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Behavioural Economics and Practicalities of Intervention

In this lecture, we will turn to behavioural economics and practicalities of intervention.

What you will learn

This introductory lecture to behavioural economics and practicalities of intervention provides a thorough view of the key contributions from five of these nascent theories: prospect theory, behavioural finance and economics, intertemporal choice, collective choice and public choice.

Prospect theory

  • Prospect (or lottery) theory attempts to explain how people choose between probabilistic alternatives involving risk, when the probabilities of outcomes are known. People base decisions based on the potential gain or loss (rather than the outcome) of real-life choices, evaluating them using heuristics (Kahneman & Tversky 1979) or biases—simple and efficient rules that people use to form judgments and make decisions—wherein they decide what outcomes they consider equivalent.
  • Individuals use a reference point (such as the status quo) to decide whether they are presently in the domain of loss or gain. Once the reference point is set, a person considers poorer outcomes as losses and better ones as gains. Curiously, losses are more painful than the elation one gets from gains, making people “loss averse.” For most people, losing one thousand Euros hurts more than gaining the same amount pleases them. Overall, the theory more accurately describes decision making (psychologically) than was commonly done under expected utility theory (Tversky & Kahneman 1992).
  • The theory has profoundly impacted economics, including its public choice sub-discipline, as well as political science. “Almost all decisions by political actors entail a certain degree of risk, whereby risk is the probability that an event occurs (e.g. losing the election) times the impact that it did (e.g. losing office)” (Vis 2011: 334). Prospect theory helps political actors deal with decision making under risk, where people make different choices when facing losses, compared to their risk-adverse behaviour when confronting gains—so they can hold on to those gains (341).

Decision process: As people choose between valuable alternatives or choices, they pass through editing and then evaluation stages. In the editing stage, the expected outcomes from a decision are ordered per a heuristic. People decide which outcomes are equivalent and set a reference point. Less outcomes are considered losses and greater ones, gains. All probabilities are treated together rather than isolated. They are, as needed, combined, simplified, segregated, eliminated and sorted in order of dominance.

In the evaluation stage, people compute values based on the potential outcomes and their expected probabilities. Lower probabilities are said to be over-weighted, or considered by the decision maker to be of a higher probability than they really are, impelling him to favour the alternative choice. The resulting computed values fit into the economist’s utility maximising equation. In the final evaluation, the decision that produces the highest utility is chosen.

Heuristics: Kahneman (2003: 1450) more recently argued that, “People are not accustomed to thinking hard, and are often content to trust a plausible judgment that comes to mind.” For that reason, they use heuristics or biases (or even prejudices) to make decisions easier. Rather than disparage such behaviour, Gigerenzer, Todd and others (1999) argue that heuristics generate accurate judgments rather than biased ones. Heuristics are “fast and frugal” alternatives to more complicated procedures, and often yield good solutions. People seek to minimise thinking tasks and decision making costs, and frequently look to lower-cost alternatives instead of doing more careful analysis.

Behavioural finance

  • Behavioural finance, like behavioural economics (Simon 1987), studies the effects of cognitive, psychological, social, and emotional factors on economic decisions. As Hirshleifer (2015: 133) notes, it is “the application of psychology to finance, with a focus on individual-level cognitive biases.” It also considers the impact of such decisions on prices and resource allocation, other kinds of behaviour in different environments.
  • The injection of behavioural finance into modelling has improved investor predictions, managerial expectations and has lessened the need for vigorous regulation (Muradoglu & Harvey 2012: 75). For example, researchers found that during the financial crisis of 2007-2008, people succumbed to non-rational behaviour: hubris, over-optimism, anchoring and herd behaviour, citing culprits of inadequate management and regulatory capture as reasons for the depth of difficulties experienced that led to the irrationality (Grosse 2012).
  • There are three prevalent themes in behavioural finance: (1) heuristics, where people often utilise rules of thumb instead of strict logic to make decisions, (2) framing, which are the mental emotional filters individuals rely on to understand and respond to events, including anecdotes and stereotypes, and (3) market inefficiencies, including non-rational decision making and incorrect pricing (Minton & Kahle 2013; Shleifer 1999). Also important is the “central role” of feelings and sentiment in decision making (Hirshleifer 2015: 151).

Intertemporal choice

  • Intertemporal choice studies how people make choices between alternatives, and how much to spend, at various points in time, given that choices at one time influence the available opportunities at others. Such choices are influenced by the relative value assigned to two (or more) payoffs at different future points, and usually require a person to make trade-offs.
  • Traditional models: Economists have traditionally used a discount rate to analyse intertemporal decisions via the discounted utility model, which assumes that people evaluate utility or disutility like financial markets evaluate gains or losses, exponentially discounting the value of outcomes corresponding to the delay required to realise them. This method has been used to model intertemporal choices and as a public policy tool to analyse spending for research and development, health and education (Berns, Laibson & Loewenstein 2007).

The Keynesian consumption function suggested that average propensity to consume falls as income rises, and early empirical studies were consistent with it. However, post-World War II studies identified the opposite thing occurring: savings did not rise as incomes rose. Thus, a refined version of the theory of intertemporal choice emerged to replace the Keynesian theory.

Intertemporal choice was introduced and elaborated over a century of thought by John Rae (1834), Eugen von Böhm-Bawerk (1884) and Irving Fisher (1930). Later, the life cycle income hypothesis was proposed by Franco Modigliani (1956) and the permanent income hypothesis by Milton Friedman (1957), both of which showed that a Walrasian Equilibrium can be extended to incorporate intertemporal choice, yielding the concepts of futures prices and spot prices—the former for what people expect prices will be and the latter what they are today.

