While taking a break from studying and researching for my Honours Economics thesis, I came across an inspirational talk on The Behavioural Shift by Colin Camerer, Andrew Caplin, and David Laibson – all of whom are leading behavioral scholars. They were invited to discuss how their research has given valuable insight into economic models of human behavior at the Becker Friedman Institute located at the University of Chicago in the United States.
I must say that especially Harvard Economist David Laibson inspires me to learn more on Behavioural Economics and pursue research in the area myself in the future! What is more, Camerer’s, Caplin’s and Laibson’s discussion about new cutting edge research and the future of Behavioural Economics reassures me that my dream of graduate studies in Economics is not only personally fulfilling but it is also going to be an exiting area to specialise in.
While the panel is lengthy, it is more than worth it. After presenting their research, the behavioural scholars Camerer, Caplin and Laibson engage in an insightful discussion with their two hosts and also answer questions from the audience.
So don’t miss out on this inspirational talk if you are interested in the behavioural shift…
Today I had the opportunity to attend the 2016 TEDx conference at the University of Stathclyde. Under the heading WORLD 2.0 the conference engaged a conversation about our shared future and the need for aspiring for progression. Six speakers with diverse backgrounds were invited to talk and each of them in their very own way showed how the idea of a single person can make a difference in world 2.0.
Impressions of TEDxStrath16
Introducing TEDxUniversityOfStrathclyde 2016
Engaging in the conversation
Can geography save the World?
Speaker Stefan Celosia with Clanadonia
Speaker 1: Edgar Grunewald
The first speaker invited to talk was Edgar Grunewald. Known as a WorldBuilder who is running his own YouTube channel Artifexian, Grunewald talked about how to construct an entire world using simple maths. He showed us how numbers can tell a story; that is a story of a planet and two stars. Ultimately it turned out to be the Star Wars planet Tatooine. Grunewald’s talk showed us how to construct imaginary places like Tatooine which feature in some of the most prominent creative works today – from books over movies to TV series. Grunewald taught us about the world of sci-fi and by walking us through the mathematics of the planet Tatooine ultimately proved that you can build imaginary worlds that have their place in reality.
Speaker 2: Sajjad Khan
The second speaker of the day was Sajjad Khan who is a student at the University of Strathclyde. He invited the audience to “come out of the bubble”; he gave an inspiring talk about human interaction and ways towards a mindful world society. He shared with us his experience of volunteering with a water project in Africa. He argued that his work, i.e. the installation of water pumps, was perceived as a huge development in technology by the local population. He then vividly contrasted this with the development in technology in our society and the large gap between these two worlds. This led him to ask what – in world 2.0 – the word humanity means and what a human is in this world. He questioned how we justify war and bloodshed if we cannot even fight poverty. He spread the vision that being different should be an opportunity to get to know another in world 2.0 and invited everyone in the audience to become a changemaker to realise the vision of an embracing world society.
Speaker 3: Catherine Cahn
The third speaker of the day was Catherine Cahn, COO of Twig World. Cahn’s talk was centred on the future of education. She reasoned that in world 2.0 the essential skills are human creativity, problem solving and analytics while subject knowledge has become worthless with the availability of google and the like. Yet governments have wrongly focused on subject matters while labeling the arts as useless. Cahn questioned whether this is the right way in world 2.0; that is having a curriculum of 40 percent numeracy/ literacy skills and 60 percent subject matter. She reasoned that we need to revamp the curriculum and move to phenomena based learning. She argued in favour of the primary school model, i.e. the model of a single teacher engaging with the class going through the steps of: (1) Question Generation, (2) Investigation and (3) Phenomena. Cahn argued that in secondary school the model has to become student driven. In her opinion students need to learn problem solving, going through the steps of research, prototyping, feedback, iterating and publishing. This would allow students to learn the essential skills of mastering their life in world 2.0, instead of overloading children with useless content knowledge.
