. In the US, mortgages are often bought using points. Points are effectively a means of buying lower interest rates and allow you to pre-pay some of your interest upfront. If you stay with the same mortgage for 30 years, it’s usually a good deal – but if you refinance, it could be bad. When people are presented with just one dimension when making a financial decision, they don’t get it wrong (assuming the dimension is sound). But when other dimensions are added, they then start making mistakes.
Our current environment is rife with systems that make it easier for people to fail
Building the right environment
If, as I mentioned earlier, human flexibility and ability has everything to do with the environment around us, then what kind of environment should we have around us? One that gets the worst out of us, or one that gets the best out of us?
Our current environment is rife with the former – with systems that make it easier for people to fail – when in actual fact we should be considering how to take human nature into account when building it.
Imagine you and I were in charge of building the next electronic wallet. What would we build? One that gets people to ignore their money as they spend it, or one that gets them to contemplate it a little more? We don’t need more systems that do the former.
Behavioural economics has made great strides in the savings and pensions arena – even just in terms of simple concepts, such as giving people different defaults for retirement. Some countries in South America (Chile, in particular) have traditionally let people decide for themselves how much to save, but the governments recently realised that people weren’t saving – a familiar story. So, they decided to force people to save 10% of their incomes. And it’s working, just as similar approaches appear to be working in the US and the UK. The whole notion of automatic deduction works so well simply because it gets people to think that they don’t have the money in the first place – an inversion of the aforementioned ‘pain of paying’ scenario.
People have a tremendous desire to be motivated. We like to feel connected to our labour, and we want to feel that what we are doing is useful. Needless to say, the place of behavioural economics in the modern workplace goes beyond savings. Actually, in many cases the role of businesses is not just to create motivation, but also to not destroy it.
Admittedly, we don’t have solid evidence to prove a correlation between financial incentives and employee motivation, but I’d wager there is one. Even simple things like kind words, social contracts, pizza – all of these things are capable of dramatically changing how employees view themselves, their work and their interest in it.
From a real world perspective, I don’t think behavioural economics can be called an emerging science any more. It’s got a multitude of different understandings, but if you look at what many organisations are doing in terms of innovation and ask them whether they rely on economic models or data to inform decisions, the answer will almost always be the latter. Similarly, ask them how much they rely on the principles of design and of human factors, and they will tell you that they use all of these – even though they may well be unaware of the fact that they are based on behavioural economics.
Standard assumptions about rationality are simply not part of the mindset of the modern workforce. Granted, there is a considerable way to go yet, but the journey has begun.
About the author
Dan Ariely is Professor of Psychology and Behavioral Economics at Duke University, North Carolina, and a founding member of the Center for Advanced Hindsight. He is the author of several books on the subject of behavioural economics, namely Irrationally Yours, Predictably Irrational, The Upside of Irrationality and The (Honest) Truth About Dishonesty. He has also produced a short movie, Dishonesty, and a card game, both on the topic of behavioural economics. These are Dan’s attempts to describe his research findings in non-academic terms so that more people will learn about the subject, discover the excitement of it, and possibly use some of the insights to enrich their own lives, at home or at work.