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Behavioral Economics and Happiness 1 Running Head: BEHAVIORAL ECONOMICS AND HAPPINESS

Behavioral Economics and Happiness: Can the former impact the latter? Scott Thor George Fox University Edited Using APA 5th Edition

Behavioral Economics and Happiness 2 Abstract The field of economics has progressed significantly over the last several centuries, beginning with its establishment as a separate discipline by Smith in the 1700s, and evolving more recently into numerous sub disciplines such as behavioral and happiness economics. The field of psychology was yet to be established during the birth of economics, but an argument can be made that early economic scholars did not exclude psychological factors into their thoughts on the subject. A gradual transition to a purely quantitative approach emerged as the discipline progressed, and psychological factors were considered irrelevant in the economic models that assume individuals always act rationally. Recently, a transition has begun to take place suggesting irrational behavior cannot be ignored, which has led to the field of behavioral economics discussed in this paper. Behavioral economists argue that a greater understanding of irrational behavior may lead to advancements in the field of economics. This paper also argues that by increasing the understanding of irrational behavior we may also uncover opportunities to increase happiness. Happiness economics has emerged as a sub discipline of economics over the last several decades and seeks to understand what makes us happy. This paper also provides a historical overview in the study of happiness, and offers suggestions on how behavioral economic theory may help increase levels of happiness. The paper also explores the historical influences in both fields of study. A final discussion point includes criticisms of behavioral and happiness economics by many researchers and scholars who suggest the experimental and subjective nature of both adds little value to economic thinking.

Behavioral Economics and Happiness 3 Introduction Little argument is needed to suggest that increasing happiness is a worthy endeavor. We all strive to live a life in which we seek happiness through a variety of means. Even the founding fathers of the U.S., who included the pursuit of happiness in the Declaration of Independence, believed happiness was, and one could argue still is, a critical element to the foundation of the country. The challenge then becomes understanding what makes us happy, and how we position ourselves to maximize opportunities to create happiness. The field of economics provides one potential source in understanding both how to improve happiness, and the potential discovery of factors contributing to increasing levels of happiness. The evolution of economics has progressed significantly since Smith helped to establish the discipline in the 1700s. Over the past several centuries the field of economics has evolved, transitioning from a study in which psychological factors were once considered, to a primarily quantitative approach, placing a heavy emphasis on rational behavior represented by statistical models (Camerer & Loewenstein, 2004). The pursuit of perfection in the quantitative models used by economists make the assumption that individuals always act in a rational manner, and have all available information needed to make a correct decision when faced with several choices. Two psychologists, Tversky and Kahneman (1974), argue that individuals do not always act rationally, and often rely on a number of heuristics that sometimes lead to systematic errors when faced with making a decision. If the arguments made by Tversky and Kahneman are valid, as many modern economists believe (Ariely, 2008, 2009; Camerer

Behavioral Economics and Happiness 4 & Loewenstein, 2004; Tideman, 2005), the foundation of rational thinking represented in economic models may not be as accurate as once thought. The early work done by Tversky and Kahneman gave rise to what has become the economic sub discipline of behavioral economics. Camerer and Loewenstein (2004) describe behavioral economics as a way to increase the “explanatory power of economics by providing it with more realistic psychological foundations” (p. 3). The authors argue that behavioral economics provides a means for generating additional economic insights, which result in better predictions of field phenomena, ultimately leading to better policies. Camerer and Loewenstein suggest that behavioral economics is not meant to replace the neoclassical approach, but does provide a basis on which to add to the foundations of economic thought rooted in the neoclassical perspective. During the same time in which behavioral economics was emerging as a sub discipline of economics so to was the study of individual happiness. This research would eventually lead to the development of another sub discipline of economics described as happiness economics. Graham (2009) defines happiness economics as “an approach to assessing welfare which combines the techniques typically used by economists with those more commonly used by psychologists” (p. 6). Stated in more general terms, happiness economics can be described as a combination of psychology and economic techniques for better understanding a society’s level of happiness through quantitative analysis, typically assessed by individual surveys. Easterlin (1974) conducted what has become seminal work in the field of happiness economics that led to the development of the “Easterlin Paradox” (Graham,

Behavioral Economics and Happiness 5 2009, p. 12), which argues that within a society the rich are happier than the poor, rich societies tend to not be happier than poor societies once basic needs are met, and as countries become wealthier they do not get happier. Since Easterlin’s early work, the field has emerged into an exciting body of research that has uncovered several elements that have been argued to have a relationship with levels of happiness. The primary focus of this paper is to explore behavioral and happiness economics. The paper provides a historical overview and detailed discussion describing the evolution of behavioral and happiness economics. Both fields of study are not without critics, and discussions on the criticisms of both economic perspectives are also reviewed. A final aspect to the paper is a discussion into whether or not the possibility behavioral economic thinking may have a positive impact on increasing happiness. Behavioral Economics Camerer (2006) describes economics as “a collection of ideas and conventions which economists accept and use to reason with. Namely, it’s a culture” (p. 2). Behavioral economics, as Camerer states, “represents a change in that culture” (p. 2). One could argue the field of economics has been in a constant state of change since it emerged as a separate discipline in the 1700s, but the rise of behavioral economics over the past few decades may represent one of the most radical changes in economic theory since classical economic thinking emerged. Defining Behavioral Economics No standard definition of behavioral economics exists, but several researchers, scholars, and authors have offered their perspectives on defining the developing body of knowledge. Mullainathan and Thaler (2000) describe behavioral economics as a