Speaker 4: Prof. Robert Kalin
The fourth speaker of the day was Robert Kalin, a professor of the Civil and Environmental Engineering department at the University of Strathclyde. He talked about his work as a hydrogeologist and his passion for water as the foundation of life and the lack of access to sanitised water in many places, especially in Africa. He talked to us about the importance of groundwater and what it means for life. He reasoned that access to water is access to life; it underpins everything including our economy. Yet the investment in water as one of the sustainable development goals is failing faster than the increase in effort that is put in. This exemplifies in so-called ghost water points. Kalin’s vision is to go from reactive to proactive action, targeting preventative maintenance. In his opinion, everyone can make a difference despite universal access to clean water being a huge challenge. The first step is to make the sustainable development goals part of your life and think about them every day.
Speaker 5: Dr. Michael Groves
The fifth speaker of the day was Michael Groves, CEO of Topolytics. He gave a talk on Can geography save the world? He showed us how big data and analytics can give us the necessary insights for this mission by tracking commercial waste and emissions. He reasoned that geography can help us becoming more sustainable by measuring and managing waste and tackling the vast amount of urban waste and the plastics floating in the oceans. It can help us tracking the use of resources and the massive growth in the extraction of resources. For him, geography is a sustainability science. With digital mapping and data, waste can be managed and information about it can be shared. It feeds into the goal of a circular economy; designing products for re-use and tracking the distribution of materials and waste. He invited us also to check out the book Prisoners of Geographyto learn more on the importance of geography in world 2.0.
Speaker 6: Stefan Celosia
The last speaker of the day was Stefan Celosia, ex-physics graduate from Strathclyde, who is now a professional musician, composer and producer. Under the heading Survival of the Funkiest, he explored with us the history of music and the importance of music in world 2.0. With the help of technology, music making today is more accessible than ever before and is increasingly about ideas and not skills. He argued that music is an important motivational tool for most people today and left us with the question: Is creativity a means to an end, or could it be the end itself?
I must say that the TEDx Conference at Strathclyde was my very first TED experience at close quarters. I have watched numerous TED and TEDx talks, but being part of such a conference yourself is mindblowing! When I reflect upon the day, I can say that the conference and especially the speakers indeed shared ideas worth spreading and I am very grateful that I was given the opportunity to attend the conference this year!
While researching and preparing for my applications for graduate studies in Economics, I came across a highly inspiring lecture by David Kreps who is the Adams Distinguished Professor of Management as well as Professor of Economics at Stanford. Under the heading “Choice, Dynamic Choice, and Behavioral Economics” Kreps contrasts how the discipline of economics models choice and, in particular, how the discipline models dynamic choice with more realistic models which draw on behavioural economics. Thereby Kreps’ research program is at the forefront of this with Kreps’ mission being:
To provide economists with “better” (more realistic, more consistent with observed behaviour) models of dynamic choice.
As an introduction to the lecture, Kreps first discusses how the discipline of economics works. Kreps argues that the bedrock of standard economics is that: (1) people make consistent choices and (2) these choices are equilibrated in markets and other institutional settings. Note here that some economists say that people make ‘rational choices’ rather than ‘consistent choices’. However, Kreps reverts to the wording ‘consistent choices’ to circumvent calling choices ‘irrational’ which do not conform with the standard economic model. Having laid out the basics, Kreps exemplifies what consistent choice in economics means in reality. It prohibits any situation like the following:
The situation in the roadside diner is the typical example of inconsistent choice. Why? Because the customer prefers the apple pie initially when having the choice between apple and peach pie. We could say that the individual maximises his utility by purchasing the apple pie. However, when confronted with a seemingly irrelevant third alternative, that is banana crème, his preference changes. He now chooses peach pie over both apple pie and banana crème. In the world of standard economics this cannot happen because economists assume that the customer will stick to his preferences no matter what. If he chooses apple pie and not peach pie if both options are available to him, then he will never choose peach pie over apple pie when both options are available to him. In short: He will always choose apple because he prefers apple pie. Besides consistent choice theory being the bedrock for economics, this assumption is also necessary for maximising utility. We need this independence of irrelevant alternatives/ preference stability in the choice of an economic agent to conclude that individuals are utility maximisers. Otherwise we cannot model the decision-making process as one of maximising utility with a simple numerical function as commonly done in utility theory, expected utility theory and subjective expected utility theory.
