WHY are credit card interest rates so high, despite the competition? Why don’t hotels ever feel the pressure to reduce the prices of their mini-bar? Why do most people undersave for retirement? And why is tax taken at the source likely to incur less resentment than taxes that are actively paid?
Explaining such idiosyncrasies is the terrain of an emerging field – behavioural economics – that challenges one of the most fundamental assumptions in the field: that of the ‘rational economic man’.
Traditional neo-classical economic theory – defined perhaps most strongly in the public mind by Adam Smith’s The Wealth of Nations – argues that consumer behaviour is, essentially, a logical sequence of choices. But in practice, when subject to scientific observation, people’s choices, it turns out, are not always logical or consistent.
The field staked its claim when it picked up a Nobel Prize for Economic Sciences in 2002. American economists Daniel Kahneman and Vernon Smith shared the award, with Kahneman recognised for having integrated insights from psychology into economics, and Smith for developing an array of experimental methods for conducting empirical economic analysis.
The theories are taught in many US and European universities as core units. In Australia they are beginning to catch on, with the approach incorporated into a number of economics offerings in the Curtin Business School (CBS).
“People make decisions that can be seen as naive and undisciplined,” explains Associate Professor Michael Thorpe, Head of the Department of Economics in CBS.
“In fact, other influences – including social, cognitive and emotional factors – are at play. The notion that consumers make sub-optimal choices – or, in some cases, no decision at all – has been found to reflect a kind of myopia, an undue weight on short-term gratification rather than on long-term rewards.
“Take, for example, payments of credit cards in light of accumulating high interest rates. While it’s logical to pay credit card bills on time so as to minimise accumulation of interest, some people elect not to do this, and to pay more. Why is this?
“People have different consumption habits and self-expectations, and live in different social and historical contexts. This means that we find competing motives among different consumer groups, with information interpreted differently – hence the presence of the odd practices around mini-bar prices and credit card interest rates, among others.”
Researchers have also found that people react more strongly to a loss than to a gain in income, and that they assign extra value to something they consider their own. Furthermore, the willingness to pay is not equal to the willingness to accept. All of these factors mean that consumer behaviour is far from what we consider, traditionally, to be rational and consistent.
“Consumer behaviour is fundamentally conservative,” adds Professor Adrian North, Head of the Department of Psychology and Speech Pathology at Curtin. “There are many biases to our behaviour around choice. Just one example is what we call the ‘ambiguity effect’, where people will always choose the option where the outcome is known. We are, essentially, risk-averse.”
THE implications for institutional policy are not insignificant. The economic decisions consumers make can affect how banks assess interest rates and how governments frame policy.
Governments can expect people will follow the path they set because consumers are influenced by default situations. For example, a federal superannuation scheme can frame its policy in one of two ways: it can give consumers the choice of opting in, or it can explain that people will be automatically enrolled in the scheme and can choose to opt out. Research shows that most people will follow the path set by the government, with a significant effect on the outcomes of a scheme or policy.
Consumer behaviour can affect larger macro-economic movements, too. It can influence the performance of individual firms and, if pervasive enough, an entire sector of an economy. And it can accentuate boom and bust cycles. The share market presents an obvious case in point: ‘peer pressure’ can create bubbles in an asset market, and a ‘herd mentality’ has brought rapid instability – such as the 1950s rush on banks or the mass exit from the market during the global financial crisis.
“Behavioural economics research is testing and modifying some basic economic assumptions,” says Thorpe. “This has to enrich our understanding of the very complex and important field of economics – one that is far from being an exact science.”