Behavioral Economics and Happiness 6 combination of psychology and economics that seeks to understand what happens when individuals within a market display human limitations and complications. Diamond and Vartiainen (2007) suggest behavioral economics is an “umbrella of approaches” (p. 1) that seeks to build on the conventional economic framework to account for human behavior not modeled into traditional economic designs. Angner and Loewenstein (2007) reinforce the aforementioned descriptions, adding the emphasis that behavioral economics provides a means for improving the explanatory and predictive power within economic thinking. Thus, behavioral economics can be summarized as a melding of psychology, sociology, and economics that provides an approach to better understanding why individuals make decisions, that in the view of traditional economic thinking, are irrational. The Need for and Benefits of Behavioral Economics Why is behavioral economics a worthy endeavor? What benefits can be derived from a better understanding into why individuals make decisions that are not based on rational thought? Behavioral economists offer several answers and arguments to these questions, most of which suggest that behavioral economics fills a critical gap left void by conventional economic thinking. Mullainathan and Thaler (2000) argue that conventional, or neoclassical, economic thinking views the world as being populated by unemotional, calculating maximizers known as “Homo Economicus” (p. 3). The Homo Economicus, what Thaler and Sunstein (2009) describe as “economic man” (p. 6), suggests we all think and make choices without mistakes. This view of economics argues for an “anti-behavioral” (Mullainathan &Thaler, p. 3) perspective long considered a cornerstone in neoclassical

Behavioral Economics and Happiness 7 economics. Mullainathan and Thaler suggest that neoclassical economists who argue that markets will wipe out irrational behavior are optimistic. They argue that based on recent empirical and experimental research, behavioral economists suggest the power of irrational behavior cannot be eliminated based on what neoclassical economists believe is a self-correcting “invisible hand” (Mankiw, 2008, p. 10) described by Smith as the forces of supply and demand, self-interest, and competition. Behavioral economics, argue Camerer and Loewenstein (2004), also offers an opportunity to create better policy. An argument can be made that if individuals frequently make irrational acts, by better understanding this behavior economists have the potential to improve not only markets, but also society as a whole. Mullainathan and Thaler (2000) provide a summation to the need and benefits of behavioral economic research, which they describe in two key elements. First, the field of research identifies ways in which actual behavior differs from the standard models, and second, behavioral economics illustrates how this behavior matters to the economic environment. Evolution of Behavioral Economic Thinking An argument can be made that behavioral economics was born out of research grounded in the field of cognitive psychology. Tversky and Kahneman (1974), both psychologists, are widely recognized as providing the impetus for which a number of behavioral economic concepts and theories are based upon (Angner & Loewenstein, 2007; Camerer & Lowenstein, 2004; Diamond & Vartiainen, 2007). The psychologists suggest individuals are biased in their judgments and often rely on a series of heuristics, often described as “rules of thumb” (Mullainathan & Thaler, p. 5), which can lead to systematic errors in judgment. Kahneman and Tversky (1979) have also challenged

Behavioral Economics and Happiness 8 expected utility theory, which argues that decision makers choose between uncertain or risky prospects by comparing their expected utility values (Davis, Hands, & Maki, 1998), with a theory of their own which they define as prospect theory. Prospect theory can be described as a theory that tries to model decisions an individual makes in real life situations, unlike expected utility theory which models the optimal decision (Kahneman & Tversky, 1979). In their early work Tversky and Kahneman (1974) describe three heuristics that include representativeness, availability, and adjustment and anchoring. The researchers argue that individuals rely on heuristics as a means to reduce complicated tasks of predicting values and assessing probabilities into simple judgment activities. Tversky and Kahneman believe heuristics can be useful in making decisions, but can also lead to choices conventional economists, and perhaps people in general, would judge to be irrational. The representativeness heuristic is a means to which individuals make a decision or prediction based on the probability of comparable known events and/or objects. For example, if Scott is described as a “quiet intellectual who is a superlative academic writer that is well read in the subject of economics”, when asked for the probability of his occupation as that of a consultant or an economist, one is likely to believe the description is more representative of the latter than the former, even though it is quite possible he could be a consultant. Similarity, or representativeness, Tversky and Kahneman (1974) argue, leads to errors because neither is influenced by the factors that should be used to assess probabilities for making judgments.

Behavioral Economics and Happiness 9 Representativeness, Tversky and Kahneman (1974) posit, leads to a number of systematic mistakes that include insensitivity to prior probability of outcomes, sample size, and predictability. In experiments conducted by the researchers in which they asked participants to determine the probability about an individual’s occupation based on a description of the person, such as the previous one about Scott, in addition to the statistical composition of the sample group from which the person was drawn (i.e. 30 economists and 70 consultants), participants ignored the statistics, which suggest a .3 chance Scott is an economist and a .7 chance he is a consultant, and instead based their decision on the description of Scott. Participants did, however, make correct probabilities when given only statistical data related to the composition of the group. This, argue Tversky and Kahneman, demonstrates that when given irrelevant information prior probabilities are ignored, but when given no specific evidence such as a description, prior probabilities are correctly utilized. The researchers found similar conclusions related to sample size in which the judgments of participants failed to appreciate the need to evaluate sample size when making decisions. Tversky and Kahneman also uncovered insensitivities to predictability related to predictions such as the future value of a stock. Through their experimentation the researchers found that participants based the value of a stock differently for two companies when only descriptive data was given for each, which should have led to equal values for each company since descriptive data has no relation to stock price or profitability. The availability heuristic, argue Tversky and Kahneman (1974), is based on the theory that the frequency of a phenomenon or the probability of an event that a person

