How Behavioral Economics Changes Personal Perception

In 2017 Richard Thaler received the Nobel Prize for research in behavioral economics. Since 2009, the HSE Laboratory for Experimental and Behavioral Economics has been researching this field of economics. Alexey Belianin, Head of the Laboratory and Deputy Director of the International College of Economics and Finance, and lab staff members told HSE News Service why standard economic models do not work and how to make a person behave in a particular way.

Alexey Belianin, Head of the Laboratory

What is Behavioral Economics?

In 2017, the Nobel Prize in Economic Sciences was awarded for research in the field of behavioral economics for the first time, but this was not the first prize for research in this field. Herbert Simon was arguably the first behavioral economist to receive a Nobel Prize in Economic Sciences back in 1978, when he was awarded the prize for his study of decision-making in business organizations. Several economists, including Maurice Allais, Reinhard Selten, George Akerlof, Daniel Kahneman, Vernon Smith, Robert Schiller, Alvin Roth, and Jean Tirol, among others, also received the Nobel Prize in different years, and one way or another have also contributed to this discipline.

Researchers working on traditional economic sciences tended to overlook the psychology of decision-making: these transient, random factors were not thought to have significant impact compared to economic incentives. Psychologists are interested in solutions that are emotional, random, driven by cultural beliefs, norms, rules, and even phobias, while economics is a serious science of rational behavior. Neoclassical economists in the second half of the 20th century tended to develop rational models of decision-making that were informed by rather rigid ideas about what is rational. But quite a long time ago it became clear that this view was flawed, and Richard Thaler was one of the first economists who not only admitted this, but who went on to make behavioral economics his profession, which was an unexpected outcome given this was the era of the liberal Chicago school in the 1970s, imbued, as it was, with the ideas of Milton Friedman and his colleagues.

Behavioral economics as a branch discipline developed at the turn of the century, although the first related works appeared earlier (much earlier in some cases). However, at the beginning of this century economists recognized that it is possible to combine psychology and classical economic theory and analyze real people’s behavior from an economic point of view.

These days most experiment-based papers start with the neoclassical decision-making model, although it is clear from the start that people’s behavior will differ from this model and that the data will not endorse the model

The researchers have now accumulated a significant amount of knowledge, results and information. For example, in 2016 there was a textbook on behavioral economics by Sangeeta Dhami from the University of Leicester that contained 1,800 pages, which the author claimed was the largest book ever published by Oxford University Press (OUP). Research results accumulate rapidly: they include interpretation of behavior in risky circumstances, inter-temporal preferences, experimental games involving two or more players (aka social dilemmas), collective interaction, and studies of market and non-market coordination mechanisms. All these studies are both interesting and informative, they shed new light on how we make decisions, and this knowledge, in contrast to many other areas of economic analysis, has been successfully applied in practice.

Such rapid growth, of course, causes expenses. Thus, economic models in behavioral economics are still based on the methodology of positive economics by Milton Friedman, which states that the realism of the assumptions used in the models does not matter if the model predicts behavior well. However, all behavioral models, without exception, are based on psychological realism, but they don’t always have a clearly better predictive effect rather than their neoclassical predecessors.

Economic Theory vs Reality

Methodologically, behavioral economics is that same neoclassical theory – simply applied to its own particular area of research. Its economic mission is a classic paradigm shift as identified by American physicist and philosopher Thomas Kuhn, and the creation of a protective zone around neoclassical economics, which has been shaken by experimental results that destroy established ideas of how people make decisions and react to stimuli.

However, these days most experiment-based papers start with the neoclassical decision-making model, although it is clear from the start that people’s behavior will differ from this model and that the data will not endorse the model. Economists have not yet achieved a comprehensive understanding of what the behavioral economic theories, applicable to the behavior they are intended to explain, should be. Attempts have been made to create such theories, but none has yet been generally accepted. And the absence of a unified paradigm prevents researchers from correctly understanding why people behave or act as they do.

For example, when we carry out an economic experiment, we usually believe that we as researchers have successfully determined a system of incentives and interests, which both subjects and researchers understand. According to key paradigms of economic science and experiments, an individual strives to maximize the amount of money earned. This means that the size of a participant’s reward should incentivize him to make decisions that are optimal from the reward perspective. But this is not always possible in practice.

For example, the average reward for an experiment participant in our lab is 500-700 rubles per 1.5 hours, and some participants do take part and make decisions that maximize their rewards. But I also know that some participants are people who earn thousands of euro per month. For them, clearly, 500 rubles cannot act as an incentive, they don’t take part to get the money, but out of interest and curiosity. And, as someone leading the experiment, I do not know who is who. Given this, how can we interpret their behavior correctly? This is actually a serious problem, and, understanding that, we should not only check how our data fits theoretical forecasts, but also analyze what people really want to achieve, and what their reasons are for taking decisions.

