Behavioural Economics and Finance

Michelle Baddeley

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781351813983
• Edition: 2
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

Behavioural economics and behavioural finance are rapidly expanding fields that are continually growing in prominence. While orthodox economic models are built upon restrictive and simplifying assumptions about rational choice and efficient markets, behavioural economics offers a robust alternative using insights and evidence that rest more easily with our understanding of how real people think, choose and decide. This insightful textbook introduces the key concepts from this rich, interdisciplinary approach to real-world decision-making.

This new edition of Behavioural Economics and Finance is a thorough extension of the first edition, including updates to the key chapters on prospect theory; heuristics and bias; time and planning; sociality and identity; bad habits; personality, moods and emotions; behavioural macroeconomics; and well-being and happiness. It also includes a number of new chapters dedicated to the themes of incentives and motivations, behavioural public policy and emotional trading. Using pedagogical features such as chapter summaries and revision questions to enhance reader engagement, this text successfully blends economic theories with cutting-edge multidisciplinary insights.

This second edition will be indispensable to anyone interested in how behavioural economics and finance can inform our understanding of consumers' and businesses' decisions and choices. It will appeal especially to undergraduate and graduate students but also to academic researchers, public policy-makers and anyone interested in deepening their understanding of how economics, psychology and sociology interact in driving our everyday decision-making.

Chapter 1

Introducing behavioural economics

What is behavioural economics?

With the award of the 2017 Nobel Prize in economics to behavioural economist Richard Thaler – one of the pioneers in developing behavioural public policy “nudging” – behavioural economics is very much in the news. There are, however, many misconceptions about behavioural economics, which raises the question: what is behavioural economics?

This is a question that many behavioural economists have worked on answering, for example see Hargreaves-Heap (2013) versus Thaler (2016) for some contrasting perspectives. To give a quick and simple answer: behavioural economics is a fascinating and fashionable subject, of increasing interest to policy-makers and business, as well as to a range of academic researchers and teachers. But, because it is such a broad field, it can be difficult precisely to define. Some would argue that all economics is behavioural economics because economics is about behaviour, albeit in a restricted context. Others would define behavioural economics very narrowly as the study of observed behaviour under controlled conditions, without inferring too much about the underlying, unobservable psychological processes that generate behaviour.

Overall, the clearest way to describe it is as a subject that brings together economic insights about preferences and decision-making with broader principles of behaviour from a range of other social, behavioural and biological sciences. In this, behavioural economics relaxes economists’ standard assumptions to give models in which people decide quickly, often using simple rules of thumb rather than rigorously but robotically calculating the monetary benefits and costs of their decisions. Behavioural economics also explores how quick thinking leads people into systematic mistakes but also explains how people can learn from their mistakes. In behavioural economic models, people look to others when making decisions and when seeking happiness. Their decisions are affected by skills and personalities and also by moods and emotions. People aren’t necessarily good at planning systematically for future events and particularly when immediate pleasures tap into emotional and visceral influences. This means that people will be susceptible to impulsive decision-making which may be detrimental to their long-term welfare, for example smoking and eating unhealthy food. So overall, behavioural economics develops more traditional economic models to explore in more depth and detail the balancing acts that we go through every day when we choose and decide. For the purposes of this book, behavioural economics will be defined broadly as the subject which attempts to enrich economic analyses of behavior – grounded as it is in theories about preferences, incentives, decision-making and strategy – with insights from psychology, sociology, cognitive neuroscience and evolutionary biology.

A quick history of behavioural economics

Whilst behavioural economics might seem like a relatively new sub-discipline of economics to some, in fact economists have been working on themes that we might today categorize as ‘behavioural economics’ for as long as economics has been around. Historically, economics had many links with psychology but as mathematical tools were used to simplify and structure economic theory, the subject moved away from psychological analysis. Also, with the increasing focus amongst economists on quantitative styles of decision-making, psychology’s focus on subjective motivations did not rest easily with economists’ focus on objective, analytical, mathematical methods of capturing economic decision-making via the observation of what people choose and decide. Economics went through something like a behavioural “dark age” – in which key insights from other social sciences were lost – until the major resurgence of behavioural and psychological economics in the 1980s and 1990s. In understanding why, it is useful to explore the historical development of behavioural economics and some of the behavioural approaches that preceded economics as we see it today – from David Hume in the 18th century through to Hyman Minsky in the 20th century. For a quick potted history see below, but more detailed accounts include Kao and Velupillai (2015) and Heukelom (2014).

David Hume (1711–1776)

Early analyses of economic psychology focused on the moral dimensions of decision-making. David Hume wrote with optimism of a society in which all people were benevolent:

If every man had a tender regard for another … the jealousy of interest … could no longer have place; nor would there be any occasion for … distinctions and limits of property and possession … Encrease to a sufficient degree the benevolence of men … and you render justice useless … ’tis only from selfishness and the confin’d generosity of men … that justice derives its origin.

