Rising East Essays

Leigh Caldwell to Stuart Derbyshire

Behavioural Economics Is Promising

Dear Stuart,

I believe behavioural economics is on the cusp of achieving something new and remarkable in the social sciences: a testable model of human behaviour with real predictive power. We all know traditional economics doesn't manage that, except in a very crude way: it's no miracle of deduction to make some basic assumptions about rational decision-making and derive from them a downward-sloping demand curve. The traditional economic assumptions about behaviour are too simplistic to provide useful guidance outside of a limited set of situations. But neither psychology nor sociology has managed to make substantive predictions, because they don't have reliable techniques for quantifying the strength of the effects they describe.

Behavioural economics bridges the gap between these fields and, as the theory is developed over coming years, I expect it to be able to make accurate predictions which will not only give us far deeper insight into the operation of the economy and financial markets, but also provide an understanding of social phenomena which at present can only be described at the level of storytelling and heuristics.

I do see a weakness in some current behavioural work, which is focused too much on demonstrating phenomena and not enough on developing good explanatory models. Phenomena make good journalistic copy; but on their own, they don't give us the means to predict behaviour in new situations, to extrapolate individual behaviour to group dynamics, or to design solutions which could guide behaviour in desirable ways. There is a need for a more mathematical approach to behavioural economics, and this is undoubtedly the direction the field will move in.

Should we be trying to guide behaviour at all? That's a normative question and so far, behavioural economics is mostly a positive science. But it's a reasonable one to ask. While one could take a philosophical stand against attempts to influence the behaviour of individuals, in practice they are going to continue. Politics, social interventions and economic policymaking are all about influencing people, and if behavioural economics can offer a better tool to do it, then it should and will be adopted.

Kind regards,
Leigh

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Stuart Derbyshire to Leigh Caldwell

False Promise, Wrong Premise

Dear Leigh,

I don’t share your enthusiasm or optimism regarding behavioural economics. Partly this is because the current output from behavioural economists is banal. Take a recent report in the respected journal, Psychological Science, as an example 1. The authors report that the recommended ‘minimum payment’ typically provided by credit card companies acts as an ‘anchor’ and encourages consumers to pay off less of their debt. Without a recommended minimum payment consumers pay more of their total debt. This is an interesting observation to be sure but other than academic psychologists and maybe credit card companies, who cares? Perhaps if credit card statements arrive with a range of possible payments consumers will pay down their debt more quickly. That might have benefits for consumers, because they pay less interest, but it will also mean they have less cash immediately available for other things. It might be good news for credit card companies because they have reduced risk of defaults and exposure to ‘toxic’ debt but, of course, they will collect less interest and make less profit. Regardless, none of this will mean that more goods are produced or more services are provided and it is hard to see how ‘anchoring’ can be elevated to an economic principle.

But behavioural economics is not just banal; it is also used to support and promote a rather limited vision of human beings. In his book, Predictably Irrational, Dan Ariely describes a series of experiments examining the lure of ‘free’ 2: he reports consumers being offered a free $10 Amazon gift certificate or a $20 Amazon gift certificate for $7. Most people choose the free $10 certificate even though the $20 certificate for $7 yields a bigger net payoff ($13 versus $10). Ariely sees this as irrational, but is it?

If you are planning a purchase from Amazon costing $13 or more then it would be rational to buy the $20 gift certificate. But if you were not planning a purchase then the deal is quite different. You can spend nothing and have $10 to spend at Amazon on whatever takes your fancy, or you can spend $7 and have $20 to spend at Amazon on whatever takes your fancy. Given that there is nothing specific that you want from Amazon then spending nothing is actually infinitely better, and more rational, than spending $7. Gift certificates can get lost, expire or turn out to have restrictions that make them worthless. If you have no desire to spend money then not spending money on a gift certificate, or anything else, is eminently rational.

Finally behavioural economics seems to be locked into a view of human beings as not just irrational but fixed in their irrationality because of the way our brains work. Writing in Scientific American last year, for example, Michael Shermer explained that we may reject an offer of free money if we see the offer as ‘unfair’. This irrational rejection of free money is because the ‘moral sense of fairness is hardwired into our brains’ 3. This view of morality as hardwired, is way too hasty. Human beings have spent centuries trying to get to grips with morality; what we consider to be moral or immoral is in a constant state of flux.

In summary, behavioural economics provides some interesting observations about consumer behaviour but those observations offer little in terms of understanding or solving economic problems. Behavioural economics also tends to build in assumptions of irrationality based on contentious assumptions of how brains work. None of this is very useful.

Fraternally,
Stuart

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Leigh Caldwell to Stuart Derbyshire

Behaviour and Benefit

Dear Stuart,

Many thanks for your stimulating comments. In fact we agree on two points.

The first is that economists should not speculate on brain structure. Economics does require some model of decision-making, but there is no need for economists to attempt to relate this to underlying physical or ‘hardwired’ aspects of the brain, which frankly we are not qualified to do. There are well-known flaws in many fMRI experiments which have tried to relate behaviour to physical brain components (see the controversial ‘voodoo’ paper for example 4).

