Behavioural Economics and Public Policy

By Rhea Bhatia

In 2017, Richard H Thaler won the Nobel Prize in economics for his work on behavioural economics. Behavioural economics has been gaining momentum and Richard Thaler’s Nobel Prize really made it a front runner, to be seriously considered for its vast implications.

What is Behavioural Economics?

Very simply put, behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain economic decision-making. The entire economic theory is built on the assumption of rational behaviour – rational consumers aiming to maximise profits and rational firms aiming to maximise profits. This seems like a very reasonable assumption to make, but when examined closely, it is also a very big assumption to make.

The Assumption of Rationality

Behavioural economics challenges this very assumption and says that people may not always make the right choice. It is now easy to see why this line of thought has such wide ranging consequences for economics as we know it. Behavioural economics aims to understand how market decisions are made and studies the mechanisms that drive public choice, by studying the effects of psychological, cognitive, emotional, social and cultural factors on these economic decisions. A very simple example of this, is the herd mentality, where individuals may not make their own independent and rational decisions, and instead take decisions based on what a larger group decides to do. Thus, it is safe to say that understanding and mastering behavioural economics can do wonders for the public policy of a country.

Implications on Public Policy

Behavioural economics has implications for public policy in 2 major domains:-

1. Policy tools to influence behaviour

2. Predictions about existing policies

In this article, we focus on how this branch of economics can help us build tools required for effective policies. Taking inputs from psychology, behavioural economics acknowledges that we may have behavioural biases while making decisions. Taking this into account while making policies can make them more effective and help governments steer the economy into the desired direction.

The Nudge Theory

The most widely used policy tool under behavioural econ is the nudge theory. A nudge is a concept which proposes positive reinforcement and indirect suggestions as a way to influence behaviour. Countries like the US and the UK have set up national nudge units and have been using this to influence behaviour. For example, in the UK, people with tax arrears were sent messages that said that 9/10 people pay their taxes on time. Thus, by sending messages that implied that this particular group of people were the only outliers, the government encouraged timely payment of taxes.

Coming up with such a policy not only ‘nudged’ people to pay the taxes on time, but also made for an effective low cost policy measure to improve the taxation system. Think of the impact of such behavioural economics driven policies, on developing countries. Not only will this save millions of dollars in policy initiative, but also improve growth prospects of such countries.

Re-evaluating existing policies by discarding the homo economicus (rationality) assumption and allowing for biases will help governments to better understand the inefficiencies that exist in a market and how certain market players take advantage of such situations (another example of irrational behaviour). For example, behavioural finance studies how some market participants may act irrationally and take advantage of market inefficiencies. By allowing for such features and biases in present day models, behavioural economics can lead to better predictions about the effects of existing economic incentives.

Since the classical period, economics was always linked to psychology, as it should be. It was somewhere in the neoclassical era that the assumptions in economics were made more mechanical and less dynamic with respect to human behaviour. So, the emergence of behavioural economics once again as a tool for policy making, represents a natural progression of (rather than a challenge to) neoclassical economic methods.