Behavioral Economics and Happiness 10 has foremost in their mind will lead to mistakes in judgment. For example, the risk of becoming diabetic by men over the age of forty may be assessed by recalling the number of acquaintances one has to such individuals. The researchers also argue the availability heuristic can lead to biases due to the retrievability of instances, such as the belief that the likelihood of a car accident is higher after driving by an accident. Even though the chances for an accident have not changed, after witnessing an accident individuals are more likely to believe the odds of being involved in one are higher. Tversky and Kahneman suggest that individuals place a higher probability of an event happening when it is foremost in their memory, which can lead to errors in judgment. The final heuristic offered by Tversky and Kahneman (1974) is the belief that when given a starting point individuals tend to make judgments based on that point even though it may have no relationship with making a rational decision. The researchers define this heuristic as adjusting and anchoring. Ariely (2008) recently conducted a series of experiments based upon the anchoring heuristic in which participants were asked to bid on a number of items. Before bidding on the items, which included an assortment of electronics, books, food, and wine, participants were asked to write the last two digits of their Social Security number in the upper corner of their bid sheet. The participants then wrote this same number next to each item listed on their bid sheet, and then answered with a yes or no whether they would pay that amount for the item. For example, if the last two digits of a participant’s Social Security number were 62 would they pay 62 dollars for a bottle of 1996 Hermitage wine, or would they pay 62 dollars for a cordless keyboard? Ariely, as would Tversky and Kahneman, argues that a rational person should not be influenced by the Social Security number

Behavioral Economics and Happiness 11 and should bid on the items based on their actual value. The results of the experiment reveal a drastically different result. Ariely discovered that participants with higher Social Security numbers outbid those with lower numbers. The researcher also demonstrated a statistically significant correlation between a participant’s Social Security number and the bid price for each item, suggesting arbitrary information has the potential to distort the decision making process. Emanating from their work with heuristics, Kahneman and Tversky (1979) sought to develop a theory to better predict decision making under risk. In contrast to expected utility theory that had previously dominated analysis of decision making under risk, Kahneman and Tversky propose an alternative theory, which they label prospect theory. Prior to their work, expected utility theory was generally accepted as the normative model of rational choice (Keeney & Raiffa, 1976), and was widely applied as the descriptive model of economic behavior (Arrow, 1971; Friedman & Savage, 1948). This led to the belief that individuals usually act in a rational manner, modeled in the expected utility theory. In prospect theory Kahneman and Tversky (1979) challenge expected utility theory, suggesting people tend to outweigh probable outcomes in comparison to outcomes that are most certain. The researchers describe this as the certainty effect, which contributes to avoiding risks in decisions that lead to sure gains, and taking unnecessary risks in decisions that lead to sure losses. Kahneman and Tversky also believe that individuals eliminate elements that are common to all prospects, which they argue leads to inconsistent preferences when the same options are presented in different forms. They describe this as the isolation effect. In their theory Kahneman and

Behavioral Economics and Happiness 12 Tversky assign values to gains and losses instead of the asset, and probabilities are replaced by decision weights. The result is what the researchers call the value function illustrated in Figure 1. In the value function the curve is typically concave for gains and convex for losses, and has a steeper slope for losses than for gains, suggesting a decrease in sensitivity for gains and losses the larger they are, and the further they lie from the reference point.

Figure 1. The value function suggests individuals assign greater value to losses than they do to gains. From Wikipedia (n.d.). Prospect theory. Retrieved November 29, 2010 from The value function can be described by the concept of loss aversion, which argues that individuals would rather avoid losses to increasing gains (Kahneman, Knetsch, & Thaler, 1991). Kahneman, Knetsch, and Thaler conducted experiments with Cornell University students that illustrate the loss aversion concept in which some students were given coffee mugs and others were not. The students were then given the opportunity to either sell or buy mugs from each other. What the researchers discovered was that many of those with mugs were reluctant to sell them, suggesting a greater loss of utility outweighs the increase in utility from either selling or purchasing a mug, respectively.

Behavioral Economics and Happiness 13 Several other concepts have evolved from the foundational work conducted by Kahneman and Tversky that include fairness, self-serving bias, and present bias. McDonald (2008) describes fairness as a false assumption by conventional economists who believe individuals are only interested in the volume of goods and services they get to consume, which behavioral economists believe to be inconsistent with human behavior. A number of experiments have challenged the notion of fairness, most notably the ultimatum experiment. In this experiment one person plays the role of proposer and the other of responder. The proposer is given an amount of money to divide between the two, which is done if the responder agrees to the proposed share. If the responder does not agree neither participant receives any money. In most experiments proposers offer on average 40 percent of the money, which is usually accepted, and in cases where the offer is less than 20 percent the offer is typically rejected (McDonald). This, argued by behavioral economists, is in contrast to what conventional economics would suggest. The self serving bias is demonstrated through surveys in which 90 percent of people place themselves in the top 50 percent of managerial skills, driving ability, health, productivity, and ethics (McDonald, 2008). Clearly many of them are wrong since only 50 percent can be in the top 50 percent. Present bias contradicts conventional economic thinking that assumes individuals discount the future using the rate of time preference, but experimental research suggests people tend to place more emphasis on the present, which may lead to bad decisions (McDonald). Some examples include saving too little for retirement and eating an unhealthy diet.

