'Nudging' people to make better choices

Nobel winner Richard Thaler's formalisation of economic behaviour that is not rational in the traditional sense reframes economic questions in ways that can improve government policies

Economists design policies based on models that assume individuals behave rationally. Presented with a set of choices, we may expect a person to decide on the option that gives her the best outcome. In reality, decision-making involves limited time and incomplete information. In addition, options may be complex and may require significant cognitive effort to evaluate and compare. Thus, it is not surprising that humans often do not behave as rationality would predict. 

Acknowledging the limitations of assuming rational choice and understanding behavioural aspects of decision-making allow better design and implementation of economic policies. Why do poor households save so little? Why do the toilets built under the Swachh Bharat Abhiyan remain unused? What explains the popularity of demonetisation among those who were affected by it the most? The answers to these questions lie in behavioural economics. Behavioural economics is a well-developed area of economics, but has become increasingly relevant since the global financial crisis, when standard models could not explain the skyrocketing prices of assets through rational behaviour of traders.

The Nobel Prize in Economic Sciences this year has been awarded to Richard H Thaler, an American economist at the University of Chicago. Thaler has pioneered a large body work in behavioural economics using theory, data from financial markets, laboratory experiments and surveys. His research identifies classes of deviations from rational behaviour, which can be applied to various economic frameworks. Applying his ideas, it becomes possible to “nudge” people towards making better choices, while preserving their freedom to choose. The UK and US governments have set up behavioural insight teams that have been influential in raising the rates of organ donation, improving electoral participation and increasing the sum of donations to charity. 

Pioneer Richard Thaler's work focuses on three ways in which humans can behave irrationally. (Photo: Reuters)

Thaler’s work is focused on three ways in which humans can behave irrationally. The first is called limited rationality. An example of this is what Thaler has coined as the “endowment effect”, where individuals value an item more when they own it rather than when they do not. This loss aversion can be seen when firms give customers the option of paying one price by cash and a higher price by credit card. The choice typically refers to the difference as a discount for cash payment rather than as a surcharge for card payment, which portrays the cost of using a credit card as a foregone gain rather than a realised loss to the customer. Another example of limited rationality is captured in the relevance of reference points — customers may prefer a product sold at a large discount from a high price to a similar product sold at an equal final price, as they perceive the product to be of a higher value in the first case.

The second insight of Thaler’s work is into the existence of “social preferences” — individuals do not necessarily make choices selfishly. They often value fairness and can value the welfare of others in positive and negative ways. They can extend cooperation and solidarity and forgo material benefits to themselves to allow for what they perceive as a more just distribution. Alternatively, they may also be willing to bear personal costs to punish those who violate fairness rules, whether the injustice is towards them or others. Combining this with the idea of measuring utility as deviations from fixed reference points gives us an insight into how crowds of people were willing to suffer in bank queues during demonetisation, where the losses of those richer to them were higher in absolute terms. Instead, if we are to view the losses as shares of wealth or income, the poor were affected the most.

A third idea of Thaler developed along with Hersh Shefrin is that of limited control. Individuals are more mindful of decisions that are in the present or the near future relative to those further off in time. This leads to a tension between what Thaler and Shefrin call the planning self and the doing self. The planning self makes decisions that value long-term goals, whereas the doing self is concerned with short-term happiness. One, the solution to this dichotomy is to reduce the number of choices the planning self presents the doing self with in the upcoming future. This goes against economic theory, which states that more choice is always as good or better. Society or policies can guide individuals towards outcomes preferred by the planning self. This is the rationale behind the opt-out rather than the opt-in defaults for organ donation in several countries, as well as the default options in the National Pension Scheme in India and pension plans across the world. This concept can also be used to organise the extension of loans to categories of borrowers, who heavily discount the future and may not be able to repay on their own.

Thaler’s formalisation of economic behaviour that is not rational in the traditional sense reframes economic questions in ways that can improve various government policies. For example, increasing awareness on sanitation will help in a higher usage of toilets built under the Swachh Bharat Abhiyan, as has already been recognised by the government. Such aspects are best incorporated into the early stages of programmes for higher uptake and implementation that leads to better economic outcomes. The translation of results from lab experiments and small surveys to wider scales is not always exact, so any applications of behavioural concepts to policy require deliberation and care. 

The author is visiting assistant professor, Indian Statistical Institute, Delhi Centre