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Behavioural
Economics and Its
Applications to Public
Policy
Shubham
2177

II Year, B.A., LL.B.(Hons.)

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Introduction
The field of Behavioural Economics is relatively new to the world since it has become a
mainstream field of study only about ten years ago. Behavioural economics increases the
explanatory power of economics by providing it with more realistic psychological
foundations. This paper is intended to provide an introduction to the approach and methods of
behavioural economics, and to some of its major findings, applications in the field of policy
making. In the study and application of policy making, interdisciplinary approach of
behavioural economics is taken into account, with respect to pension schemes in India
(Modiglianis Model), Mutual Funds had been discussed in detail. Firstly, the paper explains,
what is Behavioural Economics, and then explains the basic principles and method involved
with application of the Behavioural Economics on Policy making, with successful examples
from the UK. Secondly, it has been discussed in the conclusion whether the policy indeed is
successful or not, in the given fields or not and whether it can be applied successfully in the
prospective fields as well.

What is Behavioural Economics? How is it different from

Conventional Economics?
The study of neo-classical economics revolves around the decision making of distribution of
a limited amount of resources, which have alternative uses, into the entities which then
exploit them resulting in production of end products. Now, the said meaning rests on certain
basic assumptions which give the basic structure to the meaning, first being that people have
rational preferences among outcomes that can be identified and associated with a value.
Second being, individuals maximize utility (as consumers) and firms maximize profit (as
producers) and third being, people act independently on the basis of full and relevant
information.1
The concept of Behavioural Economics is a very different branch of the discipline as, in
behavioural economics, according to the conventional meaning, people making irrational
decisions due to variety of factors such as, when complexity leads to use of heuristics2 i.e.,
people making an educated guess so as to solve the problem goals, another one can be when
1 Alain Samson , The Behavioural Economics Guide 2014, 13, (2014), available at,
http://www.behavioraleconomics.com/BEGuide2014.pdf
2

risk preferences are not as standard economics. All in all, Behavioural economics increases
the explanatory power of economics by providing it with more realistic psychological
foundations which is relevant for empirical behaviour rather than the theoretical one.
At the core of behavioural economics is the conviction that increasing the realism of the
psychological foundation of economic analysis will improve economics on its own terms
by generating theoretical insights, making better predictions of field phenomena, and
suggesting better policy making. The neoclassical approach is useful because it provides
economists with a theoretical framework that can be applied to almost any form of economic
(and even non-economic) behaviour. For illustration, Rational Economics suggests people
save for retirement in order to smooth their consumption (lifecycle savings hypothesis). In the
simplest case, people should save while they work and then draw down savings in retirement.
Peoples savings rate should increase as they get older because their income tends to rise. The
precise pattern is affected greatly by having children and other dependants. A higher rate of
return reduces the need to save, whilst a lower one increases it. Debt and wealth (eg
inheritance) can make a big difference to savings profiles. A flat savings profile, as often
assumed, is only applicable for a tiny minority But millions of people are not saving at all for
retirement and many more are not saving enough.3

2Colin F. Camerer, Behavioral Economics: Past, Present, Future, 4,(2002),available

at:http://nowandfutures.com/d2/BehavioralEconomics(conventional)ribe239.pdf.
3Tim Harford, Behavioral Economics and Public Policy, FINANCIAL TIMES ,available
at:http://www.ft.com/cms/s/2/9d7d31a4-aea8-11e3-aaa600144feab7de.html#axzz3lDDifUFy.
3