Behavior and Experiment

In his research into behavioral economics, the new Nobel laureate Richard Thaler states that we can look at human behavior as economists, from the point of view of incentives and interests, draw conclusions about how people generally behave, and predict their behavior amid specific changes to the decision-making conditions. One of his simple, canonical problems states: imagine that you go to buy a calculator that costs $20. They tell you that you can buy the same calculator for $15 nearby, a ten-minute walk from the shop you’re in. Will you go to buy it in another store? Most people say that they will. Now imagine that you are going to buy a computer that costs $1,000, and you’re told that in another store the same computer costs $995. Will you go to another store to buy a computer? Most people respond with a negative, although we are talking about the same amount of money. What's the difference? In your mind you have a different scale of prices and different economic points of reference. This is the concept of prospect theory, as posited by Kahneman and Tversky, i.e. a basic concept in modern behavioral economics, which states that we make decisions based not only on the potential value of losses and gains rather than the final outcome.

When you make a decision, you don’t analyze an objective reality, but your own psychological reality

This is an example of what is called ‘mental accounting’. When you make a decision, you don’t analyze an objective reality, but your own psychological reality. Of course, it is connected with the objective reality, but it is not an exact copy of it. There are quite a lot of differences between the real world and how we perceive it. This is one of the insights offered by psychologists, and Thaler was the first economist who applied this in his work.

In addition, his research showed how this knowledge can be used for specific solutions in economic policy. As long as most people react the same way, researchers have the opportunity to "push" people to make particular decisions, to influence their behavior, by adjusting the context so that they behave "correctly" from the point of both public and their own interests. This approach is essentially dirigiste and anti-libertarian because it decides for people what they need and how they should behave. However, Thaler and his followers don’t see this as a problem, and call their approach "libertarian paternalism".

Imagine that you are driving along a winding mountain road. You are Russian, and what Russian does not love driving fast! Driving on a mountain road at high speed is dangerous, but how can we encourage you to reduce speed? There are different ways, for example, to place a speed bump every 50 meters, to put up road signs, or to fine you for speeding — but all these measures will only have a marginal effect. In addition, according to behavioral data, in the US 80% of drivers consider themselves more skilled than the average driver, which is not correct. Thaler suggested a very simple solution: use white paint to draw a lane on the road that is narrower than the whole road. A driver instinctively tries to fit in the lane, wherever they go, so inevitably reduce speed. This solution does not require any bans or penalties: it works because we have developed certain instincts, which work to the person’s benefit and encourage them to make the right decision.

The understanding that this is how it works formed the basics of Behavioural Insights Units (aka the Nudge unit) — public organizations that exist in many countries. They study and develop mechanisms that will enable people to make the right decisions without the pressure of laws, prohibitions or penalties. This relates to their transport behavior, health, retirement, educational strategies, and much more. They don’t discriminate people by gender, age, income etc., it applies to everyone and is a very popular approach at the moment. It is arguably part of the reason that Richard Thaler was awarded the Nobel prize.

Two classic experiments that disprove economic theory predictions

Ultimatum Game

This is a game for two players; one has a particular resource and shares a certain proportion of it with the other player. Knowing this proportion, the second player can accept the decision, which means the transaction happens; if he rejects it, both get nothing. This game was invented by the economist Werner Güth and his coauthors in 1982, it is very popular in experimental economics as a way to measure players’ pro-social intentions, and is a canonical example of how theory diverges from practice. Game theory prediction states that the first player should keep almost everything, and the second gets the minimum possible share and agrees. In reality, it turns out that the first player gives the second 45%-50% of the resource, in other words, he leaves himself a little over half, and the second agrees. If the first player leaves the second 20% or less, the second is likely to say no, and both will get nothing. This is because the sense of justice and injustice of the division is more important than the modest sum the second player could get. The second player is not satisfied with too small a share, because they consider it disrespectful, and so the most logical response is to deprive both players of profit. The first player is aware of that, so an offer around 50% is the most common and it is generally accepted.

Dictator Game

This game is a variation of ‘Ultimatum’, but with stricter rules. The first player offers the share and the second player is required to accept the offer and cannot query the share. In this situation the first player becomes a little greedier, but in almost all cases they give the second player, on average, a share of around 25%, although unlike the game Ultimatum there is no risk that the offer may be rejected. This game has been played thousands of times in different countries, and global trends are as follows: the distribution of the offers by first players is tri-modal: there are those who take everything for themselves and do not share anything with others, there is a peak at around 50%, which includes the majority, and there are also first players that choose to give everything to the second players (obviously not the most popular decision, but it happens). This distribution, of course, doesn’t conform to standard theoretical predictions, which state that the first player takes it all.

