Nobel Perspectives
Why people make the decisions they do, and what it means for society at large
Nobel Laureates discuss how – and why – behavioral economics, nudging, and mechanism design can all be leveraged to make better decisions.
Humans like to believe that they make rational decisions based on facts. But every day we make hundreds of decisions, most of them unconsciously. What we decide, to a large extent, depends on our habits and on the context in which a choice is made. Making the choice to get vaccinated against COVID-19, or not, is currently one of the most hotly debated topics in the Western world. And while the pro-vaccination group is much larger in size, both sides are as adamant that they are the ones acting rationally and that the other side are the irrational ones.
Economics has long since been concerned with how people make decisions and behavioral economists specifically were the first to incorporate insights from psychology into their work. Where our beliefs come from has been something economist, psychologist, and Nobel Laureate Daniel Kahneman has been exploring for much of his career.
“When I ask you ‘Why do you believe in some movement’, you’re going to give me arguments, and subjectively, it feels that you believe in that thing because you have the arguments for it. That’s not the way it works, it works the other way around,” says Kahneman. “You believe in the conclusion and then you believe in the arguments that support the conclusion.”
Why do people believe in conclusions? According to Kahneman, it’s because the people you love and trust believe that conclusion, something he calls being “emotionally coherent.”
Ideas Spread
Ideas Spread
Economist and Nobel Laureate, Paul Romer, challenged traditional economic thinking by creating a growth model based on ideas. He formulated the difference between ideas and objects, along with a definition of rules and norms. Ideas and the innovation they spur, to Romer, are crucial to measuring a country’s overall growth.
Kahneman, and his longtime collaborator Amos Tversky, developed Prospect Theory in the late 70s with the aim to describe people’s behavior around how they assess loss and gain.
“To understand what Prospect Theory did, you have to understand something else first, which is what makes it complicated,” explains Kahneman. “There was a dominant theory, Utility Theory, that economists just accepted. It’s based on axioms of rational choice. It was the foundation of economic analysis, financial analysis. The idea that economic agents act rationally and consistently. And part of that idea is that people think in terms of long-term objectives. They think in terms of wealth. How wealthy they will be if they make this choice or that choice. Today, most economists assume that this is what people value.”
With Prospect Theory, he and Tversky proposed a change to the way we think about decisions when facing all forms of risk. They found that people react to changes in terms of gains and losses. "Gains and losses are short-term," he says. "They’re immediate, emotional reactions. This makes an enormous difference to the quality of decisions.”
"There has to be a design of that cafeteria. Why don't we make it a good one?"
Richard Thaler
A little nudge goes a long way
A little nudge goes a long way
If Kahneman is the father of behavioral economics, then economist and Nobel Laureate Richard Thaler is the prodigal son. One of the most important concepts of Thaler’s work is what he refers to as nudging. He coined the term “choice architecture” which allows people to make their own decisions under a design that favors the better choice. By making the improved choice easier, this creates a structure in which people can ultimately make better decisions.
He uses the cafeteria at the University of Chicago Booth School of Business where he is a professor as an example, where the first thing one sees when they enter is a salad bar. “This is an example of how something that seemingly isn't very important may influence what people eat, nudge people to eat something healthy,” says Thaler. “There has to be a design of that cafeteria. Why don't we make it a good one?”
Nudgeable Areas
Nudgeable Areas
The UK’s Nudge Unit has worked on a wide range of policy areas including prompting people to meet tax deadlines, increasing organ donations, and automatically enrolling in pensions.
Source: The Behavioural Insights Team
Can we predict decisions?
Can we predict decisions?
Understanding why people make good or bad decisions has been a major part of Daniel McFadden’s life’s work. His discrete choice model analyzes people’s behavior as it relates to the use of public transportation, housing, financial diversification, and health. It also won him the Nobel Prize in Economic Sciences in 2000.
“The work that I did on predicting people’s choices was to utilize this particular, very simple mathematical model to essentially describe the share of people that were making a choice depending on how attractive the alternative was,” says McFadden.
The model takes data on discrete outcomes – for example how many people will choose to use a new public transportation system versus continuing their existing routine – and explains the probability of different outcomes.
“The reason it’s had an important role in economics is that it does give you a way of setting up systems for predicting behavior because if you’re trying to figure out whether it’s worthwhile to invest in subway lines or not,” he says. “But it also turned out to be a real contribution to economics more generally.”
Having a better understanding of how people view and make decisions has implications far beyond the individual, and this knowledge can be used to create better public policy and experiment with economic incentives. Using the aforementioned COVID-19 vaccine example, there are currently several government-backed programs designed to increase vaccination rates. In May 2021, Ohio announced a draw open to all citizens under the age of 18 for a full four-year scholarship to any of the state’s colleges and universities. For those 18 and older, they will be entered into a draw with prizes up to $1 million USD.
Economic incentives that speak to people’s behavior and emotions are an important tool for policymakers but designing incentives that are also effective require an extra layer of economic thinking.
"The reason it’s had an important role in economics is that it does give you a way of setting up systems for predicting behavior."
Daniel McFadden
Mechanism design
Mechanism design
Economist Eric Maskin was awarded the Nobel Prize in Economic Sciences in 2007 “for having laid the foundations of mechanism design theory.”
“We start with outcomes, we say these are the outcomes we would like to have, and then we work backwards, to figure out a mechanism or an institution, which will generate those outcomes,” explains Maskin. “Mechanisms are the set of rules that participants might follow to determine an outcome. Each participant in the mechanism will, of course, be following their own rules and trying to achieve their own goals – which aren’t necessarily the same as the goals of the mechanism designer.”
Information within economics is often incomplete and while this information asymmetry exists, a properly designed system helps uncover the “secret” information.
Alternative data can be leveraged to help connect dots that would otherwise seem unrelated. UBS Evidence Lab combines multiple alternative data sources to help people make more informed decisions. For example, they use mobility data such as traffic congestion to gauge the impact of COVID-19 on economic activity around the world. They also look at shipping data to identify how the pandemic has affected global supply chains, and housing data to measure “urban flight”.
One major area where mechanism design could also help is climate change, according to Maskin. “Whenever markets need a push or a modification or a tweak, mechanism design is there to tell you what modifications might help,” he says. “Think of the problem of getting clean air. We can’t expect markets to provide us clean air, there’s no place we can go to buy clean air. Instead, we need governments to step in and limit pollution.”
“You want to introduce a pollution policy which is efficient, you want to direct your pollution reduction to the polluters who are most able to make those reductions. But you can’t distinguish the high cost polluters from the low cost polluters, and so you have to develop mechanisms for ensuring those different classes of polluters get identified in the process of the mechanism.”
With the innovation and changes of the modern economy, mechanism design could become increasingly important for investors, too, as we re-evaluate and introduce new ways to determine value within the economy.
Any crisis — be it a pandemic, a financial crash, a natural disaster — can challenge our belief systems, alter how people make decisions, and impact which data the market looks to for explanations or guidance. With the right approach, right data, and an open mind, all people, and in particular investors, can be better positioned to face the uncertainties that go hand in hand during times like these.