After having set the scene what consistent choice is in economics, Kreps looks at empirical evidence. He argues that empirically the assumption that people make consistent choices does not hold. There is watertight evidence that the environment and other seemingly irrelevant alternatives available to you change the ‘frame’ of the choice. One of the examples is marketing which relies heavily on manipulating the frame of a decision, inducing individuals to buy their products. Hence, compared to economists, marketers have long recognised that people fall prey to inconsistent choices, for example depending on which products they advertise simultaneously. In contrast, economists still go with ‘consistent choice’ because otherwise their decision theory breaks down. Conventional economists tend to ignore the ‘frame’ of the decision.
Next Kreps looks at dynamic choice. The situation of the apple and peach pie is an example of static choice. Kreps, however, is more interested in dynamic choice; that is, choices that have implications for the future and influence future choices like education or savings decisions. Again, standard economics looks at dynamic choice problems through the lens of utility maximisation. It assumes that economic agents act ‘as if’ they could figure out the set of strategies and the outcomes of each strategy in a dynamic choice problem and hence could plainly act ‘as if’ they maximised their utility subject to their ‘budget constraint’. According to Kreps, utility maximisation and the ‘as if’ assumption are not a good model of dynamic choice due to the following three reasons:
People know that the future is highly uncertain and often unpredictable and they take this into account in the decisions they make today.
People rely on heuristics when it comes to complex dynamic choice problems.
In the remainder of the lecture Kreps looks at all three reasons in more detail. In terms of changing tastes, he argues that people have three basic options. On the one hand, individuals can acknowledge that tastes changes but do nothing. On the other hand, if they wanted to take some action, they could either constrain themselves via a commitment device or deliberately choose to remain flexible and choose not constrain themselves.
In relation to the second reason, Kreps takes a closer look at what motivates people. Conventional economics models individuals as homo economicus; that is consistent (or rational) and selfish. Under these assumptions incentives are guaranteed to work. Economics has a complete theory of incentives. An example is the simple principal agent model: In order to incentivise the agent, the principal can pay the agent a monetary bonus. This is sufficient for compensating the agent for the risk of putting in high effort but just being unlucky and ending up with an unsuccessful project. On the other hand, social psychologists take a rather different stand on motivation. Kreps points towards the concepts of self-determination and self-perception in social psychology. He sees both as superior to the standard economics stories and argues that social psychology needs to be incorporated into economics if we want to build theories approximating real-world behaviour.
In terms of the third reason for why the ‘as if’ model is unlikely to be a good one for dynamic choice problems, one needs to acknowledge that most of the dynamic decision problems like how much to save for retirement, which school to go to or which career to pursue are far too complex. What is more, in the real world individuals tend to choose by trial-and-error. The only way to find out which option is the best one is often merely to try or alternatively simplify the problem and then use some rule of thumbs, i.e. certain heuristics.
The bottom line of David Kreps’ lecture is that dynamic choice problems matter. They are among the most important ones in terms of their impact on individual’s economic well-being, the economic well-being of society and in aggregate the macroeconomic outlook. However, standard economics, by modeling individuals as utility maximisers, abstracts from how actual individuals behave in our economy. In contrast, what economics really should do is modeling actual human choice using proper assumptions which necessarily move away from “rational decision making” because our world is complex, risky and uncertain. Acknowledging that people do the best they can, given their cognitive limitations, paves the way to a superior theory of choice and, in particular, theory of dynamic choice.
If my short discussion of David Kreps caught your interest; then you should check out the full lecture available from here! Kreps is an amazing speaker and his way of presenting makes the topic – which is fascinating in its own right – even more captivating!