BASIC PRINCICIPLES AND METHODS

One of the pioneering figures of Behavioural Economics, Daniel Kahneman, notes with some
frustration that his work is frequently described as demonstrating that human choices are
irrational.4
There are researchers who argue, partly on empirical grounds, that the systematic behaviours
uncovered by BE often, perhaps even mostly, produce good outcomes for economic agents,
so it is perhaps unwise to imply otherwise by definition. All agree that it is partly the use of
psychology that makes BE distinctive. Wide range of experiments and research find that
peoples behaviour is affected by a range of things that rational economics would not expect
at each of the key decision points in the lifecycle of pension saving. People say they will save
4Behavioural Insights Team, Applying behavioural insight to health, 7(2010), available
at:https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/60524/4039
36_BehaviouralInsight_acc.pdf
4

and then dont, and people wish they were. Savings rates increase if it is easier to save, and if
people pre-commit to increases. The investment options offered to people change investment
allocations and too much choice puts people off. People often seem to stick with the default
annuity provider, even when there is better value to be had in the market 5. In addition,
provision

uneconomic

for

low-middle

earners

in

SMEs.

A primary goal of public policy is to increase market efficiency by remedying market failures
(to the extent possible). The typical taxonomy of market failurespublic goods, externalities,
information asymmetries, and market powerfocuses on inefficiencies that relate to either
market structure or the incentives of market participants and gives rise to policy tools
designed to change either market structure or the incentives of market participants. The tools
conventionally employed in this effort include shifting market prices through either taxes or
subsidies, regulating output, and mandating information disclosure. The traditional analysis
of market failures and the impact of public policy on market outcomes assumes that market
actorsconsumers and firmsare rational in their behavior, carefully weighing their own
costs and benefits in making economic decisions.
In Indian Pension Schemes, the use of Behavioural Economics has been used; Pension Fund
Regulatory and Development Authority (PFRDA) is a body set up to develop and regulate
Indias pension sector. PFRDA has initiated what is called as New Pension System (NPS). It
has many innovations- defined contribution plans, professional fund managers, web based
system to track investments etc. One can see the PFRDA website for details.
They released a regulation document for investments in NPS. It is an excellently written
policy report. The aim is to answer these questions:
There is considerable evidence from pension systems world-wide that pension contributors
tend not to make an explicit choice for their pension investment. Thus, one of the central
5Adam Oliver,
From Nudging to Budging: Using Behavioural Economics to Inform Public Sector Policy ,
12,(2013) available at:https://intranet.weatherhead.case.edu/document-upload/docs/1139.pdf.
5

discussions in pension fund management has been the definition of the default -where the
contributions are invested when the pension participant does not make an explicit choice.

Once the default option was designed, who manages the funds in the default choice
funds?

What would be framework for evaluation of the default choice PFMs?

PFM means Pension Find Manager; it also calls default option as auto choice.
The report is quite honest in admitting that maximum choice would be auto which is great to
begin with. It goes with the basic assumption that people do not understand basics of finance
as well and need a nudge.
Defined Contribution means people will have to choose their own pension plans (which
assets equity, debt to invest in and in what proportion). It first lists eligible assets for
investments and puts them in categories like E (equities it suggests only index finds, an
excellent idea), G (Govt Bonds, Fixed Deposits at Banks), C (Corporate Bonds, State Govt
Bonds etc).6
Once we have these next case is to distinguish between someone who can allot weights
across assets (active investor) and someone who cannot. For all falling in latter, they are
allotted auto choice and a plan is to be designed for them. Should we have one default
choices for all?
No. NPS classifies default strategy on the basis of age. Young people should have higher
weight towards equity and older towards G. It chooses age bracket of 35 -60 when the shoft
would start from equity to debt.
1. The highest risk-tolerance weight set at the start (wEs ;wGs ;wBs)
2. The lowest risk-tolerance weight set at retirement (wEe ;wGe ;wCe). In NPS, these
weights are proposed to be set to wEs = 10%;wGs = 80%;wCs = 10%

6 Aldo Rustichini , Ken Binmore,Review: Two Reviews of "Behavioural Economics and Its Applications", The
Economic Journal, Vol. 118, No. 529, Features (Jun., 2008), pp. F244-F251.

