The Power of Irrational Decisions

The 2017 Nobel Prize in Economic Sciences went to Professor Richard Thaler from the University of Chicago, USA, for his contribution to behavioral economics that takes into consideration human psychology. Behavioral economics assumes that people not always (in fact, rather rarely) are driven by rational reasoning. Behavioral economics also explains unexpected turns of events on financial markets and numerous behaviors that go against economic calculations. For example, why do you treat EUR 100 which you find in a pocket of your jeans before throwing them in the wash, differently than EUR 100 that you have earned as a payment for your work? According to Professor Thaler’s theory of mental accounting, people behave this way because they treat money from various sources differently and they mentally put them into different “accounts”.

It is not easy to encourage people to invest wisely. On the other hand, they do not need to be persuaded to lightly spend the money accidentally found on the street. It is also a challenge to motivate people to work, regardless of the type of work - blue or white collar. Research conducted by the Behavioral Economics Research Group (BERG) at SWPS University, indicates that if people agree to work at all, initially they tolerate high expectations of their boss. However, the process of increasing job expectations is like treading on thin ice. It is easy to turn motivated employees into unmotivated employees, by assigning excessive workload. Another challenge occurs when people get paid. Numerous studies show that people behave impulsively and often succumb to temptations (see: Madden and Bickel, 2010). Spending money on fun activities, regardless of the consequences, “is human”. However, it becomes a problem, when time passes and one’s savings are not growing.

One of the biggest achievements of Professor Thaler is the practical application of behavioral economics in real life. For instance, turning impulsive spending into saving behavior. People can be persuaded to make better decisions without constricting their freedom of choice. For example, in the countries where saving for the retirement is optional, the percentage of people joining the program is not satisfactory. At the same time, in the countries mandating retirement saving programs, the freedom of choice is restricted. Is there a middle ground between these two options? Thaler claims that if the default is set to a voluntary participation in the retirement savings plan with a possibility to opt out at any time, most people decide to save systematically.

Behavioral economics applies not only to specific behaviors at an individual level or to the financial sector. One of the areas that is quickly developing thanks to behavioral economics is law. Laws and regulations developed by governments may limit the freedom of choice or provide for more freedom. The retirement saving systems can be analyzed from the behavioral economics point of view. There are various retirement solutions available, depending on the country, ranging from the most liberal (you have to save for your retirement on your own) to the welfare state option (your participation in the retirement plan and the amount of your contributions to the plan are set in advance by the government).

According to the traditional economic approach, one’s choice should be the same regardless of the way a decision problem is formulated. However in real life a glass that is partially filled with water may be perceived by some people as half empty (with emphasis on loss) and by others as half full (with emphasis on gain).

Behavioral economics explains how to avoid some pitfalls related to decision making. Because behavioral economics often describes exemptions from the ideal and normative models, it shows which decisions are disadvantageous. For example, a sales pitch offering a 3% discount for cash payments sounds better than information that you must pay an additional 3% for a card payment. Although from the mathematical point of view the customer pays exactly the same amount in both cases, the 3% is presented as a gain in the first instance and as a loss in the second one.

Daniel Kahneman, psychologist specializing in psychology of judgement, decision making and behavioral economics and Amos Tversky, cognitive and mathematical psychologist, had discovered that one of the strongest factors affecting our choices is risk aversion. In 2002, many years after this discovery, Daniel Kahneman received the Nobel Prize in Economic Sciences and risk aversion has become one of the main tenets of his Prospect Theory.

Risk aversion is a strong motivator. In 1998, social psychologists Irwin Levin and Gary Gaeth asked participants of a study to rate attributes of ground beef. One group was told that the beef is 75% lean, while the other group that the meat contained 25% of fat. The results indicated that consumers who received the information highlighting the low fat aspect of the product, rated the beef as tastier than those who focused on the amount of fat in the meat. Avoiding the trap of bad decisions may be possible if you analyze both variants of the situation - the positive and the negative consequences of a given scenario.

However, it is more difficult to avoid the so called ‘endowment effect’ discovered by Richard Thaler, economist specializing in behavioral science and economics. The endowment effect is the hypothesis that people ascribe more value to things merely because they own them. For example they demand more money for things they are selling than they would be willing to pay for the same things, if they were to buy them. Thaler provides an example of his friend, a professor of economics, who had bought a few bottles of wine for a low price, some time ago. Over time, the price of wine has appreciated by a few hundred percent. From time to time, the professor would open a bottle of this wine on a special occasion, but when he was asked whether he would buy another bottle at a current market price or maybe sell one of his own bottles, he decidedly answered “No”. He valued the wine in his possession more than the same wine that did not belong to him. This type of thinking stems from the endowment effect.

Rational choices are based on logical thinking. It would seem that the traditional economic theory should be the starting point for research in behavioral economics. However, it is possible to approach economy from a different point of view, one that does not treat behaviors as anomalies and exceptions, in the idealized economic environment. Things are rarely predictable in the real world and people seldom make choices in laboratory conditions, where alternatives are carefully selected. In real life there are usually many options to choose from.

Psychologist Gerd Gigerenzer provides an example of Harry Markowitz, who developed the portfolio theory, which explains how people should invest. However, when Markowitz had to make a decision about his own investments, he applied a simple heuristic method (i.e. divide your money equally between various options), instead of using his own theory. Why? Because the real world is often unpredictable. Gigerenzer emphasizes that when you use a different point of reference, for example ecological rationality, then potential errors disappear and begin to work in your favor. It means that if you have sufficient information about the potential risks and the consequences of your choices, it is best to trust the economic approach. However, when not only the future, but also the present day are uncertain, it might be better to trust your gut feelings that have developed over the hundreds of years of evolution.

Although Richard Thaler is an economist, his prestigious award also gives recognition to all researchers who study human behavior. The 2017 Nobel Prize in Economic Sciences was awarded for discoveries related to human behavior. In his analysis, Thaler takes into consideration realistic psychological assumptions, related not only to economic decision making, but also to simple daily decisions, because psychology plays a major role in individual decision making, hence on financial markets as well.