At the Behavioural Economics Symposium in Singapore in 2013 David Laibson, who is Robert I. Goldman Professor of Economics at Harvard University, gave a lecture on how behavioural economics is changing public policy making in the 21st century. Under the heading Towards Better Policy Design and Evaluation: Behavioural Economics and Randomised Controlled Trials Laibson (2013a, 2013b) looked at the growing importance of behavioural economic concepts as well as randomised control trials.
Laibson introduces the lecture by contrasting mainstream economic assumptions with the assumptions in behavioural economics. Standard economics assumes rationality and optimising behaviour while behavioural economics recognises that people are often confused or do not follow through on their plans. Laibson then continues with the example of savings behaviour to contrast effective policy making based on classical economic assumptions with effective policies based on behavioural economic assumptions. In particular, he shows that under the assumption of rationality and optimisation (‘homo economicus’), incentives and education should prove powerful to induce people to make use of their 401(k) savings plans. Yet the randomised control trials which Laibson conducted together with Choi and Madrian in 2010 suggest the opposite: incentives and education about the benefits of enrolling in a 401(k) savings account to maximise income (targeted at workers of age 59.5 and over) did not lead to the desired effect. It raised participation by only 5 to 10 percentage points (Laibson, 2013a, 2013b).
Hence Laibson suggests that we have the ‘classical economics view’ on the one hand and the ‘behavioural economics view’ on the other hand. While the former relies on incentives and education as the most important tools for public policy making, the latter recognises that incentives and education have a rather small effect on their own. Laibson argues that the solution to such failure of incentives and education is to find “interventions that channel good intentions into action” (2013a, p.13). One example of an intervention which channels good intentions into action is a change of opt-in enrolment to opt-out enrolment. Alternatively, one could also implement ‘active choice’, meaning that an individual is required to make a choice. In terms of the 401(k) savings account, this would mean that individuals would be required to make a choice upon the start of her job with a new firm.
Finally, Laibson turns to the domain of health where he sees significant similarities to saving behaviour and where the challenge is also to channel good intentions into action. For example, he argues that individuals often want to change their behaviour in the future by improving their diet, working out more, quitting smoking or other activities beneficial for health. Yet informing people (for example about their caloric intake) does not have the desired effect either. Information and education on its own are shown to have little effect in a range of randomised control trials. What works, according to Laibson, is to align intentions and actions. One example is a flu shot communication which at basically zero costs to society can be enhanced by adding a date and time plan. His second example is a colonoscopy communication which again at basically zero costs to society can be enhanced by adding a sticky note and an action prompt (Laibson, 2013a, 2013b).
So Laibson (2013a, 2013b) summarises his short lecture on Behavioural Economics and Public Policy Design as follows: The emerging field of behavioural economics sheds light on the failure of standard economic assumptions (rationality, optimising behaviour). Simultaneously, its insights prove valuable for public policy making because they can help to design more effective interventions which nudge people into the right direction at virtually no extra costs to society. Poster children for good public policy design based on behavioural economics are saving behaviour and health decisions.
I recommend you to watch the complete lecture by Laibson, which can be found here. The slides are available from here. In my opinion it is a highly inspirational lecture and gives a good overview on the wide range of applications of behavioural economics and how it transforms public policy making in the 21st century. What is more, Laibson is a highly engaging speaker and great to listen to!
Having read the books Nudge (2009) and Misbehaving (2015) by Richard H. Thaler, I decided to get a copy of his book The Winner’s Curse: Paradoxes and Anomalies of Economic Life recently. At first sight, the book seems a bit dated because it was already published in 1992. Yet, the content of the book is as relevant today is it was in the nineties.
The title of the book already implies that it is about economics anomalies, where Thaler defines an anomaly as a “fact or observation that is inconsistent with the theory” (p.2). In order to come across a cogent anomaly, Thaler argues that one needs:
A theory which allows for clear predictions and
Observations of actual human behaviour which are inconsistent with the predictions of the theory.