Laboratory staff used this game to compare the behavior of two groups of Moscow students: junior HSE students and cadets at the Suvorov Military School. During the experiment, it became clear that the cadets’ average level of cooperation was higher: their modal decision was to share 50%, whereas HSE students behave the same way as the people from meta-studies around the world. The difference in the interaction displayed by cadets with members of their own group (other cadets) as compared to that seen with another group (students) turned out to be interesting too. With HSE students they behave the same as students behave with each other in the game, and give them an average of 25%, but they give about 50% to the cadets. There is a quite clear professional reason for this behavior, as the sense of group solidarity should be high in any military unit.

About HSE Laboratory for Experimental and Behavioral Economics

Our laboratory is engaged in both testing economic theories and socio-cultural and field experiments. An economist can find a lot of reasons to be interested in lab activity, which offers the opportunity to estimate behavioral parameters, unobserved in natural environment, discover how certain rules and institutions affect decision-making, and study the features of this environment that motivate people to make equilibrium decisions.

An understanding of how people behave and what rules they actually follow when taking their decisions, based on a good theory, is the correct approach to organize social institutions. Most students who come to work at the laboratory are economists, but there are also psychologists, mathematics, specialists in public administration, political science, and sociology. We are an interdisciplinary and pan-university laboratory, based at ICEF, and we welcome everyone interested. Some prominent students have been lab staff: lab graduates go on to enroll in internationally renowned universities such as: Chicago, Columbia, Harvard, and Caltech.

Information about the lab’s projects can be found here.

Research Assistants at the Laboratory for Experimental and Behavioral Economics discussed their academic interests and current projects.

Grigory Chernov, doctoral student, Research Assistant

I graduated from Novosibirsk State University, first I studied management, and then finance, that’s why I always keep the ‘human factor’ in mind, especially dealing with economic models. During my studies I worked on some projects dedicated to risks, and before graduation I came across the book ‘Thinking, Fast and Slow’ by Daniel Kahneman. Today I don't see myself in economic science without experimental work. I came to Moscow to work at this lab, and I think that behavioral economics is the future of economic development.

It is a young science; it has just started accumulating factual material, although there are serious results that can be used in the theory’s application in economic policy, as the recent Nobel Prize shows.

Economists have traditionally treated laboratory experiments with considerable skepticism, and therefore experiment methodology follows strict requirements: every detail is strictly checked and rechecked before each procedure. Experiment planning takes a lot of energy, but it also makes it possible to achieve high result reproducibility, comparable to results seen in neuroscience.

Working at the lab not only gives me an opportunity to create new economic mechanisms, but also a chance to understand what really affects human actions, motives, and decisions. In addition, while working with models that explain deviations from traditional, rational behavior, you can adjust your own opinion, resolve differences in behavior, and most importantly — avoid pitfalls in everyday life.

Alexey Guzey, ICEF 4th-year student, Research Assistant

I heard about the lab during my first year at HSE, when I met and talked to Alexey Belianin in the hall in HSE building on Shabolovka. After that he sometimes gave me small projects, and a year and a half ago I became the lab’s Research Assistant. I still don't know what I’ll do after receiving my BA degree, but I’m likely to be engaged in computer or cognitive sciences, rather than economics, and that is why I'm interested in the lab. During my lab work I researched mechanisms of propaganda and programmed games for economic experiments carried out by the lab, and am now studying topology and cognitive psychology, because in the attempt to answer the question ‘How do people make decisions?’, we apply economy, psychology, cognitive sciences, and other related areas (this is also why we run a joint workshop on neuro-experiments with the Centre for Cognition & Decision Making).

I am currently working with Grigory Chernov to develop a new way of measuring people's attitude to risk. We need this first because existing methods, are unstable, meaning that different studies give completely different results, and, second, because they are not ecologically valid as they are measured artificially, in situations that are different from real-life situations. We try to design experiments that are intuitively suitable for everyone, from investment bankers and HSE students to cleaners and lumberjacks, and we hope that the measures we work on will help to largely avoid these shortcomings, if not completely eliminate them.

Anastasia Kuptsova, 4th-year student of the Faculty of Economic Sciences, Research Assistant

I’ve been working at the lab for less than a month, so I’m just trying to understand how the process is organized.

As I see it, behavioral economics is an interdisciplinary field that integrates classic economic theory and analyzing people's behavior. And it is very trendy. I think that connection with reality is exactly what economic science is missing today.

I am finishing my bachelor’s studies at the Faculty of Economic Sciences, so before I joined the lab, I was looking for my niche in economics, which I find interesting. Of course, there are structured and reliable micro- and macro-economics, which, of course, factor in human behavior, but these are still very mathematical theories with a very strict background and do not always deliver applicable conclusions. First I learnt to cope with these pillars of economic science, and then I took the course in behavioral and experimental economics by Ksenia Panidi. And it turned out it is really interesting to conduct an experiment and to understand that a strict mathematical model only offers a poor description of real people’s behavior. I realized that this was what I found most interesting. Now I’m thinking about my academic career, and the lab helps me understand whether it’s just what I need and what I can do in this field.