3. The rate at, and the frequency with, which each weight (wEs ;wGs ;wBs) decreases. In
NPS, the weights will be adjusted every year from the age of 36. If we start with an equity
weight of 65%, government bond weight of 10% and credit bond weight of 25%, the
adjustments will be linear as follows:
(a) Each year (from age 36) wE will decrease by 2.2.
(b) Each year (from age 36) wG will increase by 2.8.
(c) Each year (from age 36) wC will increase by 0.6. wEs ;wGs ;wCs). In NPS, these are
proposed to be set to wEs = 65%;wGs = 10%;wCs = 25%
It also suggests that funds that fall under auto choice should be distributed equally amongst
PFMs and those that perform better (low costs higher returns) should be replaced. It also
provides an analysis of why it chose the above asset allocation for auto choice. They do
portfolio simulations based on previous data. They find though portfolio value is much
higher if more equity is taken (say 80%) it is also the case that the losses could also be higher.
Likewise, it provides a reason for shifting portfolio from 35 yrs onwards as well. Earlier RBI
Deputy Governor had mentioned usage of Nudges for selling/choosing financial products.
And now this direct application in managing pensions.7
Consider first a market with a positive externality such as that for influenza vaccines. A
traditional analysis of such a market would assume that all actors are fully rational and make
decisions that maximize their own private benefit. An introductory economics textbook might
depict the outcome in this market as shown in Figure.

7Brigitte C. Madrian ,Applying Insights from Behavioral Economics to Policy DesignAnnual Review of
Economics, Vol. 6, (2014), pp. 663-688

D1 shows the observed market demand curve, traditionally taken as the marginal private
benefit to consumers from being vaccinated against the flu, whereas D2 shows the marginal
social benefit that accrues to society from vaccination. Because this is a market with a
positive externality, D2 lies above D1 . The socially optimal quantity of vaccines, Q*, equates
the marginal cost of vaccines (as indicated by the supply curve, S) with their social marginal
benefit, but this exceeds the quantity that will prevail in the private market, Q1 , when
individuals make vaccination decisions purely on the basis of their own private marginal
benefit. The triangle denoted DWL shows the social deadweight loss from the under
provision (relative to what is socially optimal) of flu vaccines in this market. The traditional
policy tools that an introductory economics textbook would advocate in such a market are
either (a) to subsidize vaccination (change the price) or (b) to mandate a 8 vaccination level
equal to Q* (regulate the quantity). The first option, a subsidy, could be directed to either
consumers or suppliers of the vaccine. In either case, the impact of the subsidy is to drive a
wedge between the supply curve, S, and the observed demand curve, D1 , equal to the
amount of the subsidy. Suppose the subsidy is given to consumers. Their private marginal
benefit from vaccination now increases from its previous level by the amount of the subsidy.
If the subsidy is set at its socially optimal level, the private marginal benefit curve shifts up
from D1 to D2 , and the new equilibrium is the socially optimal vaccination level, Q*.

There is, however, a cost to provide the subsidy that moves the market from Q1 to Q*. The
subsidy, s, is paid to all consumers of the flu vaccine for a total cost equal to the area of
rectangle ABCD in Figure. If funding this subsidy requires distortionary taxation, economic
efficiency can be improved if there is a lower-cost way to shift vaccination demand to the
socially optimal level. The traditional rational actor framework assumes that individuals
make vaccination decisions by comparing the marginal benefit of vaccination with the
marginal cost. If the private marginal benefit exceeds the private marginal cost, consumers
get the vaccine; otherwise, they do not. In this framework, providing a subsidy to consumers
increases their marginal benefit, while providing a subsidy to suppliers decreases the
marginal cost.
But there are other factors that also influence vaccine demandthe ceteris paribus in our
economic models. One of these factors is the psychology that underlies how individuals do,
or do not, think about decision tasks such as whether to get a flu vaccine. This is where
insights from behavioral science can help shape more cost-effective public policy. Modifying
the ceteris paribus may be a less expensive approach to behavior change than applying the
policy tools traditionally wielded by economists. For example, although there may be a
significant gap between Q* and Q1 , not all of that gap may result from a wedge between the
private and social marginal benefit of vaccination. For example, individuals may intend to get
a flu vaccine but fail to follow through (e.g., their employer may offer a free workplace
clinic, but they forget which day the clinic is open).
In the context of Figure, there may be a much smaller wedge between the private marginal
benefit and the social marginal benefit of getting a flu shot; rather, individuals may fail to act
on their private marginal benefit because they are inattentive, and it is this inattention that
drives most of the wedge between D1 and D2 . In this scenario, D3 is the true private
marginal benefit curve, but D1 is the demand curve that we observe; the difference between
the two results from consumers inattention. Providing a subsidy may do little to change
market outcomes in this case; if most consumers already perceive the marginal benefit as
close to the marginal cost, further increasing the marginal benefit does not change the
calculus about whether or not to get a flu shot. If attention is endogenous, then a subsidy may
effect some behavior change by motivating greater vigilance about when and where the
vaccination clinic will occur. But if attention is the primary problem, and the problem is not
that the private marginal benefit is less than the marginal cost, there may be lower-cost policy
9

