Temptation

The neoclassical economics way of viewing people involves assuming that people are fully capable of making the best decisions for themselves. If a neoclassical economist were to see someone (lets call him Nick) blowing all their savings in a Las Vegas casino he would simply assume that Nick had done all the sums and had concluded that his own personal benefit was maximised by gambling his life savings away.

That may be the case.

But behavioural economists tend to think not.

What if Nick knows what is best for him but chooses not to do it?

What if Nick has finite powers of self-control?

What if Nick hasn't even done the sums properly? He might be aware it's not the best option for him, but not just how disastrous it is.

Behavioural economists use the term 'bounded rationality' to refer to instances where people are clearly less than perfect (often by their own admission). If Nick may overly value short term fun over long term welfare. He knows he's being irrational, but he might need a helping hand to maximise his long term welfare. This is why people are increasingly offered commitment devices - in a rare moment of clear thinking Nick could opt into a scheme which bans him from casinos.

Corporate decision making can also fall foul of self-control issues. A timely example is the over-fishing of EU waters. If politicians really had the long term welfare of fishermen (and of the fish!) in mind then they would restrict the amount of fish that can be caught.

 

Taxing Rebate

If people are rational they know how to best spend their money, regardless of how and when they get it. So a recent study by Naomi Feldman (2010) raises some interesting questions.

Feldman examined whether a seemingly unimportant change in US tax law changed savings rates. In 1992 the George H. W. Bush administration changed how income taxes were collected. The amount of the taxes stayed the same, but less was collected each month. This tended to reduce tax rebates at the end of the financial year, but increase monthly net income. It didn't change the amount anyone paid in tax, but changed when they pay it. It meant there was a shift in income. Instead of receiving a sizeable yearly tax rebate, households had a larger net monthly income. Traditional economics would not predict any change in behaviour.

However, Feldman found that people saved significantly less after the change.

The yearly rebate was large enough to be seen as special and so people carefully considered how to spend it, typically saving a high percentage. The small monthly increase in income, however, was just added to household consumption budgets and so typically not saved. This is an example of mental accounting - the process by which people sort income into different budgets and tend not to shift money between budgets.

Thus we have a textbook example of the law of unintended consequences - a minor change in tax law causing huge shifts in behaviour. An argument, if ever there was one, for the use of behavioural economics in policy making!

Heston

You are called Heston. You need to make a bar of chocolate. The process to make this bar of chocolate uses three machines, one after the other. All three need to work for the chocolate bar to be made. Each machine has a success rate of 90%. What is the probability that the whole process is a success and the chocolate bar gets made?

Answer = 73%. (0.9 x 0.9 x 0.9 = 0.73)

People often guess a higher success rate than that. This is an example of the confirmation heuristic, whereby people overestimate the probability of conjunctive events. A 'heuristic' just means a rule of thumb, we use them all the time and mostly that's okay, but sometimes they lead us to make systematic mistakes just like the one above.

Percieved Intentions

This interview with the founder of Wikipedia about the takeover of Tumblr by Yahoo touches on how internet advertising works, and why it is important to get it right.

Jimmy Wales (BBC)

As he says, 'it's a social contract'. That is, things that aren't strictly financial, like intentions, matter. For example, if I think a website is taking advantage of me by throwing too many adverts at me, I might be offended or put off using that website. But if I perceive the website as just using fair means to make ends meet I might put up with the same amount of adverts. In summary, perceived intentions matter. (And as we speak behavioural economists are beavering away to include intentions in standard economic models...)