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Behavioural Economics

By Nigel Hill, Founder of TLF and Editor of Customer Insight Magazine

Ever heard of the “Jam Experiment”? Conducted by academics from Stanford and Columbia Universities, it provides insight into how we make choices, why we often end up dissatisfied with our choices and how organisations can aim to influence our decision making by getting better at the way they present options to us. Here’s the experiment in a nutshell. On a promotional counter in the supermarket, shoppers were presented with some new jam flavours to try. Some shoppers saw a display of 6 new flavours. Others were given 30 choices. There was little difference in customers’ propensity to taste the jam at either table. However, 30% of individuals who visited the 6 jam table purchased jam, but only 3% bought after visiting the table with 30 options. People always say they like having choice (often visiting enormous stores where they find the most choice), and with 5 times as many flavours of jam they were more likely to find one that they really enjoyed, but were ten times less likely to buy one. And that’s an incredibly low cost, low risk purchase decision.

To complete the story, a second stage of the experiment offered some students six topic options for a graded essay whilst others were given a list of thirty choices. Again, I’m sure we would all vote for more choices. Yet more students from the fewer choices group completed the assignment on time and they also wrote papers of higher quality.

The third experiment offered students six or thirty choices of chocolate. Those in the extensive-choice group reported a higher level of satisfaction with the range of choices they were given, but were less satisfied when they consumed the chocolate and more regretful about the choice they made.

Are we stupid?

At face value, the series of attitudes and behaviours described above don’t make sense. Faced with the range of choice we would prefer, we seem incapable of making decisions that will make us happy – suggesting that we are not logical, rational beings. For predicting our behaviour, this is very unfortunate, particularly since the ‘science’ of economics, has been based on the opposing premise - that we make rational choices designed to generate the greatest ‘utility’ from our available options.

Behavioural economics

In recent years, work by behavioural scientists, plus the recent failure of financial markets, has led many people to question economics. This has led to the rise of ‘behavioural economics’ whose proponents attempt to increase the predictive power of economic theory by providing it with more psychologically plausible foundations. Before exploring behavioural economics, let’s step back and outline the assumptions of traditional economists.

Jevons and Bentham

Although Adam Smith with The Wealth of Nations (1776) is regarded as the father of economics, the origins of modern economic theory are generally attributed to the ‘neoclassical’ economists of the mid 19th century. William Stanley Jevons built his theories on ‘hedonic psychology’, according to which individuals seek to maximize pleasure and minimize pain. In Jevons’ words: “Pleasure and pain are undoubtedly the ultimate objects of the Calculus of Economics. To satisfy our wants to the utmost with the least effort ... in other words, to maximize pleasure, is the problem of Economics”. Jevons and other neoclassical economists were inspired by philosopher Jeremy Bentham, who wrote: “Nature has placed mankind under the governance of two sovereign masters, pain and pleasure.... They govern us in all we do, in all we say, in all we think”.

Behavioural economists’ criticisms

Critics argue that this standard economic model of human behaviour includes at least four flawed assumptions about peoples’ decision making. It is based on people who are 100% rational, who have unlimited willpower, are completely selfish and have all the information necessary to make the best decisions.

(1) Rational beings There are many well researched examples of people making decisions that are not rational. For example, 401(k) retirement plans in the USA let workers save and invest for retirement on a tax-deferred basis, with many firms matching employees’ contributions. Based on records of many pension schemes, David Laibson highlighted peoples’ irrational propensity to delay joining in his article, “$100 Bills on the Sidewalk”, thus spurning ‘free money’. “It’s a lot of free money,” says Laibson. “Someone making $50,000 a year who has a company that matches up to 6 percent of his contributions could receive an additional $3,000 per year.”

Conventional economic theory predicts that people will jump at this opportunity. But they don’t “It turns out that about half of U.S. workers in the older age group, who have this good deal available (ed – extra tax advantages), are not contributing,” says Laibson. “There’s no downside and a huge upside. Still, individuals are procrastinating - they plan to enroll soon, year after year, but don’t do it.” In a typical American firm, it takes a new employee a median time of two to three years to enroll, but because Americans change jobs around every five years, that delay could mean losing half of one’s career opportunity for this ‘free money’.

If people procrastinate about joining a pension plan, it should be possible to increase participation by lowering the ‘psychological’ costs of joining. In most companies, employees who become eligible for the 401(k) plan receive a form inviting them to join, which they have to complete and send back, so the inertia option is not to join. Several firms simply switched the default. Employees were enrolled unless they opted out. This change produced dramatic increases in savings rates. In a study by Madrian and Shea (2000), employees were 50 percent more likely to participate when the default became opt-out rather than opt-in.

