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Behavioural Economics and Finance; a Look of TheConcept, Implementation an Implication

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By : Wiku Suryomurti (PhD student in Ethical, Islamic Finance and Behavioural Finance at Adam Smith Business School, University of Glasgow)

According to several studies, people make around 23,000 and 35,000 decisionsevery day. Moreover, 200 of them are about food (Wansink, Brian and Jeffrey Sobal; 2007). How complex a process of making decision have been drawing interest of many scholars and scientists.

In October 2017, Richard Thaler was announced as Nobel Prize winner in Economics science. The Royal Swedish Academy of Sciences has decided to award himfor his contributions to behavioural economics. Prior to the award, Professor Thaler, an academia from the University of Chicago Booth Business school, is widely known for his bestselling books:“Nudge: Improving Decisions about Health, Wealth, and Happiness (2008) ” and “Misbehaving (2015)”. He incorporatesrealistic assumptions into analyses of economic decision-making, by investigating the consequences of limited rationality, social preferences, and lack of self-control.

What is Behavioural Economics and Finance

By definition, behavioural economics and finance is a study of how thinking, information, perception affect our economics and financial decisions. Put simply, behavioural economics and finance combine themselves with psychology and sociology to determine human behaviour. Contrary to the mainstream economics that assume people are rational and thus behave rationally in making decision, behavioural economics/finance enthuse that most people are influenced by many external and internal factors.This economics thought arealso developed previously by Daniel Kahneman and Robert Shiller, of which were Nobel Laureates as well in 2002 and 2010 respectively.

There are several basic tenets of behavioural economics and finance.First, people are not always rational as conventional economics says.It is rather that their decision making are influenced by many factors such as biases and fuelled by irrationality, heuristics, and emotions.

Second, people tend to follow the trend or called as herding behaviour. They also opt to be in status quo, meaning that they hesitate to try something new.

Third, people perceive more value in loss than gains, even though the cost are the same. This is known as loss aversion.They are also easily distracted by too many choices.

To conclude, behavioural economics and finance explains why people are subject to making a good decision given the factors that influence them both frominternal and external sources, in short term and long term, and from new information or past memories.

Moving forward, in economics or public services, it is widely known that people behave irrationally in spending their money, paying taxes, or commute for works. For example, in some developing countries, many people give up in driving the cars to their offices due to severe traffic jam they encounter every day. Instead of using public transport, they choose to ride motorcycles, even though the risk are bigger than using buses, MRT or any other public transports. They also hesitate to join government health care program since they think the benefits are not significant compared to the monthly or annual cost they have to pay.

On the other hand, in investment, most people or investors fear losses more than they enjoy the profit. They overlook the future benefit of investment. As a result, most investors are likely to sell the winning stocks while keep hold their losing stock. They are also not doing their homework – that is analysing the stocks or investment product both fundamentally and technically. Moreover, they usually overreact and underreact in the wrong situations. All of these would impact their return in the future.

Implementations and Implications

In his book, Professor Thaler introduces the concept of Nudge, where people are given a prompt to influence them into making a better decision. For example, in health care service, it is more useful to use Opt-out instead of Opt in. The reason behind it is that people incline to the default setting. By puttingof joining the health care scheme as the standard, more people will be included in the program.

As the theory develops and more research are published, the concept of Nudge is now being adopted by a couple of governments. Take a look at British government. In 2010, British Government formed Behavioural Insights Team (BIT), consisted of economists, sociologists and policymakers. The team who based in London has a task to help government in making better public policy using behavioural science. They assist the policy maker to create a more efficient and cost effective public service for the citizen. They also create insight about how to give people more choices for themselves. The fields range from health care services, pension schemes, transportations and education.Furthermore, some of the key messages and recommendations are in progress, whileothers have been published and can be accessed for public.

Another country to implement behavioural economics is Turkey. On November 20, 2017, Turkish government launch a project called ‘Nudge Turkey’ in order to improve public decision making. This project was actually initiated two years beforeThaler’s Nobel Prize winner announcement.Turkey also collaborates with the Behavioural Insights Teamfrom the UK.

In business related area, companies could implement behavioural science in selling and marketing their product or services. By using different packaging, price framing or ads, it would hugely impact the consumers’ mind set and the probabilities of them to buy the products become greater.

As countries begin to understand that their people are likely irrational, they could employ behavioural economics and finance in theircountry decision-making policies. This works also for companies, with regardsto understand their consumer better. Furthermore, with the benefit and advantages of behavioural science implementation, it is foreseeable that many countries will also employ the behavioural science into their public policy making, including Indonesia hopefully.

Conclusions

Apart from the hype, there are still several measures need to be taken carefully in order to implement the concept of behavioural science in economics and finance,for example, into public decision making. The appointed team should be capable in determining not just common behaviours but also local people’s culture, by doing some experimental test for instance. However, behavioural economics and finance is believed could help many areas in our life to improve our decision making.So, the prospect is there. It is now depending on us, how government or policy decision maker make use of it for the goodness of the people.

AsProfessor Thaler him self asserts:“In order to do good economics, you have to keep in mind that people are human”, we have to acknowledge that it is true that people might think and behave irrationally. Nevertheless, these behaviour could be anticipated and modelled.

Finally, when asked about how he will spend his Nobel Prize money, Professor Thaler joked that he will spend it as irrationally as possible.

Miftahul AnwarBehavioural Economics and Finance; a Look of TheConcept, Implementation an Implication

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