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!

Cold Beer

The following question was originally posed by Richard Thaler (1985):

You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favourite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy hotel). He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of him bargaining with the bartender. What price do you tell him?

Now imagine instead of there being a fancy hotel there is only a small, run down grocery store. What price do you tell him?

In the experiment half those questioned were told it was a fancy hotel, half were told the grocery store. Interestingly, the answers differed.

The median response for the hotel was $2.65 while for the store it was only $1.50 (in 1984 dollars).

This contradicts standard economic theory where our preferences are supposed to be stable, regardless of who we interact with. I should value a beer the same regardless of who sells it to me. But as the example above shows, we use reference points. What we are willing to pay for a beer is not only based on our thirst, but also on our perception of a fair price or a good deal.