Behavioral Economics and Happiness 14 The early work conducted by Tversky, Kahneman, and several others helped to establish a consistent methodology that has continued to be the basis for much of the contemporary work in behavioral economics. Camerer and Loewenstein (2004) describe this pattern of research consisting of four steps that include evaluating normative assumptions used by economists, identifying anomalies in the assumptions, creating alternative theories that address the anomalies, concluding with the development of new theories and models that can be tested. While the majority or early behavioral economic research focused on laboratory experiments, recent work has evolved into field research, computer simulation, and a new emerging field of neuroeconomics that may offer new insights into decision making through the use of brain scans. Historical Influences Despite the recent popularity in the field of behavioral economics, an argument could be made that many of the thoughts in which the subject is based can be found in work conducted throughout the classical and neoclassical periods. Psychological themes are abundant in the work of many early economists, but the drive to develop the perfect economic model, and the advancement of statistical analysis capabilities, drove the field of study away from a mixture of qualitative and quantitative analysis to a purely mathematical approach (Camerer & Loewenstein, 2004). Several prominent economists even suggested psychology had no part in the study of economics, pushing the subjects even further apart. Perhaps the most vocal was Robbins (1932) who stated: Why the human animal attaches particular value in this behaviouristic sense to particular things is a question, which we do not discuss. That

Behavioral Economics and Happiness 15 may be quite properly a question for psychologists or perhaps even physiologists. All that we need to assume is the obvious fact that different possibilities offer different stimuli to behavior, and that these stimuli can be arranged in order of their intensity. (p. 86) With a clear link between psychology and economics developing with the behavioral economic movement, contemporary economic researchers have begun looking back to early influences that include the work of Smith and Keynes (Angner & Loewenstein, 2007; Ashraf, Camerer, & Loewenstein, 2005; Camerer & Loewenstein, 2004; Pech & Milan, 2009). Ashraf, Camerer, and Loewenstein (2005) explore “passions” and the “impartial spectator” (p. 131) Smith wrote about in his early work. The researchers describe passions as hunger, sex, emotion, fear, and pain, and the impartial spectator as a moral third person looking over an individual’s shoulder. Ashraf et al. argue that Smith believed the impartial spectator could be led astray by emotions. The researchers quote Smith (1759/2007) who states: There are some situations which bear so hard upon human nature that the greatest degree of self-government…is not able to stifle, altogether, the voice of human weakness, or reduce the violence of the passions to that pitch of moderation, which the impartial spectator can entirely enter into them. (p. 132) Camerer and Loewenstein (2004) also quote Smith who stated, “we suffer more…when we fall from a better to worse situation, than we ever enjoy when we rise from a worse to better” (p. 4). The authors argue this is a clear demonstration of the

Behavioral Economics and Happiness 16 concept of loss aversion discussed previously. One can hardly argue against Smith believing psychological factors influenced economic behavior. Keynes has also been the focus of many behavioral economists suggesting, like Smith, he also considered behavioral factors important to economic thought. Pech and Milan (2009) explore Keynes’ work for links to behavioral economics arguing his research is filled with references to psychological underpinnings. One of the key findings the researchers argue is that Keynes made numerous references to the concept of heuristics common to behavioral economic theory. Pech and Milan cite Keynes (1964) who states: It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other factors about which our knowledge is vague and scant. (p. 148) Pech and Milan (2009) argue this passage is a clear link to the availability heuristic. The authors go on to argue Keynes’ work has ties to behavioral economics citing numerous passages from Keynes’ writing using the word “psychological” and/or “psychology”. Pech and Milan also argue Keynes’ thoughts had ties to other heuristics such as representativeness and anchoring. Criticisms of Behavioral Economics Despite the research suggesting behavioral economic thinking provides a new means of contributing to the body of knowledge within the field of economics, criticisms still exist, making behavioral economics a somewhat controversial field of study. The

Behavioral Economics and Happiness 17 critics argue a number of points such as, experimentally observed behavior does not accurately mimic the true market (Myagkov & Plott, 1997), and that markets will cancel out individual psychology (Stewart, 2005). Over the past several decades behavioral experiments have been replicated numerous times with similar results, providing an argument the conclusions reached through early experimentation have validity (Camerer, Loewenstein, & Rabin, 2004; Rabin, 1998). Conventional economists continue to believe individual behavior is not significant enough to shift markets, and behavioral economists agree (Stewart, 2005) more work is needed to push their side of the argument further, suggesting the controversial nature of this research is likely to continue into the future. What is abundantly clear is that both sides of the argument want to continue to develop the field of economics in pursuit of greater understanding, which is likely to result if existing theories continue to be challenged. Happiness Economics Aristotle was believed to have stated, “happiness is the meaning and purpose of life, the whole aim and end of human existence” (Schwerin, n.d., p. 4). Little argument is needed that living a happy life is desirable, but what can be argued is what leads to happiness, and whether greater understanding of happiness is of value in the field of economics. Research on happiness amongst economists was nearly non-existent three decades ago, but has since risen in popularity, reaching over one thousand economic journal articles having “happiness” in the title as of 2007 (Clark, Frijters, & Shields, 2008).

