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Not every economic decision is rational- policymakers beware

Tuesday October 17 2017

By KWAME OWINO
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One of the most common errors human beings make is to reason intuitively, and then extend that thinking to business ideas and public affairs.

Many economists find that what posh and serious businesspeople, or commentators, state about the working of an economy would occasionally make decent student laugh.

This is why the award of the Bank of Sweden Prize on Economic Sciences for 2017 was an interesting choice.

While it is referred to as the Nobel Prize in Economics, it is not one because it is not awarded as part of the bequest by Alfred Nobel. On Monday last week, the Prize was awarded to Richard Thaler, a professor of economics at the University of Chicago.

In the established tradition, the award is accompanied by a 37-page paper, tracing Richard Thaler’s contributions, which form the basis for his award “for his contributions to behavioural economics”.

Definitions vary, but behavioural economics is a sub-discipline or school of thought that integrates psychological insights into economic decision-making.

Despite the interesting insights behavioural economics has generated, a significant number of economists believe the value of its insights and tools to be limited. However, this discipline is now established and its real practitioners are not only recognised by faculty and governments, but their cutting-edge insights are also used by private institutions as banks, utility corporations and even lawyers.

GREEDY OR PREDATORY

The committee’s detailed paper cites four reasons for Richard Thaler’s award, among them that he pioneered the use of laboratory experiments to test personal preferences in economic decision-making.

The results showed that the individual not only faces limits in rational decision-making (bounded rationality) but also that human beings exhibit systematic preference for fairness in dealing with people, especially where the possibility of repeat transactions is high.

Therefore, while engaging in transactions, the individual considers fairness as essential and could frustrate a transaction if it was evident that his or her counterpart is greedy or predatory, irrespective of the positive value of the trade to both sides. This means that people can absorb personal costs to “punish” an unfair person in a market transaction.

Richard Thaler’s scholarship is useful in its applications in the area of inducing savings and longer term planning. The idea is that many people face difficulty in self control and therefore require “nudges” from an external actor.

These nudges include the design of employment contracts to automatically enroll employees in pension savings plans as the default option. This is not compulsory, but uses the instinct for people to leave default options on and thereby build their savings.

SCHOOL ABSENTEEISM

Such an approach to pension savings “relieves” the employee from having to make the decision by considering all options. It is therefore recommended by Richard Thaler as a sensible response to procrastination and inadequate saving, because “people have a tendency to overvalue present consumption”.

The value of behavioural economics and its insights to policy are not questionable. No less than the government of the United Kingdom established a Behavioural Insights Team, or Nudge Unit, in crafting and executing policy.

The unit extracts and uses insights generated by Richard Thaler, and other behavioural economists, to improve policy initiatives and design experiments to determine optimal policy choices.

For instance, the BIT noted that school absenteeism affects the cognitive development of youth. It designed a programme to use short message text communication (SMS) to remind at-risk-youth to attend classes. Published information shows that this very cheap and non-coercive approach has outstanding results in reducing truancy and retention for the pupils most at risk.

Another creative use of behavioural economics insights by the BIT used electricity bills to alert consumers about the possibility of changing suppliers in order to get better tariffs and save reduce their costs.

PANTHEON OF ECONOMISTS

This action led consumers to web sites that allowed them to compare monthly or weekly consumption against the average and their neighbours, and thereafter take measures to make savings.

These examples show that economics insights are generally not trivial, but especially that using this information not only creates better policy but also improves its uptake and effectiveness.

It is clear that Kenyan regulators in finance, insurance, utilities and education, together with policy implementers, need a primer in behavioural economics.

Kenya has a lot of policy initiatives based on populist rhetoric, for which evidence of effectiveness is zero.

The sector’s role and voice in the pantheon of economists is growing. They now produce an annual Behavioural Economics Guide, with the latest, even including Richard Thaler’s, contributions. That would be a good reference point.

Kwame Owino is the chief executive officer of the Institute of Economic Affairs (IEA-Kenya), a public policy think tank based in Nairobi. Twitter: @IEAKwame