The Law of Demand posits that the quantity demanded of a good or service has an inverse relationship with the price (i.e. the higher the price, the lower the quantity demanded). On the other hand, the Law of Supply teaches us that the price and quantity supplied share a direct, positive relationship. As Economics students, you might poke a hole in these two statements: I know, ‘ceteris paribus’. (For those who are not familiar with the subject, it is simply the assumption that all other factors are held constant.) Yet, even when so much precision and attention are paid to mastering theory, we often overlook its application and therefore relevance, or rather a lack thereof of it, in reality. The disparate between what is taught in our Economics lectures and its general lack of application in real life is well-accounted for by the discipline of Behavioural Economics. The study of Behavioural Economics challenges the foundational assumption of the Rational Choice Theory – individuals do not always choose what maximises their own satisfaction which their cognitive abilities (rationality) direct them to do, but are often governed by heuristics, cognitive biases, gut instinct or even altruism in their decision-making. Put in simpler terms, the propositions of Economic theories do not always see their applications in reality because humans are inconsistent, fallible beings.
Of two minds
Economic principles assume people make decisions based on rationality and self-interest alone. This could not be further away from the truth. Herbert Simon, Nobel Prize winner for his work in developing the concept of bounded rationality, argues that the theory of rational choice places unrealistically high cognitive demands on people. Indeed, humans operate in two minds, not one! Our cognitive processes are divided into two systems – the Automatic System and the Reflective System. The Automatic System is rapid, intuitive and unconscious. On the other hand, our Reflective System is more deliberate, reflective and self-conscious. These two systems reflect different processes, different ways of handling information and forming responses. Evidently, this is incongruous with the economic theories we learn whose dominant assumption is that we make choices using only the Reflective System. Inherent in our natures, our irrational Automatic Systems may gain a foothold in decision-making instead. This ironically renders the economic principles we learn predictably inaccurate in anticipating human behaviour – but such is the consequence of the befuddling workings of the human mind. However, this does not necessarily translate as something negative.
Recognising indelible human fallibility, Richard Thaler has proposed the ‘Nudge Theory’ – the subfield in Behavioural Economics that explores how psychological biases causes people to act in a way that diverges from pure rational self-interest. As humans are nudgeable beings, such a characteristic can be capitalised on by both private firms and governments to influence behaviour through nudges. However, it is important to note, just as the word itself suggests, that nudges are based on the principle of libertarian paternalism. At first glance, while libertarian paternalism may seem like an oxymoron, it is actually the movement that people should be free to choose what they like or want to do (libertarian aspect), but are simultaneously consciously influenced by choices in a particular direction (paternalism aspect). In its entirety, the Nudge Theory is grounded on the basis of altering people’s behaviour in a predictable way without forbidding options or changing their economic incentives. Choice architects, especially private firms and companies, frequently exploit the Nudge Theory for personal benefit. Conversely, the government, as another key choice architect, can use nudges in public policy in ways that are beneficial to society. In the following paragraphs, we will explore applications of the Nudge Theory – both from a firm’s perspective and the government’s perspective. More importantly, we hope to shed light on the mechanics of nudges, developing a deeper appreciation of consumer behaviour that does not always align with what economic principles anticipate of consumers due to man’s tendency to err.
An example would be the strategic arrangement of goods in supermarkets. Have you ever wondered why flowers and fruits are always placed near the entrance of Cold Storage or Fairprice supermarkets? Or why the slightly more expensive goods are placed on shelves that are at eye level? If not, be sure to keep a lookout for these completely uncoincidental and non-accidental marketing strategies employed by the firm when you visit a store next time. The vibrant colour of flowers and fruits project the store in a positive light, and the fresh smell subconsciously signals to consumers that the goods are in good conditions. As for placing goods at eye level, a commonly used phrase is “eye level is buy level.” Again, these techniques used by retailers are not forcing consumers to buy more, but in a way, guiding them to spend more. Thus, from this application of “nudging”, we can see that Behaviour Economics differ enormously from classical economics in the way that it works on people’s psychology rather than rationality.
A significant difference between “nudging” and other forms of intervention lies in its gentleness. While direct bans, taxation and subsidies are usually imposed by government to incentivise or deter people, “nudging” adopts a much “softer” approach to guide people’s subconsciousness to achieve desired outcomes. Another example of “nudging” could be our CPF scheme. Our government has been a textbook authority to utilise economics theories to carry out policy. In classical economics theories, people should be as willing to save for future as to spend it now. But in reality, nobody likes the idea of saving for later. “Enjoy life while you can” sounds more gratifying and much easier that few are drawn to the idea of carefully planning for the future. However, in retrospect, this is not beneficial to society– if nobody prepares for their golden age, the future taxpayers will have to pay for the generation of working adults today. Hence, the Singapore government uses “nudges” to subtly encourage citizens to take their initiatives to prepare for future (and to avoid criticism also). One of the nudge used is that the deduction of funds are made prior to people getting paid. The rationale of the scheme comes from a psychology theory showing that people are loss-averse, which means that they prefer avoiding losses than acquiring gains. In this way, saving can be accumulated more painlessly. Medishield also adopts this approach by making people feel that if they opt out the scheme, they are losing the privilege, thus maintaining high participation. Another nudge is the “status quo bias” which suggests that people are more willing to live with already established behaviour unless there is a compelling need to change. This is used in the default option setting in CPF scheme and Medishield which take advantage of people’s inertia. Hence, our government is well aware of the power of “bounded rationality” and use it extensively, which consolidates the effectiveness of behavioural economics in today’s age.
In all, economics is a social science. In essence, it is about using models to make sense and explain various phenomena in the world. So do not be surprised by the psychology involved in the calculation and modelling. As this science evolves, models become progressively more accurate and relevant. The aspects that were previously ignored or overlooked are now taken into serious consideration. Proponents of the concept of Libertarian Paternalism support the use of nudging by choice architects to consciously influence consumer behaviour. On the other hand, this study of nudging brings along with it wider ethical and proprietary concerns. To what extent does nudging influence the consumer? Does it infringe on the person’s fundamental right to freedom of choice? Or does it exploit the irrationality of the person’s automatic system to subconsciously “force” them into making a choice? Behavioural Economics is the new field that encapsulates the aspect of people’s thinking and psychology in decision-making. It explores a multidisciplinary approach across the Economics and Psychology, expounding on how rationality and emotions work together to help us to comprehend the world around us.
Sarah-Ann Tan (18-U1)