  • Hyperbolic discounting: Hyperbolic discounting theory demonstrated that one’s discount rate for future utility might decline over time (Thaler 1981), especially since deferring consumption for one period on objects of choice in the distant future is not very relevant, although there have been some effective criticisms of the theory (Rubinstein 2003). In the final analysis, many scholars would agree that, “dynamic consistency has been acting as an invisible straitjacket obstructing the development of intertemporal choice theory, and that it is only by undoing it that this field of research can achieve in the future a satisfactory understanding of human decision-making” (Loewe 2006: 217-218).

Collective choice

Collective choice deals with “the ability of groups to implement efficiency-enhancing institutions,” especially those that “foster cooperation.” Indeed, people prefer to cooperate rather than compete if there are well-defined, inter-group competition rewards for the best-performing groups—although it does not usually improve Pareto conditions (since losing groups are worse off). Nonetheless, individuals were shown to prefer to contribute to their group’s overall performance and, “the incentive to outperform other groups mitigates the free-rider problem within one’s own group.” This fact holds true whether the rule is imposed or selected by majority voting (Markussen, Reuben & Tyran 2014: F163, F186-F188).

In households, individual intertemporal choice was found to be consistent with exponential discounting models. However, household consumption choices were not, and took on different characteristics when collective, where individual heterogeneity is subject to renegotiation. Moreover, heterogeneity discount factors were found to be correlated with the head of household’s age and education level, as well as the wife’s employment status (Adams, Cherchye, De Rock & Verriest 2014). In firms, collective choice in capital-intensive firms can be especially prominent when a firm has financial difficulties and, thus, the workers have a unified common concern. However, the best success stories of such collective action occur in a “muted or indirect forms of worker participation” in company management rather than direct management by employees (Dow & Skillman 2007: 123).

Public choice

Given that a single vote is virtually meaningless, i.e., yields infinitesimal political influence, choosing not to vote is rational—especially where the state does not obligate citizens to vote. However, investing time in convincing others to vote for some important issue is apparently of great value, since special interest groups (SIGs) and political action committees (PACs) clearly abound in democratic societies. Moreover, since successful SIGs and PACs represent large blocks of votes, they command considerable political influence. Therefore, mature democratic processes tend to rationally proliferate SIG and PAC activity, especially when government regulation is expanding.

While the market process is guided by an “invisible hand” (Smith 1776) that coordinates catallactic coordination and cooperation among self-interested human actors, the political process is “led by an invisible hand to promote other kinds of interests” (Mitchell & Simmons 1994: 39) and SIG and PAC activities distort or subvert “public interest” goals in favour of private interests. Likewise, public policy cannot cure market failures. Instead, it often makes social problems worse.

Rent seeking: A frequent goal of SIGs is to gain market power and maximise profits through political action. Contrary to the market process, where entrepreneurs gain monopoly benefits that are quickly dissipated as others rush to enter the market, the political process can be used to thwart this natural check against long-lived monopoly privileges. For instance, government often enforces monopoly privileges by barring all potential entrants through patents, import tariffs, forcing consumers to buy goods from patent holders through “public interest” legislation (e.g., air bags in cars, fire extinguishers and fire-suppressing devices in buildings), taxicab medallions, occupational licensing, etc. For firms, obtaining government-sanctioned monopoly is very attractive, and often much cheaper than dealing with competition in the marketplace.

Such attempts to manipulate or control markets are known as rent seeking, which is probably better termed “privilege-seeking.” Tullock defines rent seeking as “the manipulation of democratic [or other types of] governments to obtain special privileges under circumstances where the people injured by the privileges are hurt more than the beneficiary gains” (Tullock 1993: 24, 51). Buchanan says, “The term rent seeking is designed to describe behaviour in institutional settings where individual efforts to maximise value generate social waste rather than social surplus” (Buchanan 1980: 46-47).

Vote seeking: Quixotic notions of public service aside, public choice theory states that self-interested politicians are primarily driven by the dominant objective of re-election. Successful ones generate political benefits in excess of political costs. Accordingly, when spending public money, they calculate how many votes they will receive per dollar spent. Likewise, they calculate how many votes are lost from favouring one group at the expense of another. In the end, they determine the policy mix that optimises their vote count (Mitchell & Simmons 1994: 52, 73).

The “median voter theory,” coupled with the fact that more women than men vote, instructs vote seekers about optimal methods of securing the votes they need. Hence, they tailor emotional appeals to the relatively unprincipled and predominantly female voters near the centre of the frequency distribution. Subsequently, vote-seeking politicians not only gain political power, but also perks, milking money paid to their “foundations,” favour-broker benefits, and at times outright opportunities from venality—all of which accompany their office.

Conformably, “[t]he politician is…always selfish no matter whether he supports a popular program in order to get an office or whether he firmly clings to his own—unpopular—convictions and thus deprives himself of the benefits he could reap by betraying them…Unfortunately the office-holders and their staffs are not angelic. They learn very soon that their decisions mean for the businessmen either considerable losses or—sometimes—considerable gains. Certainly, there are also bureaucrats who do not take bribes; but there are others who are anxious to take advantage of any “safe” opportunity of “sharing” with those whom their decisions favour” (Mises 1966/1949: 734-735, 852). Thus, the politicians who decree and oversee regulation will practice vote-seeking. Their first objective will be to get re-elected, not to serve the public interest.


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