With these two basic ingredients Thaler succeeded in composing a book of 13 anomalies in total. His main intention at the time of writing was to raise awareness of economics anomalies. His vision, however, went beyond this: he envisioned the development of an improved economic theory which is consistent with actual human behaviour. For him, the cornerstones of this new theory would need to comprise optimising behaviour coupled with bounded rationality and social preferences. In Thaler’s words:
This new theory will retain the idea that individuals try to do the best they can, but these individuals will also have the human strengths of kindness and cooperation, together with the limited human abilities to store and process information. (p.5)
In the introduction to the book, Thaler gives a good overview on the model of rational choice on the one hand and actual choice on the other hand. Rational choice models are based on the assumptions of (1) rationality and (2) self-interest. This allows for the well-known ‘homo economicus’ (rational man) in standard economic theory. He (or she) maximises his (her) utility by making optimal choices, knowing his (her) preferences and planning well ahead. Then there is actual human choice with anomalies like the winner’s curse, under-saving for retirement or a significant gap between the willingness to accept (WTA) and the willingness to pay (WTP) for a good.
Despite considerable evidence for the incompatibility of rational choice and actual human choice, proponents of the rational choice model provide a range of reasons for why rational choice should be retained. Thaler lists the following four as examples:
People act ‘as if’ they possessed the knowledge necessary for making a rational choice.
The shortcomings of the rationality and self-interest assumptions do not matter (“it does not matter if the assumptions are wrong if the theory still makes good predictions” (p.4)).
The mistakes of individuals cancel out in aggregate.
Strong incentives for optimal choice, for example transaction costs, will induce people to behave rationally and in self-interest.
Having described the proponents’ strongest arguments for rational choice models, Thaler continues to refute each of them. For example, mistakes are unlikely to cancel out in aggregate because they are likely to be in the same direction. This might be due to confounding factors. Imagine that the individuals in an economy base their investment decisions on the news and forecasts available to everyone. Then, over-optimistic or over-pessimistic news will likely bias individuals in the same manner. As a result, individuals as collective will likely be over-optimistic or over-pessimistic in their investment decisions. Hence the argument that mistakes are irrelevant to aggregate behaviour in the economy and therefore the conclusion that rational choice is the golden rule for economic theory is rather weak.
I am in the midst of reading Thaler’s book. However, the inspiration and motivation behind The Winner’s Curse as well as Thaler’s vision of economic theory in the future makes me keen to read more on the 13 anomalies. I love his writing style; it is engaging and challenging your mind at the same time. It also makes you aware of your own biases and from an economist point of view, it challenges your conventional training. In sum, if you enjoyed Thaler’s books Nudge and Misbehaving as much as I did, then you should not miss out on The Winner’s Curse.
Many thanks for reading,
Thaler, R.H. (1992). The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton: Princeton University Press.
Sunstein, C.R., Thaler, R.H. (2009). Nudge: Improving Decisions About Health, Wealth and Happiness. London: Penguin Books.
Thaler, R.H. (2015). Misbehaving: The Making of Behavioral Economics. New York: W.W. Norton & Company.
Just shortly before the announcement of this year’s winner of the Sveriges Riksbank Prize in Economic Sciences – commonly known as the Nobel Prize in Economics – the Guardian speculated about the 2016 top contenders. It named Olivier Blanchard, Edward Lazear, Marc Melitz and Paul Romer (Inman, 2016). However, with the announcement of the actual winner by Professor Göran K. Hansson, Secretary General of the Royal Swedish Academy of Sciences, all speculations came to an abrupt halt yesterday. The winners are:
Oliver Hart (Harvard) and Bengt Holmström (MIT)
“for their contributions to contract theory”
Bengt Holmström is “known for his research on the theory of contracting and incentives” (MIT, 2016). The 2016 Nobel prize explicitly honours Holmström’s contributions to principal-agent theory and Holmström’s informativeness principle. Oliver Hart is known for his work on contract theory, the theory of the firm, corporate finance, and law and economics (Harvard, 2016). The 2016 Nobel prize honours Hart’s contributions to contract theory in the case of incomplete contracts (The Royal Swedish Academy of Social Sciences, 2016).
