Richard Thaler won the Nobel Prize for Behavioural Economics this October, paving the way for this multi-disciplinary field to be reverently included in the realm of economics. While Daniel Kahneman did receive the first Nobel Prize for his pioneering work with Prospect Theory, Thaler’s recent recognition allows for the entry of this quirky blend of psychology, business studies and economics into the mainstream.
The underlying basis of behavioural economics is cognitive bias. Basically, no matter how logical and “rational” we claim our decisions are, we will always tend to be a little more Watson than Sherlock Holmes in our choices. Opposing the assumptions laid out by traditional economics, behavioural economists maintain that people do not naturally choose the most optimal course of action. This phenomenon can be explained with the concept of risk aversion.
Prospect Theory by Kahneman and Tversky published in ‘Econometrica’ was one of the ground-breaking concepts put across in the 1970s that challenged the commonly accepted ‘Expected Utility Theory’. It is based on decision making processes that involve risk and uncertainty; how people think about utility with respect to a reference point rather than absolute outcomes. The context plays an important role and the way choices are framed affects our willingness to take risks. The following example can illustrate the basic idea behind it:
Which of the following would you prefer:
A) A certain win of $250, versus
B) A 25% chance to win $1000 and a 75% chance to win nothing?
In an alternative situation, would you pick:
C) A certain loss of $750, versus
D) A 75% chance to lose $1000 and a 25% chance to lose nothing?
Tversky and Kahneman’s work shows that responses are different if choices are framed as a gain (A&B) or a loss (C&D). When presented with the first set of options, the likelihood of people picking A over B is higher. Contrary to that, in the second set of options people would be more willing to pick D over C. The inferences drawn from these choices are: with the first set of options with gains, the definite option will be chosen while in the second set, there is a higher tendency to choose the lottery option. The dislike for losses is higher than that of an equivalent gain. Losing and giving up something is far more painful that the pleasure derived from receiving it. This demonstrates the simple principles of human risk aversion.
There are a variety of applications for the paradigm of prospect theory in today’s world; these range from public health policies to applications in marketing and finance. One of the more creative applications of prospect theory that has caught the public’s attention recently is how it explains the votes in favour of Trump and Brexit. To explain why voters rejected a safer option, Quattrone and Tversky in the year 1988 explained that people have a higher probability of choosing risk seeking attitude when the general consensus among the citizens is that the country has been at a loss lately. In the US as well as the UK, dissatisfaction with the prevalent economic conditions and growing inequalities have been cited as the primary cause for the growing frustration among the public. A large majority of the public believe that the situation is much worse than it ought it to be.
Looking at the aforementioned example, it is evident that within a loss framework, the risky choice is opted for. Trump was very clearly the lottery option among the presidential candidates. Due to his unpredictable nature, contradicting statements (eg. his going from pro-choice to pro-life but still supporting the core tenets Planned Parenthood) and having funded both Republicans and Democrats running for office over the years, it was evident that there was no telling what he would do as President. His frequent outrageousness and problematic statements strengthen the spontaneous image he aimed to build.
The political discourse of the Trump and Brexit advocates has framed the stakes in terms of losses rather than gains. The slogans “Make America great again” and “Take back control” clearly refer to the lost grandeur of the past. Additionally, the fear mongering carried by these campaigns reinforces the frightfully terrible image of the present world that they wish to portray. It warned the voters about the urgency of the situation while creating a loss framework. Trump reinforced the predominant fear of extinction of the white working class due to increasing diversity and reminded them of their stagnating wages. These factors combined, motivated voters to favour risky options: the gains, even if they are unlikely, are so strongly desired that they induce discounting the very likely losses. It encouraged them to indulge in a political lottery, to choose a personified political lottery like Trump.
The Lockean Exclamation
Another theoretical explanation for the Trump vote is based on a concept proposed by Cass Sunstein named ‘The Lockean Exclamation’. It derives its name from the popular character John Locke who often exclaims, “Don’t tell me what I can’t do!” during pivotal moments. Its emergence dates back to 1981 when Brehm & Brehm pointed out the tendency of people to carry out a task solely based on the fact that they’ve been told to not do it. Known as the principal of reactance, when people feel that control is no longer in their hands, they rebel. They do so even in situations, they know will not bring them any direct benefit. On the contrary their actions could even aggravate the condition further causing even more harm. The intrinsic value of control is much higher than that perceived by economists. The echo-chamber reminding voters of Trump’s debatable stands towards immigration and periodic sexism may have been instrumental in creating a bubble of public opinion. This judgement may be perceived as an imposition on individuals to stand against him thereby creating a controlled framework within which one is meant to act and make decisions.
Behavioral economics is a burgeoning field with numerous interesting applications that tear down and challenge conventional economic theory. The idea of Trump being elected due to him being a lottery clubbed with a false sense of control derived from voters is interesting to say the least.
Useful readings for this field would include:
Thinking Fast and Slow – Daniel Kahneman
Nudge – Cass Sustein and Richard Thaler
Choosing Not to Choose: Understanding the Value of Choice – Cass Sustein