interventions to redirect attention (the shift observed in demand from D1 to D3 ) and move
the market equilibrium closer to Q*. Possible interventions that directly address the problem
of attention include reminding individuals more frequently or making reminders more salient,
encouraging individuals to make a concrete plan about when and where they will get their flu
shot, and moving the vaccination clinic to a central location to increase visibility. The first
two interventions are practically free; the third, changing the location of the vaccination
clinic, may impose some costs, but these costs are potentially much lower than the costs of
providing a subsidy to everyone who gets an influenza vaccine. Note that there may still be a
role for traditional policy tools such as subsidies to change behavior.
In reality, we may have heterogeneous consumers who vary both in their degree of 10
inattentiveness and in the extent to which they internalize the positive externalities of
vaccination. For those individuals whose private marginal benefit is substantially lower than
their marginal cost, interventions to remind or help them plan to get vaccinated are unlikely
to change behavior because they fail to make vaccination attractive. In this case, a policy
intervention that changes the individual cost-benefit calculus is needed. A subsidy to
consumers will make getting the flu shot more attractive by increasing the private marginal
benefit. Similarly, a subsidy to providers will decrease the marginal cost and make it more
likely that the benefit to consumers of vaccination exceeds the cost. If part of the cost of
getting a flu shot is the time cost of getting to the vaccination clinic, then moving the clinic to
a central location is an intervention that potentially kills two birds with one stone: For
attentive consumers who fail to vaccinate because the cost (inclusive of time) exceeds their
private benefit, changing the location of the clinic reduces their marginal cost; for inattentive
consumers who fail to vaccinate because they forget when the flu clinic is, changing the
location of the clinic provides an effective visual reminder to get a flu shot. More generally,
in thinking about what types of policy tools are likely to be most effective at generating
behavior change, a useful starting point is to examine how aligned individual preferences are
with the socially optimal outcome. Sometimes individual preferences may be much closer to
the social optimum than what is observed in the market. If so, there must be some barrier to
behavior change other than the private marginal cost exceeding the private marginal benefit;
in this case, helping individuals execute on their preferences may go a long way toward social
efficiency.8
8 Brigitte C. Madrian, Working Paper Series, Applying Insights From Behavioral Economics
To Policy Design, National Bureau Of Economic Research, available at
10

Conclusion
If, alternatively, there is a significant wedge between what is individually and what is socially
optimal, then there may be a role for policy in changing the cost-benefit calculation. In some
cases, this may be best accomplished through the traditional tools of public policy. In others,
there may be more cost-effective approaches to increasing the private marginal benefit or
decreasing the marginal cost to effect behavior change; behaviorally informed interventions
that target perceived costs and benefits are examined. But the bottom line is that in almost
any circumstance, understanding what impedes individuals from taking a desired action helps
inform the most productive margins along which to target a policy intervention.

http://www.nber.org/papers/w20318.
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