Today I went back to work on my dissertation. When researching more about reference-dependent preferences and reference-dependent risk attitudes, I stumbled across an interesting lecture of the economist Matthew Rabin, held at ITAM in 2011. Rabin is the Pershing Square Professor of Behavioral Economics in the Harvard Economics Department and Harvard Business School. Together with Koszegi, Rabin published an alternative model of reference dependent preferences in 2006. Furthermore, Koszegi and Rabin used this alternative model in 2007 to look at reference dependent risk attitudes and this is how I took notice of Rabin’s lecture at ITAM in the first place.
What I want to talk about in my post today is how Matthew Rabin described the evolution of behavioural economics in his lecture at ITAM (Galvan, 2011a, 2011b, 2011c). In particular, he argues that behavioural economics has emerged in three waves:
Formalising alternatives and
Fully integrating behavioural economics into economic theory.
What he calls the ‘first wave’, was the time in which behavioural economics was mainly concerned with describing anomalies in actual human behaviour which does not fit into the standard economic model and does not correspond to ‘homo economicus’ (economic man). During that period, Richard Thaler, for example, published a regular column entitled ‘Anomalies’ in the Journal of Economic Perspectives.
In the ‘second wave’, behavioural economics reverted to formalising alternatives and empirical tests of the alternative models. This was the time of extensive experimental research on concepts like loss aversion, present-bias and social preferences and in some respect this experimental research continues.
However, Rabin argues that we are now in the stage where behavioural economics starts to become fully integrated into the field of economics. In this ‘third wave’, the insights of behavioural economics now improve the realism of economic models. Furthermore, Rabin argues that behavioural economics today enables us to reintroduce theory into empirical economics, which has taken over in recent years after abandoning standard economic theory due to its major shortcomings. In the ‘third wave’, behavioural economics is now merging with empirical economics. This is why these are exciting times for aspiring economists: On the one hand, we have empirical economic research which can capture actual human behaviour and, on the other hand, we have behavioural economics which provides the theoretical backbone for explaining the data. This merger is crucial for understanding the driving forces of human behaviour and for better policy making as well. Empirical economics in itself – without the necessary theory – is of limited value for policy makers if it remains unclear what the underlying systematic mechanisms of behaviour are. As far as I understand, the combination of behavioural economics and empirical economics is what Rabin envisions the ‘new economics’ to be: Having both the mathematical formalism and rigour in behavioural economics as well as empirical evidence for explanatory power.
Another interesting point raised by Rabin is that behavioural economics is actually not arguing against ‘rationality’; rather it is arguing against the stereotype of the self-interested ‘homo economicus’ and the unrealistic assumptions that accompany this stereotype. Rabin argues that behavioural economics is not about people systematically making ‘errors’ because they exert bounded rationality. On the contrary, it allows for ‘rationalisable behaviour’. People may be perfectly rational in not acting in a purely self-interested manner. If they have, for example, social preferences then they actually act rational by being altruistic, fair etc. because they derive pleasure from doing so. Hence what Rabin argues is that behavioural economics has not ruled out rationality per se. In fact, behavioural economics shows that people behave ‘rational’ or ‘rationalisable’ most of the time when accounting for their preferences and other factors. As Dan Ariely (2009) put it, we are predictably irrational; ‘predictably’ implying that there are systematic forces that can explain the behaviour we observe.
I encourage you to have a look at the lecture (it is split into three parts; see references below uploaded by J.M. Galvan). After the overview on behavioural economics, Rabin continues to talk about the concept of ‘present bias’ and, in particular, his research in the field, including examples of procrastination and time inconsistency. It is inspiring and exemplifies how this emerging field is revolutionising the study of economics.
Many thanks for reading!
Ariely, D. (2009). Predictably Irrational: The Hidden Forces that Shape Our Decisions. London: Harper Collins.