Behavioral Economics and Happiness 18 Graham (2009) describes happiness economics as “an approach to assessing welfare which combines the techniques typically used by economists with those more commonly used by psychologists” (p. 6). Similar to behavioral economics in relation to psychological factors, happiness was a focus of early philosophers and economists such as Aristotle, Bentham, Mill and Smith, but as a transition to a more quantitative approach in economics progressed less emphasis was put into understanding the subjective concept of happiness (Graham). Believing all humans act in a rational manner, neoclassical economists have been challenged in their assumptions related to maximizing utility, which leads one to argue that choices such as those related to selecting a job are based purely on quantitative measures such as salary. Happiness economists have challenged this assumption suggesting that despite the opportunity to earn a higher salary many individuals often choose a job with lower compensation that provides a greater level of happiness. If, as happiness economists argue, individuals seek not to maximize utility, but to balance utility with happiness, then the challenge becomes measuring and understanding what leads to happiness. Measuring Happiness As the study of happiness has emerged several methods for measuring the construct have been utilized. The primary method of measurement is through survey data represented by a number of questions asked to participants related to their current level of happiness. The process of surveying individuals has ranged from highly complex systems to simple multiple-choice questions. In early happiness research conducted by Cantril (1965) participants from 14 countries were surveyed using what the researcher describes as a self anchoring

Behavioral Economics and Happiness 19 striving scale. Representing the more complex method of measuring happiness, Cantril’s approach began by asking individuals to describe a life that they would be happy living in the future. The researcher asked probing questions to help participants describe their hopes and dreams related to creating a happy future. On the opposite end of the spectrum participants were asked to describe what would make them unhappy. Using the two extremes as anchoring points, individuals were then asked to rate their current level of happiness on a scale of zero (the worst life) to 10 (the best life). Using a more simplistic approach, organizations such as Gallup and the National Opinion Research Center (NORC) have utilized multiple-choice questions to gauge the level of happiness in respondents from around the world. Early research by Gallup asked whether an individual was very happy, fairly happy, or not very happy (Easterlin, 1974). NORC has used a similar question since 1972 in the General Social Survey (GSS) that asks participants whether they are not too happy, pretty happy, or very happy (Brooks, 2008). Whether a more complex evaluation such as Cantril’s is used, or a more simplistic version such as that of Gallup, the concept of happiness both measure is the same (Easterlin, 1974). In either case the individual is believed to be the best judge of their own feelings. The measurement of happiness is far from a perfect science. Issues can arise based on where happiness questions are placed within a survey, but overall agreement of the aforementioned methods have been widely accepted in the happiness economics literature (Brooks, 2008; Graham, 2009; Hagerty & Veenhoven, 2003; Stevenson & Wolfers, 2008).

Behavioral Economics and Happiness 20 Evolution of Happiness Economics The study of happiness economics has greatly evolved over the last half century, and greater understanding into what leads to happiness has grown exponentially as data from countries around the world has been collected an analyzed. Cantril (1965) offers some of the earliest insights into happiness research. Studying the happiness of Americans in the 1960s, Cantril uncovered common themes among participants as they described their hopes and dreams during the process of establishing the aforementioned anchoring scale. Table 1 includes the most frequently mentioned items leading to happiness. To summarize the results Cantril grouped the items into categories shown in Table 2. Item
Own health Decent standard of living Children Housing Happy family Family health Leisure time

Percent Response
40% 33% 29% 24% 18% 16% 11%

Table 1. Items most frequently mentioned by Americans when discussing their hopes and dreams. From Cantril, H. (1965). The pattern of human concerns. New Jersey, NJ: Rutgers University Press. Category
Economic Health Family Personal values Status quo Job or work situation

Percent Response
65% 48% 47% 20% 11% 10%

Table 2. Categories of items most frequently mentioned by Americans when discussing their hopes and dreams. From Cantril, H. (1965). The pattern of human concerns. New Jersey, NJ: Rutgers University Press.

Behavioral Economics and Happiness 21 Cantril’s (1965) research provided some of the impetus for Easterlin’s (1974) seminal work in happiness economics. Easterlin is largely credited as establishing the field of happiness economics (Brooks, 2008; Graham, 2009; Hagerty & Veenhoven, 2003; Wolfers & Stevenson, 2008). In his early work the researcher sought to understand whether or not a positive relationship exists between economic growth and happiness. Easterlin analyzed data from a variety of surveys that included Gallup, NORC, and the American Institute of Public Opinion (AIPO). In the analysis Easterlin first reviewed data from within countries before moving on to a comparison between countries. Easterlin’s (1974) findings suggest a positive correlation between income and happiness exists within countries. In each of the surveys the higher earning respondents were happier on average than the lower earners. Easterlin’s analysis also uncovered a positive correlation between happiness and years of education. The data also suggests married people are happier than unmarried, younger individuals are happier than older ones, and whites are happier than other races. Even though correlation does not mean causation, Easterlin argues, “I am inclined to interpret the data as primarily showing a causal connection running from income to happiness” (p. 104). The researcher bases his conclusion on the responses of participants who overwhelmingly state personal economic concerns are directly tied to their levels of happiness. In the comparison of countries Easterlin (1974) states, “if there is a positive association among countries between income and happiness it is not very clear” (p. 108). This conclusion is in conflict with Cantril’s (1965) research studying 14 countries a

