People often are stubborn, miss out on advantageous deals, often procrastinate and sometimes act heroically. A lot of such behaviours puzzle the economist, because they appear to deviate from rational, utility maximizing behavior. But like all puzzles, they are in crying need of an explanation. Not only is this necessary to satisfy the intellectual urge, but sometimes important for policy as well. After all, if seemingly irrational decisions by individuals are standing in the way of improvements in their lives, then it is important to understand the reasons and provide the necessary nudges to push people into taking the correct decisions. Behavioural economics is one such attempt. The area can be broadly defined as the area that seeks to understand the impact of psychological, social, emotional and cognitive factors on decision making by individuals. As you can well imagine, behavioural economics is a very active academic agenda and has given rise to a great deal of research in some of the world’s leading journals. It is obviously impossible to discuss even a fraction of the research is a small note such as this. I will only discuss an important concept in behavioural economics, i.e. loss aversion that will give the reader a flavor of how this subject helps us understand seemingly irrational decisions.
Loss aversion is the idea that we value potential gains from a reference position less than potential losses from the same reference position. The function that maps potential outcomes into values is called the “value function”, a part of a construct called “Prospect Theory” that was introduced to economics in a famous paper by Daniel Kahneman and Amos Tversky in 1979. For example, assume that after your performance appraisal in your office, you are told that you have been promoted with a substantial pay rise. As you are enjoying this bit of good fortune, you are informed that the message in fact was not for you, but for somebody else and that your position and pay have remained unchanged. Most people will feel hurt, though their position has actually remained unchanged. This is the key idea behind loss aversion. Prospect theory also argues that when it comes to losses, people are more risk taking, while they are risk averse over gains. That is, most people will prefer a sure gain of Rs.50 compared to a lottery that gives nothing with 50% probability and Rs.100 with 50% probability, while when it comes to losses, they would prefer the lottery to a sure loss of 50 Rs. This gives rise to “framing effects”, that is, sensitivity of a decision to the manner in which questions are framed. Take the following example. Suppose a dreaded disease is sure to kill 600 people. Some people are presented with options A and B where option A if adopted, will save 200 people for sure, while with option B, there is a one –third probability that all 600 will be saved while there is a 2/3 rd probability that no one will be saved. Asked to choose, majority choose A. Others are given options C and D, where, if option C is adopted, 400 people will die, whereas with option D, there is a one-third probability that no will die and a two-third probability that all 600 will die. Asked to choose, majority choose D. That is because, prospect theorists argue, when the same information is presented as lives saved, people prefer the sure outcome, whereas when it is presented as losses, people prefer the risky bundle.
How does this help? In a study that we undertook, we found that about 43% of individuals from a sample of 700 people from various walks of life were indeed individually loss averse. One important insight that we have is if people are loss averse, they might be unwilling to undertake even perfectly sensible expenses. Boiling water before drinking is a small investment that one makes for future health. Yet, the expense for boiling is an out of the pocket expenditure, whereas future gains are uncertain and difficult to disentangle from other gains. Even when the discounted present value of the future gains outweighs the present cost of boiling water, loss averse individuals might not make that decision because they value the loss from the current position much more than the future benefit. An educational programme that highlights the benefits along with a fuel subsidy for those who boil water may lead to improvements in public health. Because people compare gains and losses from a present position differently, trades may not happen simply because from the sellers point of view, the loss attached to parting with the article may be far higher than the value that the buyers put on possession of that article. That could be the reason that some articles may be quite hard to sell. Another crucial insight is that communication matters. How you present the information impacts the decision. If you are selling cars with advanced safety features, presenting information about lives saved because of the safety features may lead to different buying decisions compared to when the same information is presented in terms of lives lost. Food articles may sell better if they are advertised as “80% fat free” rather than “20% fat”.
Loss aversion is one crucial building block in the literature. There are several others. Good behavioural economics is strongly grounded in formal theory and has implications that can be empirically tested. A good deal of experimental economics is involved with testing such implications. From this perspective, behavioural economics is different from psychology or other disciplines that also study the impact of social and psychological factors in human decision making. Its ability to derive testable implications also makes it different from the airy-fairy marketing jargon that is often sold as science. Behavioural economics has the potential to add significant value to our understanding of human decisions.