(Hume 1739, pp. 547–8)

The role of the market in solving economic problems might be more complex than Hume suggests but the psychological forces of benevolence and philanthropy can be justified if there are market failures such as externalities and free-rider problems. Benevolence does imply some sort of interdependence amongst people’s utility and this is something that standard economic analyses of independent, atomistic agents cannot capture but it is a theme that has received a lot of attention in modern behavioural economics.

Adam Smith (1723–1790)

Adam Smith is widely attributed with founding the subject of economics (not entirely accurately) and he too was interested in the social and psychological dimensions of behaviour, even if his interests in these areas are not apparent in the caricatures of his thinking. Whilst his name is popularly associated with his rhetorical justification of free markets and the accompanying metaphor of the Invisible Hand of the price mechanism coordinating individual behaviour in socially beneficial directions, as described in An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Adam Smith also thought carefully about socio-psychological motivations. One key theme in his writings is the impact that social emotions have on our choices – foreshadowing a number of areas in modern behavioural economics, particularly models of social influence. In The Theory of Moral Sentiments (1759) he emphasizes the importance of imaginative sympathy in human nature: “How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him” (Smith 1759, p. 9).

Adam Smith foreshadowed the importance of sentiment in modern behavioural economics, with his emphasis on social, unsocial and selfish passions – focusing on the importance of vividness in events in determining how strongly we respond to them. Linking with modern analyses of bad habits and inconsistent plans he analyses self-deceit and the impact of customs and fashions – which are also the focus in modern behavioural economics analyses of social influences and group bias. Vernon L Smith (1998) notes that whilst on first inspection there may seem to be a contradiction between Adam Smith’s Wealth of Nations, emphasizing self-interest, and The Theory of Moral Sentiments, emphasizing sympathy – in fact these concepts can be reconciled if cooperation and noncooperation can both be understood in terms of a “self-interested propensity for exchange” in friendships as well as markets.

Jeremy Bentham (1748–1832)

Most famously, Jeremy Bentham was the founder of utilitarianism. He analysed a range of behavioural and psychological drivers of human action, especially the impacts of pleasures and pains. His conceptions of utility were focused on the balance of pain and pleasure and formed the basis for the emphasis on utility in modern economic theory. If welfare, utility and happiness are quantifiable, then right and wrong can be measured by reference to the greatest happiness principle: the greatest happiness for the greatest number. This principle has flaws in that it assumes happiness to be objectively quantifiable and easily aggregated, implying that people’s utilities are separable. One focus in behavioural economics is on unravelling what happens when utilities are not easily separable.

A second Benthamite principle – of psychological hedonism – was conceived as a guide for legislators, focusing on the assumption that people maximize their own self-interest. For Bentham, pain and pleasure are the “sovereign masters” motivating what we do (Harrison 1997). Something is good if the pleasure outweighs the pain; it is evil if the pain outweighs the pleasure. Legislators can formulate rewards and punishments to exploit this psychological hedonism principle and thereby promote the greatest happiness principle (Harrison 1997). Bentham emphasized the quantification of happiness and developed a hedonic calculus – a detailed taxonomy ranking key features of pleasures and pains. Bentham’s emphasis on happiness has its parallels in today’s happiness and well-being literatures.

Vilfredo Pareto (1848–1923)

Vilfredo Pareto is probably best known by economists for his mathematical rigour, his concept of Pareto efficiency and his influence in general equilibrium theory. Less well known is that he developed an interest in social psychology later in his career. He spent time specifying the nature of social relationships, foreshadowing modern behavioural analyses of social influence. In Trattato di sociologia generale (1916; translated to “The Mind and Society” in 1935), Pareto explored a range of behavioural/psychological influences and divergences between logical and non-logical conduct, focusing on feeling, residues (instincts) divided up into classes to explain individual differences and derivations (logical justifications) – paralleling the dual processing models seen in modern behavioural economics. He also recognized the importance of diversity in skills: in describing cyclical sociological forces, he explores how intergroup conflicts mirror a struggle between foxes and lions, adopting Machiavelli’s distinction between cunning foxes and courageous lions. This links to the idea in modern behavioural economics that there are differences amongst people – a challenge to the conventional economist’s assumption of homogeneity – that is that all people behave in the same way, on average at least.