The other is the misuse of ‘irrationality’. Dan Ariely has done the field no favours by associating us with ‘irrational’ behaviour. As you say, people do have reasons for behaving in the way that these experiments show: these reasons are not consistent with the assumptions made in traditional economics, but it doesn’t mean they are behaving at random. Economists are well aware of the idea of liquidity preference and the fact that a $20 Amazon voucher may not be worth $20; and non-academic descriptions of behavioural economics do sometimes turn up the contrast dial on their results while glossing over the caveats.

So where do we disagree? It’s a little simplistic to say that these results are banal just because you’re not interested in credit card repayments. If I demonstrate that some people choose to buy more apples when the price of apples is higher, it would be unimaginative to argue that this is only of relevance to apple farmers.

To criticise behavioural economics for its ‘limited vision of human beings’ is to dismiss most of the social sciences. Traditional economics has an even more limited vision, and perhaps you would apply the same comment to that field also. But outside of the realms of face-to-face contact and conversation – where behavioural economics is hardly more applicable than opinion polling – the fact is that people do often relate to others as groups or populations, and any prediction of group behaviour is distinct from a law about how individuals will act. The prediction can be statistically valid without diminishing any individual’s freedom to make their own choices.

More critically, you say that ‘none of this will mean that more goods are produced or more services are provided’. Economic welfare is not a function of how much stuff is produced. It’s actually about the benefit people get from it.

The best example of this from the behavioural field is the perception of quality of wine. Consumers who pay more for their wine – or whose wine is served in posh glasses or classier surroundings – find that it tastes better than the same stuff when served in a plastic cup out of a £3 bottle. Isn’t this a genuine benefit for the consumer?

It might look trivial, but once our material needs are met, our experience of the goods and services we consume becomes the primary way (at least within the sphere of economic relations) for us to improve our lives.

Optimistically,
Leigh

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Stuart Derbyshire to Leigh Caldwell

Rational Agreement 

Dear Leigh,

It is interesting, and gratifying, that we seem to agree that economists should stop naturalising human behaviours with hardwired brain-based accounts of our choices. It is an approach commonly adopted by other behavioural economists. John Naish, for example, has suggested that we have ‘want more’ brains that drive consumerist behaviour 5. Last year, Michael Shermer explained that we may irrationally reject an ‘unfair’ offer of free money because the ‘moral sense of fairness is hardwired into our brains’ 6. Such accounts are often justified with reference to fMRI and brain chemicals driving our behaviour. It is easy to associate behaviours with brain function (people with heads full of sawdust don’t tend to do anything), but association is not cause. And, as you rightly comment, neuroscientists are not averse to making sure the association looks as large as possible, and maybe even larger than possible 7.

It is also interesting, and gratifying, that we seem to agree that economists should put rational man back on the table. It is now very fashionable to suggest that the current economic crisis is down to irrational outbursts of hope, greed and fear on the part of consumers and bankers. Richard Posner, however, usefully explains that there was nothing irrational about bankers making money using financial instruments 8. Posner reminds us that shareholders would have punished banks that failed to take advantage of low interest rates and a runaway property market. Similarly, consumers acted rationally in accepting mortgages they could not pay given the increasing value of property and the apparently low risk of a burst bubble. So long as property prices increased faster than their debt, they were moving forwards financially. Until it all collapsed.

Just to clarify, then, are we in agreement that the naturalisation of economic behaviour through brain imaging and evolutionary psychology and the dismissal of behaviour as irrational are both unwarranted and lacking support?

Yes, I probably would dismiss most of the social sciences for having a limited vision of human beings! I take your implicit point that such a rejection is perhaps based on an unreasonable demand: it is asking a lot to have a complete vision of human beings. Nevertheless, your comment that predictions can be statistically valid ‘without diminishing any individual’s freedom’, does set off alarm bells. Attempts to manipulate the environment so as to coordinate consumer behaviour can be coercive, cynical and even Orwellian. There may well be many good reasons to ‘encourage’ consumers to pay off more of their debts, for example; but that doesn’t mean consumers must be manipulated. What it means is that we should have a discussion about the best way for consumers to use credit, and the kind of credit we want to be made available.

Finally, I do see the focus on benefits as banal and detached from the very real need to address the serious economic crisis that is upon us. It might be vaguely interesting that consumers will pay more for, and enjoy more, a glass of wine served in a posh glass and classy surroundings. But it is surely an overstatement to suggest that such things are now the prime way to improve our lives. Where is your imagination?! Whatever happened to the plans for abundant cheap fuel, holiday trips to outer space, flying cars and so on? I like to enjoy a glass of wine but it is hardly a substitute for bigger, better, faster; and enjoying a glass of wine won’t create many new jobs or get us out of this economic impasse.

Slightly confused,
Stuart

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Leigh Caldwell to Stuart Derbyshire

Redefining Rationality

Dear Stuart,

Perhaps we are at risk of agreeing (or appearing to agree) too much. I don’t like the idea that people are irrational, because it implies they behave at random or against their own interests. But rather than endorsing the traditional view of rationality, I think we need to redefine the term – by understanding what people’s ‘interests’ really are.

