Behavioural Economics from the New Economics Foundation – on Designing Better Policies and Effecting Change Based on Deeper Understanding of Human Nature

The aim of this Briefing is primarily to be an aid to policy-makers who use economic tools, by providing a summary of the latest thinking from behavioural economics.

The standard (neoclassical) economic analysis assumes that humans are rational and behave in a way to maximise their individual self-interest. Whilst this ‘rational man’ assumption yields a powerful tool for analysis, it has many shortfalls that can lead to unrealistic economic analysis and policy-making.

This Briefing distils the many observed human traits from the fields of behavioural economics, experimental economics and psychology down to seven key principles, which highlight the main shortfalls in the neoclassical model of human behaviour. They have been chosen as they are thought to be the most relevant to policy-makers.

Our aim is to change the analytical framework for policy as well as to maximise the impact of policy interventions [effecting change]. We hope to reduce unintended outcomes arising from making decisions based solely on a neoclassical economic analysis. We believe that this will lead to better and more cost-effective policy.

The seven principles are:

1. Other people’s behaviour matters

People do many things by observing others and copying; people are encouraged to continue to do things when they feel other people approve of their behaviour.

On the other hand, the neoclassical model assumes we independently know what we want and that our preferences are fixed. This standard theory is very good at explaining short-term decision-making (I want green vegetables and choose beans as they are on special offer) but cannot explain longer-term changes in preferences (I now only choose organic food, [probably due to a shift in public perception on it's benefits despite of higher price])

Once policy-makers have identified the particular behaviour they are trying to change, they can evaluate the role that social norms play in influencing this behaviour. For example, most of us wear seatbelts as it has become normal behaviour – everyone does it. We neither evaluate the likelihood of having an accident, nor the chance of getting caught without our seatbelt on and incurring a fine. The enforcement of seatbelt wearing is now hardly necessary, as it has become a social norm.

2. Habits are important

People do many things without consciously thinking about them. These habits are hard to change – even though people might want to change their behaviour, it is not easy for them.

For example, perhaps I think it is a good idea for people to use public transport, but I don’t know where the bus stop is or when the bus runs. I think I should find out, but I don’t know how, so I continue using my car. The rewarding feeling – my journey by car was easy and hassle free – reinforces my old bad habit. On the other hand, doing something out of habit, for example, choosing my normal coffee in the usual-sized jar when shopping, is outside of neoclassical theory, in which I would do a full analysis of all the available coffee/jar-size/price options, where the assumption made is that, given their particular preferences, people act rationally to maximise their utility (utility broadly means happiness or satisfaction).

An example of habit-changing policy with extremely successful results has been the introduction of a small charge (15p) for plastic shopping bags in Ireland. Since the introduction almost everyone brings their own shopping bags when grocery shopping. Although most people could easily save a little money on their shopping basket by carefully choosing which brands and quantities to buy, most people don’t bother (due to habit). However, when they must explicitly pay 15p extra for a plastic bag, this acts as a strong incentive (cue) to bring their own bags.

3. People are motivated to ‘do the right thing’

A standard neoclassical analysis would use the financial costs and benefits, so financial rewards would always be expected to encourage and financial fines would always be expected to discourage. People would also be expected to take advantage of any bargaining position that they had. Further, the fact that people are willing to punish the wrongdoing of others at considerable cost to themselves, without any obvious benefit cannot be explained by neoclassical analysis. In short: altruism in any form is difficult to explain.

There are cases where money is de-motivating as it undermines people’s intrinsic motivation, for example, you would quickly stop inviting friends to dinner if they insisted on paying you.

Another example in tax-collecting is when taking into account of the probability of being caught evading taxes, and the size of the punishment if caught, a neoclassical analysis indicates that taxpayers should evade taxes more than they actually do. It appears that people are motivated to ‘do the right thing’ and further, the more fairly and respectfully the tax authorities treat them, the more willing they are to pay their taxes.

4. People’s self-expectations influence how they behave

They want their actions to be in line with their values and their commitments.