Framing

Daniel Kahneman of Princeton and Amos Tversky of Stanford called this ‘framing’ in “Prospect Theory: An Analysis of Decision under Risk,” (1979), which became one of the most cited papers in economics. They argued that how alternatives are ‘framed’, not simply their relative value, heavily influences people’s decisions. This paper has also influenced marketing and theories on customer service and the customer experience. But back to the 2nd problem with classical economics.

(2) Intertemporal choice – or no willpower! This is the assumption of complete selfcontrol. When people say they want to save for retirement, eat better, start exercising, stop smoking, they mean it but often continue spending more than saving, eating the wrong things and smoking rather than exercising. Since people think they can and will change their habits in the future, they often continue with the bad habits today. David Laibson called this ‘intertemporal choice’, saying “If you ask people ‘Which do you want right now, fruit or chocolate?’ they say, ‘Chocolate!’ But if you ask, ‘Which one a week from now?’ they will say, ‘Fruit.’ Now we want chocolate, cigarettes, and a trashy movie. In the future, we want to eat fruit, to quit smoking, and to watch Bergman films.”

(3) Information Herbert Simon (1955) was an early critic of the idea that people have unlimited information-processing capabilities. He suggested the term “bounded rationality” to describe a more realistic description of human problem-solving ability. An example of this suboptimal behaviour is a study of self-employed New York City taxicab drivers (Camerer et al. 1997). They must decide how long to drive each day. The profit-maximizing strategy is to work longer hours on good days (e.g. rainy days or days with a big convention in town) and to quit early on bad days. In reality, cabbies set a target earnings level for each day and tend to stop working once they reach it even though it means they end up quitting early on good days and working longer on bad days for a lower rate per hour!

(4) Selfish Finally, people are completely selfish. Although economic theory does not rule out altruism, economists stress selfinterest as people’s primary motive. For example, traditional economic theory suggests that individuals cannot be expected to contribute to the public good unless their private welfare is improved. But people do act selflessly. For example, around two thirds of us regularly give some money to charity.

Are we too stupid for classical economics?

According to behavioural economists we seem to be irrational to the point of stupidity, totally lacking in willpower, lazy and completely unwilling to make any sacrifice right now for very obvious future benefits. Famous behavioural economics books like Dan Ariely’s ‘Predictably Irrational’, (see June 2009 review at www.customerinsight. co.uk/article/844) and Pete Lunn’s ‘Basic Instincts’ seem devoted to human irrationality.

Are we mugs?

Lunn describes an experiment where people volunteer for a survey. On arrival they are given a chunky mug as a gift for filling in a long questionnaire. As they leave, they are offered a cash alternative. They could ‘sell back’ their mug, and can name what price they would accept for the mug. In a second experiment, participants are given the option of buying the very same mug and can state what they’d be willing to pay. The price people accept for selling the mug they already ‘own’ is roughly twice what they’ll pay to buy the same mug. The ‘endowment effect’ means we value possessions more highly than things we don’t already own. Economic theory would say that any product or service has a value to an individual and they would happily buy it for 1p less than that value or sell it for 1p more. In a slight twist, subjects are offered the choice of a mug or chocolate for completing the survey, all happily going away with the gift of their choice. In the follow-up test participants don’t get a choice. Half are given a mug, the remainder chocolate, then offered the choice to give it back and exchange it for the other option. Whether given the mug or the chocolate, 90% choose to keep what they have, even though far more than 10% would have opted for the other gift if they had been asked to choose beforehand. Doesn’t make sense, but it’s the endowment effect.

The Ultimatum Game

Invented by German sociologist, Werner Guth in the 1980s, the simplest form of this game sees person 1 (the proposer) being given a sum of money, e.g. £10, on condition that they share some of it with a stranger (the responder). It’s entirely up to the proposer to decide how much and if the responder accepts the proposal, both parties walk away with their respective amounts. Conversely, if the responder rejects the proposal, both parties end up with nothing. If you were playing that game, how much would you offer? How much would you accept if you were the responder?

Now think about it rationally. If both parties were to walk away with more money than they had previously and with more than the alternative of zero if the responder rejected the proposal, it would be ‘rational’ for the responder to accept even if the offer was only 1p. Is that what happens? Not a bit of it. Whilst most proposers offer at least 30% of the sum, and the most common offer is 50%, most responders reject anything below 30% and quite a few reject any offer below 50% - spurning a windfall of up to £4.99 in the £10 example. This is basically the fair play effect. People are willing to make financial sacrifices (act ‘irrationally’ in economic terms) to punish someone who is not acting fairly.