Classical economics imagines our interests in purely material terms: we want to have the best wine, the most money, the longest holiday in space, or the fastest flying car. But in order to work with this viewpoint, it assumes that we can objectively evaluate our preferences and predict them in advance.

Actually, we are dreadful at knowing in advance what we will enjoy. And we are equally bad at acting today to maximise our utility in the future. All we can really do with today’s actions is optimise our welfare today. And there are so many influences on that welfare that we can’t possibly optimise for all of them; we need to make choices based on our limited cognitive capacity.

This in turn means that material fulfilment is only one part (a substantial part, I accept) of what provides us with satisfaction in life. The fulfilment I get from working to earn the material goods, or the subjective ways in which I enjoy that space holiday, are a necessary part of what makes me happy, just as the salary or the holiday itself is. And these are precisely the areas that behavioural economics aims to understand, and give us the ability to improve.

What’s more, subjective factors are equally valid as a contribution to GDP. If I repackage the same wine in a different bottle and sell it for £6 more to a consumer who gets £6 more of enjoyment out of it, that’s £6 more economic output. Economically, it’s no different than discovering a new kind of grape, or inventing a £6 flying car. And, though it might look illusory at first glance, a genuine recovery can be stimulated by just this kind of effect.

Behavioural economics is as much about understanding that, as it is about trying to change it. Like any tool, having it available is one thing; the choice of how to use it is another. But I suspect we have a basic philosophical difference about whether government should be influencing people’s behaviour at all, which is really a debate for another time.

Regardless of that, the tools and insights that the field offers are just as available to the individual as they are to companies or government. If you do want to maximise your material gain, it’s very useful to understand your own decision-making processes and how to avoid the traps of short-termism, cognitive bias, and misunderstanding of risk.

I agree that bankers and other professionals have behaved in their own material interest over recent years. The problems arose from consumers whose decisions were based – ‘rationally’ – on the near-term utility of their choices, with little understanding of the reasons why they might be making those choices. If more individuals had realised this when taking out credit, or investing in other people’s debt, the economic crisis would not have been as serious as it is. And if more people understand it now, we’ll recover a lot quicker.

Immaterially,
Leigh

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Stuart Derbyshire to Leigh Caldwell

Absurd Rationale

Dear Leigh,

I think we can probably both agree that rationality is being redefined. Perhaps we disagree as to whether that is a good thing. Certainly classical economics had an unreal view of what rationality is. People cannot, as you point out, compute every possibility to arrive at a ‘perfect’ decision regarding their best economic outcome. We must cut corners to make decisions more rapidly; goal directed behaviour requires constraint lest we are drowned in options.

My concern is that behavioural economics (and psychology more generally) is veering towards a view of human beings as unable to make even quite banal economic decisions. People can and do decide for themselves how much they will save, how much debt they will take on, what type of wine they will buy, how much they will pay for it and so on and so forth. It is unreasonable, and worrying, to suggest that these banal decisions cannot be made by rational consumers. And it is very worrying, and unwarranted, to suggest that consumers need to ‘nudged’ by governments or companies to make the ‘right’ choices.

I do understand that consumers are willing to pay more for the ‘extras’ associated with a product. A glass of wine in a nice glass is worth more than the same wine in a Styrofoam cup because people are prepared to pay more for the glass. They are paying for the enhanced experience of drinking out of a glass. But I do see it as a stretch to suggest that these kinds of enhancements can deliver the same economic boost as a new flying car industry. It is to the serious detriment of the British economy that there has been considerable dependence on finance, services and value enhancement but very little development of new productive industries.

It is this fundamental imbalance in the British and, to a lesser extent, American economies that created the conditions for reckless sub-prime lending and other financial gambles. In the absence of any other alternative, profits were pursued parasitically and absurdly, inside a bubble. Clearly that bubble has now burst, but I think it burst because of structural economic, rather than psychological, problems. And I think recovery can only come about when we address those structural economic problems. Psychology really matters very little.

With kind regards,
Stuart

Leigh Caldwell and Stuart Derbyshire will be in debate at the Battle for the Economy, produce by the Institute of Ideas at Goodenough College, London, on May 16th 2009.

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Notes

1. 1‘The cost of anchoring on credit-card minimum repayments,’ Neil Stewart, Psychological Science, 2009, 20: 39–41
2. 2Predictably Irrational: The Hidden Forces That Shape Our Decisions, Dan Ariely (2008)
3. 3The Mind of the Market, Michael Shermer (2008)
4. 4Vul et al, ‘Voodoo Correlations in Social Neuroscience’, and follow-up paper
5. 5Enough is enough: learn to want less, The Times, 12 January 2008.
6. 6The Mind of the Market, Michael Shermer
7. 7Vul et al (2008). Puzzlingly High Correlations in fMRI Studies of Emotion, Personality, and Social Cognition
8. 8Posner, R. (2009), A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression

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