On the other hand, a standard neoclassical analysis would disregard self-expectations and commitments, as these are expected to influence our preferences; but preferences are taken as ‘given’ in this analysis. Promises are irrelevant in neoclassical theory unless they are backed by sanctions.

For example, a Canadian programme using a combination of public commitments and visible signals was used to establish a strong community composting-norm. Several months after the start of the project an exceptionally high proportion (80 per cent) of the people originally approached were found to be composting.

5. People are loss-averse and hang on to what they consider ‘theirs’.

In neoclassical theory people are expected to have a preference on risk (i.e. be either risk-takers or riskavoiders) but it is usually assumed that people are neutral to loss or gain, meaning that the amount of effort I should put into saving $100 of my money should be the same as the amount of effort I would put into getting $100.

However, an example from duck hunters in the US proves this wrong. It was found that they would pay $247 each to maintain a wetland suitable for ducks, but asked for $1044 to give up the wetland. [Another example is the fact that generally], a fine is a much stronger disincentive than a similar-sized reward is an incentive.

Loss-aversion also has implications for tax collection: taxes taken at source may cause less resentment and therefore be easier to introduce than taxes that must be actively paid.

6. People are bad at computation when making decisions

They put undue weight on recent events and too little on far-off ones; they cannot calculate probabilities well and worry too much about unlikely events; and they are strongly influenced by how the problem/information is presented to them.

On the other hand, standard neoclassical theory assumes that people act rationally and logically. As well as having all the necessary information at their fingertips, they are fully capable of making the complex calculations to compute their optimum best choice from the many possible choices available to them.

For example, would you agree to undergo a medical operation if your doctor told you: “of those who have this procedure, 10 per cent are dead after five years?” Would it have made a difference if the question had been phrased differently: “of those who have this procedure, 90 per cent are alive after five years?”.

Another example, in Barry, Canada, a water conservation scheme that avoids up-front costs has proved very successful. To encourage people to install ultra-low-flow toilets and showerheads, the City offered purchasers an interest-free loan to be paid off as part of the water bill. As the water is metered, the water saving offset the cost of the repayments making the equipment appear effectively free. The added incentive was that water bills would be cheaper in the future.

7. People need to feel involved and effective to make a change

Just giving people the incentives and information is not necessarily enough.

Too much information can lead to a feeling of helplessness and inaction. For example, I care about the planet and climate change, but it is all just so complicated to solve that I don?ft know where to start, so I will continue behaving as before.

Too much choice can also have a counter effect. We feel overwhelmed and don’t know what to choose, thereby often not making any choice at all. Even when we do choose something, we are often dissatisfied, thinking we have probably made the wrong choice.

In neoclassical theory, people are expected to rationally make the ?ebest?f choices given their preferences, independent of how these choices are presented. Therefore, more information and choice is always considered good. Using this theory, policy-makers should ensure that people always have as much information and as many things to choose between as possible; the process of introducing policy is irrelevant.

Ideas from behavioural economics indicate, however, that this is not the right approach. For example, the freeing-up of the market for telephone directory enquiries is an example of counter-effective choice. Since the introduction of over 100 new directory-enquiry numbers to try to promote competition, the use of the service has fallen.

It also has been found that a participatory approach to problem solving can be highly motivational and effective in encouraging behaviour change, as well as making people happier. An example of this is in Swiss Cantons (districts) which use referenda for making major decisions. There, the participatory approach not only improves policy, it also makes their citizen happier. Most interesting of all, around two-thirds of the well-being effect can be attributed to actual participation itself, and only one-third to the improvement in policy as a result of the participation.

~ From “Behavioural Economics: seven principles for policy makers” by the New Economics Foundation (NEF)

Read the full report (in PDF) for more details and implications for policy design and implementation.

Keywords : neoclassical economics, new economics, behavioural economics, experimental economics, theoretical new economics, human nature, human traits, policy design, policy implementation, social norm, habits, self-expectation, altruism, information overload, too much choices, loss-aversion, participatory democracy, life-sustaining economics, life-sustaining civilization design
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