Agents in an economy are supposed to be rational. People – wearing multiple hats as consumers, investors, employers or employees – take decisions on an everyday basis. The task at hand for decision-makers is seemingly simple and intuitive in that a decision (leading to an action, belief or desire) ought to be taken solely if the benefits outweigh the costs. If people always behave rationally, then why do we often observe behaviour which contradicts rational decision making?
In practical terms, why do we make commitments to follow a strict diet and a rigorous exercise routine, and postpone it to tomorrow? Why is it that we tip waiters we are never going to meet again? Why is the pain associated with a loss greater than the happiness associated with a win, even though the monetary amount at stake is the same? Why do we find it easier to spend with credit cards rather than splurging an equivalent amount of physical cash? These contradictions or perverse observations are not just anomalies of a general framework, occurring intermittently and rarely. Rather, shockingly enough, they are observed frequently in a consistent and predictable manner.
If you think that such biases in human behaviour are trivial and dismissible, think again! Irrational behaviour is the primary underlying factor which led to the property market bubble in the US, pulling down much of the world economy in recession. It is also at the heart of the sovereign debt crisis where irresponsible governments have borrowed and spent beyond sustainable levels. All of this leads to an important question. If decision-makers consistently make systematic errors, with wide-ranging and painful consequences, is it not reasonable (rational?) to ditch the traditional theories of economics and adopt this novel frame of mind? More importantly, from a micro perspective, are businesses fully aware of irrational behaviour and the effects it has on everyday decision-making?
In order to demonstrate how irrational human beings can be, Daniel Kahneman and Amos Tversky conducted a simple experiment among University students, intended to show a violation of decision-making consistency and coherence. There are many ways in which the same decision problem can be framed, often by re-formulating wording, presenting additional alternatives or looking at the same option from a different perspective. However, framing the same decision problem differently should not, according to the principles of rationality, alter preferences. Surprisingly enough, due to human perception imperfections, preferences are affected!
Consider the following example. Assume there is an outbreak of a new disease which, if untreated, is expected to kill 600 people. Due to resource constraints, the Government can implement either one of two programmes: Programme A or Programme B. With Programme A, the government will distribute 200 vaccines. Therefore 200 lives will be saved for sure. With Programme B, the government will distribute vaccines to all 600, but the vaccine has a 1/3 probability that it will work (saving all 600 lives), and a 2/3 probability that it would not work (no people will be saved).
Many of you would choose Programme A over Programme B. In fact, 72 per cent of respondents in the experiment chose A.
Now let us frame the decision problem differently. If Programme A is adopted, 400 people will die for sure. If Programme B is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die.
Astonishingly, even though both decision problems are identical, 78 percent of respondents now chose Programme B. Re-framing has caused a shift of preferences.
From this Kahneman and Tversky deduced that, when faced with choices involving gains, we prefer certainty (risk-averse). When faced with choices involving losses, we would be willing to take a bet (risk-taking). This is only one type of human irrationality.
A 1/3 probability that nobody dies is equivalent to saying that the expected lives saved are 200.
Similarly, 2/3 probability that 600 people will die is equivalent to 400 expected deaths. Notice how this is the same problem as before, albeit re-worded differently.
From where does this bias come?
The human species is the smartest animal living on the planet. We are self-aware, creative and can demonstrate unmatched computational and metacognitive abilities.
Particularly relevant to this discussion is our ability to reason, solve problems and make decisions.
However, before we pat ourselves on the back for being smart, there is one thing to note – humans can also be incredibly obtuse when it comes to decision-making!
It is interesting to investigate the roots of this human ineptitude. This is far from being a case of a few bad apples making wrong decisions – humans can be predictably irrational as we make the same mistakes over and over again. Even when we receive negative feedback, and learn about our biases, we are still prone to such cognitive traps.
Laurie Santos, professor of psychology at Yale University, believes there are two hypotheses which can explain human biases and irrational behaviour. One is that we are subject to an overly complicated environment which we have artificially created ourselves, such as financial markets. In this sense, we are not capable of understanding the complexities of these systems and thus make consistent errors. Alternatively, humans are innately predisposed to conduct such errors.
To test this hypothesis, researchers have conducted experiments in controlled environments, which can be considered as the bread and butter of psychologists and behavioural economists. More specifically, to test whether human biases are the result of ancient evolutionary thrusts, researchers sought the help of our very close cousins – brown capuchin monkeys – which broke from the human evolutionary branch some 35 million years ago.