Irving Fisher (1867–1947)

Irving Fisher is renowned for his early analyses of investment and interest rates and the balance between impatience to spend and opportunities to invest. He sets out the impatience principle in which the rate of time preference, what modern economists call the discount rate, captures the fact that interest is the reward for postponing consumption. These ideas about balancing present versus future pleasures and rewards form the bedrock of modern analyses of inter-temporal decision-making (Fisher 1930, Baddeley 2003). However, Fisher’s analysis of this principle suggests subjective, psychological motivations are driving choices. The “inner impatience” of consumers is balanced against “outer opportunities” for rewards from interest. Thaler (1997) emphasizes Fisher’s focus on “personal factors” as determinants of time preference. Fisher presciently explores the idea that time preference is affected by individual differences in foresight, self-control and willpower, and factors reflecting social susceptibility to fashions and fads – all ideas developed in modern behavioural economics. Thaler also argues that Fisher’s analysis of money illusion is another illustration of a way in which Fisher foreshadowed modern behavioural economics because it is a form of bias consistent in the analyses of Kahneman, Tversky and others. Fisher’s explains sluggishness in the adjustment of nominal interest rates in terms of people’s confusion about the difference between real and nominal values. This also links with Akerlof and Shiller’s (2009) identification of money illusion as one of the animal spirits constraining rational decision-making, as we will explore in Part III of this book.

John Maynard Keynes (1883–1946)

John Maynard Keynes was one of the 20th century’s great thinkers about economics – and he made key contributions to economic policy too – especially in the sphere of macroeconomics. The economists we have met so far focused mainly on the microeconomics of behaviour – how individual “agents” – people and businesses – make their decisions. When it comes to macroeconomics, capturing psychological and social influences on economic behaviour is much more complex – but these are themes that John Maynard Keynes was keen to explore. He focused on some key psychological drivers of behaviour and in The General Theory of Employment, Interest and Money, Keynes argues that economic and financial decision-making is driven by a series of fundamental psychological laws: the propensity to consume, attitudes to liquidity and expectations of returns from investment. Keynes applies his psychological analysis most clearly when analysing the interactions between the players in financial markets and the macro economy. Short-termist speculators, preoccupied by a thirst for liquidity, are driven by social influences and conventions to “beat the gun” and “outwit the crowd”. Thus, speculation becomes similar to parlour games such as Snap, Old Maid and Musical Chairs – in all these games, the winner is the person who says “Snap” just in time – neither too early nor too late.

Like Adam Smith, Keynes also strongly emphasized the role of emotion and sentiment in economic decision-making. In a world of fundamental uncertainty, judgments will rest on flimsy foundations, introducing fragility into macroeconomic and financial systems. Keynes argues that whilst a social view of economic progress requires a long-term view, longer-term outlooks cannot rest on strictly rational grounds because in a world of uncertainty it is rational for profit-seekers to focus on the short term. Paradoxically, it is the emotionally-based animal spirits of entrepreneurs that propel the far-sighted behaviours necessary to justify sufficient capital accumulation for sustained economic growth (Keynes 1936, pp. 161–2) – as we will explore in more detail in later chapters of this book.

For Keynes, economic behaviour is the outcome of a complex mixture of the rational and psychological/emotional. This fits with modern neuroeconomic models in which behaviour is the outcome of a complex interaction of emotion and cognition. There are further parallels: Keynes’s ideas about herding, reputation and beauty contests are resurfacing in modern models of behavioural economics including literatures on herding, social learning, reputation, beauty contests and animal spirits; for examples, see Bhatt and Camerer (2005), Camerer (1997, 2003b) and Ho, Camerer and Weigelt (1998) on beauty contests, learning and reputations. Keynes’s dual focus on reason and emotion also foreshadows the focus in neuroeconomics on interacting systems in the brain, for example Loewenstein and O’Donoghue (2004) assert that animal spirits are a reflection of the interaction of deliberative and affective systems.

Joseph Schumpeter (1883–1950)

Joseph Schumpeter was born in the same year as Keynes and his analyses of macroeconomic influences rivalled Keynes’s contributions – but he had a different conception of the drivers of macroeconomic fluctuations, focusing particularly on entrepreneurs as the heroes of the capitalist system.

Foreshadowing the modern emphasis in behavioural economics on the importance of social influences in driving corporate behaviour – for example, via corporate social responsibility initiatives. Schumpeter focused on the idea that entrepreneurship is driven by social forces but nonetheless is essential to the success of a capitalist economy. Social influences drive not only the outward-facing publicity initiatives of businesses, they also lead businesses to copy each other.

In Schumpeter’s analyse...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of figures
• Acknowledgements
• 1 Introducing behavioural economics
• PART I MICROECONOMIC PRINCIPLES
• PART II EXTENSIONS: POLICY, NEUROECONOMICS AND BEHAVIOURAL FINANCE
• PART III MACROECONOMICS AND FINANCIAL SYSTEMS
• Bibliography
• Index