Listener: 12 May, 2012.

Keywords: History of Ideas, Methodology & Philosophy;

Economists have long assumed individuals try to do what they judge best, but from the 1970s a notion of “super-rationality” became popular. This assumed that decision-makers took everything into account and made optimal choices. This assumption simplified some otherwise tricky mathematics, but its greatest attraction was its politics. If someone is making decisions in her or his best interests, what justification is there for intervention by the state to change the outcome? Need the Government do anything? Economists were criticised for assuming this extreme rationality.

Probably their best defence was that they did not want to descend into pop psychology; what was the rigorous alternative? Also about 30 years ago, a couple of Israeli psychologists, Daniel Kahneman and Amos Tversky, began collecting evidence of how people made decisions. They concluded that people did so in fundamentally different ways from the economists’ theory of super-rationality. Kahneman has said when he showed the findings to his mother, she told him she knew them already. He suggested it took years studying economics at university to find his research surprising.

In 2002, he was awarded a Nobel prize in economics. (Tversky, alas, died in 1996.) The field of behavioural economics has evolved since and now has a set of well-established findings based on the evidence of what humans actually do, rather than assuming they are “Econs” who pursue super-rationality. Some of the research is quite astonishing. It is not just that people can make inconsistent decisions, but their decisions can be influenced by factors that they are told are irrelevant. In one experiment, the spin of a chocolate wheel affected guesses of the proportion of people starving in Africa. Unfortunately the resulting models of behaviour are much more complicated – more like us, in fact – but key themes are: People make heuristic decisions based on rules of thumb, not those of mathematically sophisticated super-rationality.

People frame their decisions through anecdotes and stereotypes that enable them to understand and respond to events but which may mislead them. As Richard Thaler and Cass Sunstein say in their book Nudge, “People often make poor choices – and look back at them with bafflement!… We do this because as human beings, we all are susceptible to a wide array of routine biases that can lead to an equally wide array of embarrassing blunders in education, personal finance, health care, mortgages and credit cards, happiness and even the planet itself.”

Awareness of the approach can help individuals live more sensibly. Sometimes people make instant decisions, which earlier they thought they wouldn’t. Later they regret that decision. Some New Zealand gambling addicts have asked casinos to exclude them in case, in the heat of the moment, they restart their addiction. Wise recovering alcoholics won’t touch the stuff ever again, in case the first drink leads to the next.

Kahneman and Tversky’s findings do not necessarily justify government intervention in our lives (although there are economists who are so anti-government that they hold onto versions of super-rationality to defend their political ideology). What the research suggests is that when we consider public policy, it is arrogant and wrong-headed to assume people will behave totally rationally. Perhaps the government should “nudge” people in rational directions. For instance, people starting a new job must join KiwiSaver but may opt out. The  research evidence is that individuals are less likely to make decisions they regret with this arrangement than through the “opting-in” alternative. In the advocates’ jargon, the authors support “libertarian paternalism” and actively engineer the “architecture of choice”.

The point is, as the private sector well knows, the way options are presented can determine outcomes. Austrians have an opt-out provision for organ donations; Germany has an opt-in. Almost all (99%) Austrians agree to donate after their death, but only 12% of Germans. This tendency is so important that there is much more to be written about behavioural economics, as practical economists say goodbye to rational economic man and increasingly consider flawed but wonderfully complex human beings.