Paste your Google Webmaster Tools verification code here

Behavioural economics has had its Nobel moment, but take it with a pinch of salt

Behavioural economics has received the ultimate accolade.

Richard Thaler of the University of Chicago Business School has been awarded the Nobel Prize in economics for his work in this area.

Economics over the past 20 to 30 years has become far more empirical. Leading academic journals do still carry purely theoretical articles, but far less than they once did.

This shift towards the empirical takes two forms. Major advances have taken place in the heavy duty statistical theory of analysing large scale databases containing information on individuals and their decisions. This was recognised when James Heckman and Daniel McFadden were awarded the Nobel Prize in 2000.

Behavioural economics is much less technical. In any given situation, the decision which a purely rational person would take is identified. We then look how people actually behave, and see if there are any deviations from the rational way of doing things.

Perhaps the main finding of behavioural economics is so-called prospect theory, first set out nearly 40 years ago by Daniel Kahneman. In essence, prospect theory says that people dislike making losses more than they like making gains of the same amount.

Another important discovery is that, when weighing up how to value future costs and benefits, people often place much more weight on the present and very immediate future than standard economic theory assumes. Last month I wrote about how this helps to explain the reluctance of electorates to deal with climate change.

These two results are backed by large amounts of evidence obtained in a range of different contexts. So now they are being integrated into economic theory.

But many economists are altogether less sure about much of the rest of behavioural economics. One of the issues is that it often gives the impression of being rather ad hoc. No reason is given as to why people in one situation appear to behave rationally, but in another they do not. Very few guidelines have emerged as to when we can expect to see deviations from rationality.

Another issue is that many economists are prepared to accept that non-rational behaviour might be observed at a point in time. But in a reasonably stable situation, people will learn over time to be rational.

Behavioural economics is not just about advancing knowledge on the workings of the economy. Policy-makers have become interested.

Cass Sunstein, Thaler’s colleague, served in the Obama administration as head of the Office of Information and Regulatory Affairs. David Cameron set up the so-called “Nudge Unit” in his government based on Thaler’s ideas. Thaler claimed 10 years ago that a “nudge” could lead to “better investments for everyone, more savings for retirement, less obesity, more charitable giving, a cleaner planet, and an improved educational system”. In his 2016 book Misbehaving, he has backed off the extravagance of these claims.

Still, whatever the doubts and qualifications, behavioural economics has made a big impact. An economist can no longer be said to have a good training if he or she is not familiar with its main themes.

As published in City AM Wednesday 11th October 2017

Image: Richard Thaler by Chatham House is licensed under CC by 2.0
Read More

Thomas Schelling – a true polymath of genius

Thomas Schelling – a true polymath of genius

Thomas Schelling is probably best known in economics for his contributions to game theory. Indeed the citation for his 2005 Nobel Prize states it was for “having enhanced our understanding of conflict and cooperation through game theory analysis”.

In the early, tense years of the Cold War between America and the Soviet Union in the late 1940s and 1950s, the US government invested heavily in the then new science of game theory. Schelling’s ideas were enormously influential in preventing nuclear conflict from breaking out. The opening lines of his Nobel Prize lecture point out the real danger that existed: “The most spectacular event of the past half century is one that did not occur. We have enjoyed sixty years without nuclear weapons exploded in anger”.

How do you handle a weapon which is so devastating you do not want to use it, whilst at the same time you must convince the other side that you might? Schelling was instrumental in creating the strategy of credible threats.

His Nobel lecture focused exclusively on game theory, the area par excellence of rational agent behaviour. This was a rather curious decision on his part.  For his mind ranged powerfully over a wide range of issues.

Schelling made seminal contributions both to complex systems theory and to the rigorous  analysis of agent behaviour on networks. It took time for scholars to appreciate the importance of this work. But these two themes are now at the forefront of science in the 21st century.

His 1971 paper in the Journal of Mathematical Sociology, entitled “Dynamic Models of Segregation”, was a brilliant illustration of the principle of emergence in complex systems. Schelling postulated a giant chessboard populated by an equal number of two types of agent located at random, and a few vacant squares. Each agent has a very weak preference for being in a majority in its local neighbourhood. This latter concept can be defined in a number of ways, but the simplest is the eight immediately adjacent squares plus the square the agent is on.  If only four of its neighbours are of its own type, and four are not, the agent is happy. But  if it is a minority, it moves at random to an empty square.

Although the individual preferences for location are weak, the board segments rapidly into a highly segregated pattern, with blocks of agents all of the same type. As Schelling puts it: “The systemic effects are overwhelming: there is no simple correspondence of individual incentive to collective results”. In other words, the properties of the system emerge from the interactions of the individual agents.

Schelling described the “analytics of neighbourhood tipping”, and stated that “a general theory of tipping begins to emerge”.  Nowadays, of course, the phrase “tipping point” is in common parlance, not least because of Malcolm Gladwell’s popular book on the topic, written thirty years after Schelling’s paper.

Our understanding of crime, obesity, smoking, binge drinking – a whole host of social problems – has been improved substantially by Schelling’s work. He saw that there are underlying similarities in how they develop.

His most important work in this area was published in 1973, in a paper in the Journal of Conflict Resolution with the wonderful title “Hockey Helmets, Concealed Weapons and Daylight Saving”. Schelling’s inspiration was a piece in the sports section of a newspaper about ice hockey, a game even more brutal than Rugby League.

A star player had suffered serious head injuries from the flying puck whilst not wearing a helmet. The reporter interviewed other leading players, none of whom wore helmets. It was clear that they understood the very real dangers involved.  A rational economic person, weighing up the costs and benefits, would always wear a helmet. But when asked why not, a top boy answered “I don’t because the other guys don’t”.

Schelling crystallised this into a mathematical concept he called “binary choice with externalities”. The choice facing an individual is binary. Either you wear a helmet or you don’t. Either you smoke, or you don’t. But your choice may affect how other people in your peer group make their choices. If no one else wears a helmet, you look soft by wearing one. If all your friends smoke, you may do so just to fit in. So the decision of an individual can have effects which are “external” to the decision itself. Understanding this is crucial to policy makers trying to influence the outcome. Rational choice theory may not always apply.

Schelling’s segregation paper was all the more remarkable because, nearly five decades ago, he essentially had to work out its properties by hand. In the same way, the concept of binary choice with externalities was set out with diagrams.

Advances in computer technology enabled the mathematical sociologist Duncan Watts to develop the idea dramatically in a 2002 paper entitled “A Simple Model of Global Cascades on Random Networks”. Agents in the Watts model, as in the original Schelling piece, take no account of the attributes of the alternatives facing them. Instead, they select using a variety of rules, all based on the principle of the choices made by agents to which they are connected. At the start, all agents are in the same state of the world. A small number is selected to switch the other. Watts analyses and simulates the cascade properties – how many will eventually switch – when agents are connected on different types of network.

Schelling made strikingly powerful and original contributions in a range of disparate areas. Much of his work was decades ahead of its time. Overall, he was a true polymath of genius.

As published in the Royal Economic Society newsletter April 2017

Image: Thomas C. Schelling by New America is licensed under CC by 2.0
Read More