Actually, one can challenge the conclusions of many of the examples used by behavioural economists. Cases like the Ultimatum Game are effectively laboratory experiments. The decisions made have no serious consequences. Since most subjects in the experiments are students (what market researchers would call a convenience sample), their behaviour probably isn’t representative of the wider population. They may for example have heightened curiosity, making them more likely to experiment with behaviours in lab tests to observe the effects.

Is the cabbies’ behaviour irrational?

Even if we take real life examples such as the pension contributions and the cab drivers’ work schedules, their behaviours are not necessarily irrational. With pensions, money today is worth more than money in the future and people may not expect or want to live to an old age thus not getting ‘value’ from contributions, or they might simply make a choice to have pleasure / utility from the money now even if it does mean less pleasure when they are old. Who says deferred gratification is a good thing, or rational? Moreover, as Herbert Simon said in 1955, since we have only so much brainpower and only so much time, we cannot be expected to always make decisions that are in our best interest. Calling his theory ‘bounded rationality’, he claimed it was eminently rational for people to adopt rules of thumb simply as a cognitive survival strategy. Apart from bounded rationality, there are many reasons why cab drivers could be making sensible decisions when getting what the behavioural economists call a sub-optimal return on their labour. With today’s often hectic lifestyles, and both parents often working our cabbie may have to collect children from school while his partner works late. He can’t leave them standing at the school gate on rainy days because his income is 15% per hour higher. Alternatively, he may place little value on increased leisure time when hourly earnings were lower if the alternative were less attractive, e.g. at times when there was no family at home or no sport on TV.

Behavioural finance

The one field of economics where the four ‘flaws’ of economic theory should matter least must be stock markets, where decisions should be rational and selfish, based on huge amounts of readily accessible information and with willpower having less relevance in this market. Economists coined a phrase, the ‘efficient markets hypothesis’, which states that prices in stock markets are ‘correct’ in the sense that they reflect the true value of a share, at least over a period of time. If investors believe the price of a security to be underor over-valued, they will buy or sell it until the price returns to equilibrium. How ever, apart from the catastrophic failure of the markets in 2008, there have been research projects that have cast doubt on economists’ efficient markets theory.

News, news, news

An early study by De Bondt and Thaler (1985) was explicitly motivated by the psychological finding that individuals tend to overreact to new information. They hypothesised that if investors behave this way, then stocks that perform quite well over a period of years will eventually have prices that are too high because people overreacting to the good news will drive up prices. Similarly, poor performers will eventually have prices that are too low. If true, past “winners” ought to underperform, while past “losers” ought to outperform the market. Using New York Stock Exchange data, De Bondt and Thaler found that the thirty-five stocks that had performed the worst over the past five years (the losers) outperformed the market over the next five years, while the thirty-five biggest winners over the past five years subsequently underperformed. Follow-up studies showed that these early results cannot be attributed to risk; by some measures the portfolio of losers was actually less risky than the portfolio of winners.

Admitting defeat

Behavioural economists have also hypothesised that investors are reluctant to realise capital losses as it would mean “declaring” the loss to themselves. Shefrin and Statman (1985) dubbed this hypothesis the ‘disposition effect.’ The tax system even encourages just the opposite behaviour but Terrance Odean (1998) found that investors were more likely to sell a stock that had increased in value than one that had decreased. While around 15 percent of all gains were realised, only 10 percent of losses were realised. Moreover, loser stocks that were held underperformed the gainer stocks sold.

Adam Smith Perhaps we should leave the final word to the grandfather of all economists, Adam Smith, who always did see psychology as a part of economic decision-making. On self-interest, for example, Smith wrote in 1759:

"How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it."

Regarding people’s rationality, Smith wrote: “How many people ruin themselves by laying out money on trinkets of frivolous utility? What pleases these lovers of toys is not so much the utility, as the aptness of the machines which are fitted to promote it. All their pockets are stuffed with little conveniences … of which the whole utility is certainly not worth the fatigue of bearing the burden.” Some say economists ignored Smith’s psychological points because it’s easier to build mathematical models if human behaviour is rational and predictable. This is a debate that will no doubt continue in the customer experience as well as the economics field. As we’ve always said, the more emotional elements of the customer experience will often get you ‘wow factor’ brownie points, but ignore the rational, ‘givens’ at your peril. If you don’t keep customers informed, don’t arrive within your service call appointment window, don’t have a spotlessly clean restaurant or deliveries that arrive on time every time, it doesn’t matter how many emotional wow factors you’ve delivered, you’ll lose those customers and they’ll each tell at least five other people how bad you are.

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