Behavioral Economics and Happiness 22 decade earlier in which a positive correlation was uncovered. Easterlin’s final conclusion, working with time series data from the U.S. from 1946-1970, creates the last element in what has become known as the “Easterlin Paradox” (Graham, 2009, p. 12). Analyzing the time series data, Easterlin concludes that even though income levels were higher in 1970 than they were in 1946 the percentage of very happy people did not change significantly. In explaining this phenomenon Easterlin cites Duesenberry’s (1952) relative income explanation, which suggests that unless an individual’s income rises at a greater rate than those in which comparisons are made, a feeling of greater wealth will not be realized. In a sense, argues Easterlin, individuals are constantly comparing their wealth with that of others and when it is rising at the same rate as others a greater sense of wealth is not achieved. From Easterlin’s work three elements have come to establish the Easterlin Paradox. They include: 1. Within a society richer are happier than poorer. 2. Rich societies tend not to be happier than poorer (once basic needs are met). 3. As countries get richer they do not get happier. (Wolfers, 2008) Since Easterlin’s groundbreaking work, the field of happiness economics has been filled with controversy related to the Easterlin Paradox. Some researchers have found small effects between happiness and national income (Hagerty, 2000; Oswald, 1997) while others have found none (Diener & Oishi, 2000; Easterlin, 1995). Recent research by Hagerty and Veenhoven (2003) and Wolfers and Stevenson (2008) appear to be helping establish an argument suggesting increased levels of happiness are related to rising national income levels.

Behavioral Economics and Happiness 23 Using the World Database of Happiness (Veenhoven, 1999) that includes data from 21 countries, 9 of which are developing nations, Hagerty and Veenhoven (2003) argue that increasing national income is positively correlated to increasing happiness. Based on their analysis the researchers reject Easterlin’s claim that an individual’s happiness is not dependant on absolute income, but on their income relative to others. In a rebuttal to the Hagerty and Veenhoven paper, Easterlin (2004) argues against their conclusions using the U.S. GSS data illustrated in Figure 2. As the data clearly illustrates, argues Easterlin, despite a rise in GDP per capita the percentage of individuals stating they are very happy has not changed.

Figure 2. Trends in per capita GDP and percentage of individuals stating they are very happy. From Davis, J. A., Smith, T. W., & Marsden, P. V. (2008). General Social Survey 1972-2006. Chicago: National Opinion Research Center.

Behavioral Economics and Happiness 24 The reason Easterlin (2004) argues Hagerty and Veenhoven (2003) arrived at a different conclusion is due to the use of survey data not included in the GSS from 19721974. Hagerty and Veenhoven acknowledge the inclusion of the additional survey data in their paper stating that sampling design and administration may have differed, which Easterlin does not agree with. Easterlin suggests that the difference in results are due to seasonal and context effects (the GSS is conducted in spring when happiness is higher). The most recent challenge to the Easterlin Paradox has come from Wolfers and Stevenson (2008). Their research that used recent data collected from the Gallup World Poll argues against the paradox suggesting richer people are happier, richer countries are happier than poorer countries, and as countries increase their wealth happiness also increases. Figure 3 illustrates the relationship between average life satisfaction and per capita GDP. Although the Gallup data measures life satisfaction, an overall measure of well-being, and not happiness, Wolfers and Stevenson argue that correlations between life satisfaction and happiness show the two are quite similar measures. With more data continuing to be collected, the argument between happiness and wealth is likely to continue into the future. Perhaps, as the data set continues to grow, happiness economist will begin to consolidate their views, and the argument for or against the Easterlin Paradox will be settled. Until then energy may well be better spent focusing on non-income related factors to happiness.

Behavioral Economics and Happiness 25

Figure 3. Relationship between average life satisfaction and per capita GDP. Size of circle is relative to population of country. From Deaton, A. (2008). Income, health, and well-being around the world: Evidence from the Gallup world poll. Journal of Economic Perspectives, 22(2), 53-72. Application of Happiness Economics While significant debate continues related to income and happiness, most happiness researchers agree that certain factors such as education, religion, marital status, age, health, and employment are positively related to happiness (Graham, 2009). Certain activities such as volunteering, charitable giving, and participating in religious events have also been shown to increase happiness (Brooks, 2008).