It seems that we hate losing much more than we love winning, and this behaviour is ingrained in the nature of our evolutionary history
Monkeys were presented with simple economic decisions, using tokens to ‘buy’ food from human participants. Interestingly enough, the capuchins make very good monkey economists – they all prefer more to less when exchanging tokens for grapes.
However, in subsequent experiments, risk and uncertainty was introduced. Astonishingly, when monkeys were presented with two options – either two extra grapes with a 50/50 chance or one bonus grape for sure – monkeys chose the latter, playing it safe (risk-averse monkey) when facing bonuses. On the other hand, when monkeys were presented with losses – two fewer grapes with 50/50 chance or one fewer grape for sure – monkeys took a risk and chose the first option! This underlines two types of biases both humans and monkeys exhibit – relativity and loss aversion.
Clearly, we both treat losses differently than gains. It seems that we hate losing much more than we love winning, and this behaviour is ingrained in the nature of our evolutionary history.
What is important here is not the fact that evolution has shaped us with a cognitive mindset which displays consistent errors in judgement. What is important is that we can recognise our limitations, accept them, and figure a way to overcome them. In the same way humans have invented planes to overcome biological limitations, we can also invent tools to overcome our cognitive ineptitude. This is why we should compare classical economics and behavioural economics.
Classical economics thrives on the concept of Homo Economicus, a rational, logical and self-interested individual who weighs benefits and costs before taking a decision.
Homo Economicus is not swayed by gut feelings. He does not mindlessly follow the herd, nor is he tricked by marketplace illusions.
Conveniently enough, the rational Homo Economicus is perfect when it comes to designing elegant and rigorous economic theories and models which are meant to explain human behaviour in different contexts. But do they really?
Actual human beings are nothing like this. We often display behaviours which can be considered irrational, self-sabotaging or purely altruistic, contrasting starkly with Homo Economicus’ characteristics. These perverse observations, which could not be explained by the prevailing economic wisdom, created quite a stir in the field of economics. Indeed, up until two decades ago, this sub-branch of economics called behavioural economics, lambasted by those who felt it challenged existing doctrines, was largely sidelined by neo-classicists. Nowadays, even though still relatively new, this discipline has garnered widespread attention and is the subject of highly interesting empirical research meshing psychology and economics.
The roots of behavioural economics can be traced back to the 1940s when Herbert A. Simon, a political scientist, economist, sociologist, and psychologist, developed the concept of “bounded rationality” which explains how humans take decisions within the limits (or boundaries) of available information, cognitive capacity shortcomings and limited time at hand. In this case, individuals do not seek to optimise every outcome arising out of a decision-making process, but rather opt for a satisfying outcome. Simon was eventually awarded a Nobel Prize in Economics (1978) for his pioneering work in the area of organisational decision-making within the context of uncertainty.
However, perhaps the starkest wake-up call to traditional economics was when Daniel Kahneman and Amos Tversky published a paper dealing with how individuals demonstrate inconsistent preferences when the same problem is presented in a different format. Unlike the prevailing economic doctrine at the time, which advocated that the actual value of alternatives is what matters most (implicitly assuming a rational decision-maker), the paper argued with distinctive mathematical rigour, that framing highly influences people’s decisions. In other words, humans tend to act irrationally, since framing the same problem in a different way should not, in principle, affect choice preference.
This revolution in economic thinking sparked more research in the area, propelling behavioural economics from anathema in the late ‘70s to a lucrative and exciting discipline which still generates academic interest till this day. The principles of behavioural economics were first applied in the field of finance, and then later on permeated the fields of consumer choice, organisational decision-making and policy-making.
It might be tempting to consider behavioural economics as an alternative to the more traditional neo-classical economics, replacing more than 200 years of established doctrine. This is erroneous. Traditional economics and the standard economic model based on rationality can still be relevant for policy making. Behavioural economics merely adds a layer of complexity by relaxing the assumption of rationality, acknowledging that humans have bounded rationality, and their decisions are affected by seemingly trivial things.
In this respect, behavioural economics enhances the standard economic model, not replace it altogether. This discipline is still young and there is so much more to learn. Hopefully, by applying cognitive economic principles, we can better understand the intricacies of human behaviour in order to devise better macro-economic policies.
Read more on: www.kpmg.com/ MT/en/IssuesAndInsights/Articles Publications/Pages/Insight2013.aspx
Source: Kahneman, D. & Tversky, A., 1979. Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), pp. 263-291.
Mark Bamber is a partner and Jan Grech is a director at KPMG in Malta.