Behavioural economics is useful, but with limited scope

Behavioural economics seems to have captured the popular imagination.

Authors like Michael Lewis write about it in best sellers like The Undoing Project, while pioneers of the field like Daniel Kahneman popularise it in books like Thinking, Fast and Slow. Its lexicon of “nudging”, “framing bias” and “the endowment effect” has become part of the vernacular of business, finance and policymaking.

Even Crazy Rich Asians — the summer’s blockbuster romantic comedy — features an explicit nod to “loss aversion”, a key concept in the field.

What is behavioural economics, and why has it become so popular? The field has been described by Richard Thaler, one of its founders, as “economics done with strong injections of good psychology”.

Proponents view it as a way to make economics more accurate by incorporating more realistic assumptions about how humans behave.

Glitch of loss aversion

In practice, much of behavioural economics consists in using psychological insights to influence behaviour. These interventions tend to be small, often involving subtle changes in how choices are presented: for example, whether you have to “opt in” to a 401(k) savings plan versus having to “opt out”.

In this respect, behavioural economics can be thought of as endorsing the outsize benefits of psychological “tricks”, rather than as calling for more fundamental behavioural or policy change.

The popularity of such low-cost psychological interventions, or “nudges”, under the label of behavioural economics is in part a triumph of marketing. It reflects the widespread perception that behavioural economics combines the cleverness and fun of pop psychology with the rigour and relevance of economics.

Yet, this triumph has come at a cost. In order to appeal to other economists, behavioural economists are too often concerned with describing “how” human behaviour deviates from the assumptions of standard economic models, rather than with understanding “why” people behave the way they do.

Consider loss aversion. This is the notion that losses have a bigger psychological impact than gains do — that losing $5, for example, feels worse than gaining $5 feels good. Behavioural economists point to loss aversion as a psychological glitch that explains a lot of puzzling human conduct.

But in an article published this year, the psychologist Derek D. Rucker and I contend that the behaviours most commonly attributed to loss aversion are a result of other causes.

For example, in a classic experiment, participants who were given a mug demanded, on average, about $7 to sell it, whereas participants who were not given a mug were willing to pay, on average, about $3 to acquire one. This finding has been interpreted by behavioural economists as evidence for loss aversion: The loss of the mug was anticipated to be more painful than its gain was anticipated to be pleasurable.

But Dr. Rucker and I note that there is an alternative explanation: The participants may not have had a clearly defined idea of what the mug was worth to them. If that was the case, there was a range of prices for the mug ($4 to $6) that left the participants disinclined to either buy or sell it, and therefore mug owners and non-owners maintained the status quo out of inertia.

Only a relatively high price ($7 and up) offered a meaningful incentive for an owner to bother parting with the mug; correspondingly, only a relatively low price ($3 or below) offered a meaningful incentive for a non-owner to bother acquiring the mug.

Generalisable knowledge

In experiments of our own, we were able to tease apart these two alternatives, and we found that the evidence was more consistent with the “inertia” explanation. Dr. Thaler has dismissed our argument as a “minor point about terminology”, since the deviant behaviours attributed to loss aversion occur regardless of the cause.

But a different account for why a behaviour occurs is not a minor terminological difference; it is a major explanatory difference. Only if we understand why a behaviour occurs can we create generalisable knowledge, the goal of science.

The lack of sufficient attention to understanding why behaviour occurs matters in practical contexts, too. For example, advertisers influenced by the idea of loss aversion have focused on framing their messages in terms of loss (“you will lose out by not buying our product”) rather than in terms of gain.

But such framing techniques have been shown to be ineffective: A meta-analysis of 93 studies found “no statistically significant differences” in the persuasive power of public-health messages when framed in terms of loss as opposed to gain.

The effects of this kind of intervention are often small. Recent studies have found that providing households with information on how their electricity usage compared to that of other households — a classic “nudge” — reduced electricity consumption by only 2 per cent or less.

There is nothing wrong with achieving small victories with minor interventions. The worry, however, is that the perceived simplicity and efficacy of such tactics will distract decision-makers from more substantive efforts — for example, reducing electricity consumption by taxing it more heavily or investing in renewable energy resources.

It is great that behavioural economics is receiving its due; the field has contributed significantly to our understanding of ourselves. But in all the excitement, it’s important to keep an eye on its limits.