Behavioral Economics and Happiness 26 If happiness economists are mostly in agreement with the aforementioned factors, perhaps the next question facing researchers should be what to do with this knowledge. How can society use happiness data to increase overall well-being? Graham (2009) argues that happiness research should be used for better understanding inequality and poverty, and setting policy related to individual welfare and controlling addictive substances. Studying happiness may also provide exciting opportunities to improve worker productivity. Research suggests that happier workers tend to perform better and have increased future earning potential (Diener, Sandvik, Seidlitz, & Diener, 1993; Graham, Eggers, & Sukhtankar, 2004). With time, more research into happiness is bound to uncover new opportunities to better understand what leads to increased levels of happiness, and how capitalizing on this knowledge can help create a better society. Criticisms of Happiness Economics The study of happiness is not without criticisms. The subjective measurement of happiness is perhaps the most significant criticism facing the field of happiness economics. Nearly all happiness data is based on individual survey responses, and based on the time of year (Easterlin, 2004) or even the time of day (Layard, 2004), levels of happiness tend to fluctuate. Despite these fluctuations and the subjectivity of happiness measures, an argument can be made that the conclusions dating back to research conducted by Cantril (1965) in the 1960s proceeding on through to the most recent research suggest a very consistent theme in what makes individuals happy. In spite of its subjectivity, happiness research has been consistent in elements such as wealth within a country,

Behavioral Economics and Happiness 27 education, health, age, and marital status. New developments in neuroscience have also provided further evidence that the subjective nature of happiness can be measured through brain activity (Layard, 2004). Happy feelings tend to stimulate the left pre-frontal cortex, while negative feelings stimulate the right. Moving forward, neuroscience may offer a more quantitative method of measuring happiness, giving the field of study greater credibility. The bright spot in the happiness economics research suggests that many of the elements leading to increased happiness are within an individual’s control. An argument can be made that an individual’s behavior and the decisions they make play a significant role in determining their current and future potential happiness. Bad decisions related to happiness factors such as financial savings, education, physical and mental health, and employment may lead to lower levels of happiness. Tideman (2005) argues that conventional economics does not help society in the pursuit of happiness, having left out the psychological elements that arguably play a key role in happiness. Perhaps one solution lies in using the concepts found in behavioral economics to help individuals make better decisions that lead to a higher probability of creating happiness. Increasing Happiness Through Behavioral Economics Can behavioral economic thinking help make the world a happier place? While a paper such as this cannot fully explore the answer to this question, an attempt will be made to provide an argument for areas in which behavioral economic thinking has the opportunity to positively influence individual happiness. These areas include education, financial planning, and health care. The focus is not so much on providing detailed

Behavioral Economics and Happiness 28 solutions, although some suggestions are offered, but more so on arguments related to the areas in which behavioral economists (or those acting as behavioral economists) could have the potential to make a positive impact on happiness. A final point of discussion is related to what is perhaps the most significant barrier to sustained happiness-materialism. Choice Architecture, Libertarian Paternalism, and Nudges One could argue a great deal of unhappiness is related to bad choices individuals make throughout their lives. Deciding not to finish high school or go to college, taking out a mortgage that is beyond one’s means, not saving for retirement, eating an unhealthy diet, living a sedentary life that leads to obesity and eventually health issues, and abusing drugs and alcohol are all examples of poor choices. While many of these decisions may lead to short-term happiness they are highly unlikely to garner happiness over the course of one’s lifetime. Many of the bad decisions individuals make are due to heuristics, or rules of thumb, discussed previously. The research conducted by Tversky and Kahneman (1974) clearly indicates individuals often times take shortcuts in making decisions that lead to undesirable results. To combat the probability of making bad decisions, behavioral economists have the ability to become what Thaler and Sunstein (2009) describe as “choice architects” (p. 3). The authors describe a choice architect as having “the responsibility for organizing the context in which people make decisions” (p. 3). A simple example in choice architecture can be described using the analogy of creating elementary school lunch selections (Thaler & Sunstein, 2009). Designing a school lunch menu can be based on several factors such as choosing food randomly to

Behavioral Economics and Happiness 29 increase choice options, focusing on profit maximization by choosing low cost/high margin foods, or arranging food to help students make healthy selections. From a conventional economic perspective one would choose to maximize profit, although unhealthy eating in elementary school may lead to an adult life of unhealthy eating, ultimately resulting in long-term health issues such as obesity. Thaler and Sunstein argue that a choice architect will select the healthy choice for students, which is in the best interest of the student, but does not necessarily prohibit them from making an alternative selection such as bringing their own lunch or eating somewhere else. Choice architecture is based in the concept the authors describe as “libertarian paternalism” (p. 4). Libertarian suggests the freedom of individuals to make their own decisions, while paternalism centers on the idea of paternalistic oversight that helps in making good decisions that lead to living healthier happy lives. At first the concept may seem like someone else is making decisions for individuals without their input, but as Thaler and Sunstein (2009) suggest, “libertarian paternalists want to make it easy for people to go their own way; they do not want to burden those who want to exercise their freedom” (p. 5). The authors describe this process of helping individuals make decisions as a “nudge” (p. 6). A nudge can be defined as “any aspect of the choice architecture that alters people’s behavior in a predictable way without forbidding any options or significantly changing their economic incentives” (p. 6). Choice architecture, libertarian paternalism, and nudging may be one way in which behavioral economists can help increase happiness.

