Ethos Perspectives

Behavioural Economics

The life-cycle theory in standard economics was developed in the 1950s and 1960s as a model for understanding savings behaviour. Its central assumption, typical of neo-classical economic theory, is that human beings are rational economic agents. It assumes three things: first, that human beings are fully capable of calculating the amount they would earn over the course of their working lives; second, that they can figure out what they would need for their retirement; and finally, that they would have the discipline to save enough for a comfortable retirement. If these assumptions were true, people would generally be financially stable and comfortably living out their golden years. Yet, people typically under-save for the future. Why is this so?

Conventional economic theory offers some explanation to this puzzle. First, it argues that people are liquidity-constrained, and therefore do not save as much as the life-cycle theory suggests. Second, capital markets are usually not as well-developed as the theory assumes; consequently, people may find it difficult to borrow against future incomes to fund present consumption needs.

Conventional economics, however, does not question the assumption that human beings are inherently rational. Surely, under-saving for one’s own future betrays an element of human irrationality. In this respect, conventional economics offers an incomplete analysis of real human savings behaviour.

Indeed, the recent years have seen a growing perception internationally that standard economic models are inadequate for understanding and predicting human economic behaviour. In the light of this, behavioural economics as a multi-disciplinary sub-field has emerged to provide better explanations for human economic decision-making. Combining economic analysis with an understanding of human psychology, behavioural economics questions long-held assumptions of human rationality and impartiality—assumptions which have always been foundational to neo-classical economic analyses. By suspending the assumption of complete human rationality, behavioural economics offers a richer explanation of real-world human behaviour.

Key Concepts in Behavioural Economics
Bounded Rationality
Many standard economic models assume that people, being rational economic agents, would not make decisions that violate their preferences. In the 1950s, political scientist Herbert Simon suggested that people make irrational and sub-optimal choices, despite available information, because there is a natural limit to the human ability to process data and handle complex computations. We may therefore end up under-saving, simply because we underestimate or miscalculate the amount we need for retirement.

A related concept is that of hyperbolic discounting—the irrational human tendency to disregard the future in present-day decision-making. As the future is distant and unpredictable, we tend to disregard the longer-term consequences of our actions in favour of present-day gains. Inadequate savings for retirement is therefore largely the result of people choosing short-term gratification (current consumption) over longer-term rewards (more savings for their golden years).

Bounded Willpower
We sometimes fail to make rational and optimal choices because we succumb to temptation and procrastination. The primary cause of insufficient savings, for example, appears to be a lack of self-control on the part of households to reduce current consumption in favour of future consumption. In the United States, forced savings plans and home ownership rules are in place to help individuals overcome this lack of willpower. Social security and mandatory defined-benefit pension plans require little willpower on the part of participants, while monthly mortgage bills force homeowners to build up equity. These systems are important in helping individuals accumulate retirement wealth, as any disposable income not immediately locked away or channelled into forced savings plans tend to be quickly spent away.

Loss Aversion
People are also naturally loss-averse. Once a person takes ownership of something (money, material objects, even other people), he attaches a premium to his ownership of it, and would tend to be reluctant to let it go. Letting it go would be seen as a loss, which is felt more keenly than a gain of similar value. Neo-classical economic theory generally assumes that people are neutral to losses and gains. Behavioural studies, however, have shown that people attach a higher value to losses and are thus more willing to take risks to avoid losses than to make gains. This often translates into a difference between their willingness-to-pay (for a good) and their willingness-to-accept (compensation for a loss). For example, if residents were asked the same question in two different ways—how much they are willing to pay to maintain the public park in their neighbourhood versus how much they demand to be paid to give up that park—the answer to the latter question would invariably be higher. Loss aversion also suggests that penalties and disincentives would have a stronger effect than incentives of the same value.

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