Behavioral Economics and Happiness 30 Nudging Toward Happiness One can easily argue the U.S. could use a nudge when it comes to education, personal financial management, and health care. The previously discussed happiness research suggests that each of these areas has an impact on individual happiness, providing three potential areas in which behavioral economic thinking could help improve individual happiness. As the old adage suggests, “higher learning leads to higher earning”, and what is consistent throughout the happiness data is the relationship between happiness and income and higher education. Higher earners and those with more education tend to be happier than less educated lower earners (Graham, 2009). Despite the improvement in high school dropout rates in the U.S., which have declined from 14 percent in 1980 to eight percent in 2008 (U.S. Department of Education, 2010), there are still over one million students who dropout of high school each year (Alliance for Excellent Education, 2009). Clearly, a nudge that could help entice students to stay in school, and even better still go on to college, would help increase the chances for happiness. One potential nudge could come in the form of tempting students who have graduated high school and are in college to become mentors to those still in high school. Research suggests that while parents play a key role in helping their children succeed in school a greater influence to success is played by those they interact with the most (peers, teachers, etc.) (Levitt & Dubner, 2005). Providing a financial incentive to potential mentors, such as tuition reimbursement, may also help nudge them to become mentors for high school students. An added side benefit may be that the mentors also go on to graduate from college, which is highly likely to impact their future level of happiness.

Behavioral Economics and Happiness 31 Personal savings is another area in which behavioral economic thinking may help to increase happiness. Surprisingly, even though the mainstream media continues to bombard the public with the challenges of funding Social Security and the need to establish individual retirement savings accounts, 27 percent of individuals report they have less than $1,000 in savings and 54 percent have less than $25,000 in investments (Employee Benefit Research Institute, 2010). Thaler and Sunstein (2009) offer two suggestions that may help provide the nudge needed to increase personal savings. One suggestion is to make the default option for employer funded 401(k) retirement savings programs to automatically enroll employees at a level that takes advantage of company matched investment. Employees still have the option to pull out of the plan, but by making enrollment the default Thaler and Sunstein argue more are likely to stay in than opt out. Another suggestion by the authors is what they call the “save more tomorrow” (p. 105) plan. This technique allows an employee to automatically invest future increases in earnings into a savings plan. Since the employee never receives the increase on their paycheck by selecting this option they never miss the added income. Health care is another area in which behavioral economic thinking may provide an opportunity to improve happiness. There is no question Americans have an obesity problem as the number of individuals considered obese has risen dramatically since 1990 when no state had an obesity level greater than 15 percent to what in 2009 has increased to only two states having less than 20 percent, and 33 states greater than or equal to 25 percent (Centers for Disease Control and Prevention, 2010). As the U.S. population grows larger, figuratively and literally, health care costs are likely to continue increasing. One could argue the irrational behavior of consumers has had a dramatic

Behavioral Economics and Happiness 32 affect on their health, and behavioral economic thinking may provide some answers into helping individuals make healthier choices. Some suggestions might be to give healthy individuals the opportunity to pay lower health care premiums by completing routine annual exams proving they are living a healthy lifestyle, and forcing those who do not have the exams to pay higher premiums. This suggestion is no different than the process used to price auto insurance policies for those who pose a greater risk. Better caloric labeling of foods has helped to inform consumers as to what they are buying, but the temptation is still high when healthy choices are intermixed with unhealthy options. Another suggestion could be to mandate a segregation of unhealthy food from healthy food in grocery stores to make it easier for consumers to avoid high calorie foods. An even more radical proposition may be to enact an “obesity tax” for airline travelers who are overweight. Stepping on a scale before getting on a plane and having to pay an additional fee is bound to change some individual’s behavior. There are certainly a multitude of others ways in which behavioral economic thinking presents an opportunity to increase happiness solely on the choices individuals are faced with. Many of the decisions individuals make are based on the default options given, which creates a number of arguments as to who chooses the default options, and who determines which are the best for society. There is no simple solution, but as Thaler and Sunstein (2009) argue, the goal of choice architecture is not to force individuals into a decision, but to help them increase the probability of choosing wisely. Even if individuals make better decisions as a result of behavioral economic thinking, another ever-increasing hurdle to happiness continues to threaten society-materialism.

Behavioral Economics and Happiness 33 Materialism and Happiness Bogle (2009) describes an interesting conversation between Kurt Vonnegut and Joseph Heller, both famous authors, at a party on Shelter Island that is hosted by a billionaire hedge fund manager. Vonnegut tells Heller that their host has made more money in one day than he has made over the entire history of his popular novel Catch22, to which Heller responds, “yes, but I have something he will never have…enough” (p. 1). The concept of enough Heller describes is similar to what has become a common argument by happiness economists as to the reason happiness has not significantly increased despite the twofold rise in GDP per capita in the past 34 years (see Figure 2). Economists describe the phenomenon as a “hedonic treadmill” (Graham, 2009, p. 15), which suggests that once basic needs are met human aspirations continue to rise, and changes in income are measured in relative rather than absolute terms. A more common phrase used by many to describe this situation is “keeping up with the Joneses”. In effect, a point of reaching enough is never achieved, thus, individuals continue to pursue more, always chasing the elusive situation of having enough. This analogy leads to the question; if an individual can never achieve or have enough will they ever be able to reach a maximum state of happiness? It is unlikely that behavioral economics will be a panacea to all problems related to happiness such as materialism, but the field of study offers some promising hope that by simply helping individuals make better choices they can live a much happier life. Tideman (2005) argues the bigger challenge for economists lies in changing the warped sense of progress that is tied primarily to growing levels of GDP and corporate profitability, much like society’s measure of individual prosperity that is heavily rooted in

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