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How governments ‘nudge’ you to regulate your economic behavior

Our decisions sometimes have bad side effects – we can inadvertently damage our pensions, clog the roads with traffic or pollute the environment. Governments around the world – including in Israel – have taken to using tools of behavioral economics to encourage us to adopt healthier practices – without penalizing citizens or incentivizing them outright through stipends or subsidies.

How does it work? Sometimes a small change in wording or punctuation can be enough to encourage citizens to behave differently, behavioral economists have found.

These tools can be put in place to tackle a long list of public policy challenges.

Government policy is supposed to have a strong economic basis, including incentives that encourage the public to act in a specific way, and calculations to ensure that the public cost doesn’t overstep the benefits. And yet, classical economics doesn’t always work – the public doesn’t always behave in the rational manner that classical economics predicts.

Classical economists presume that people behave rationally, that they know all their options and behave consistently. Their models presume that people – such as consumers – will always maximize their utility.

Behavioral economics, by comparison, combines both traditional economics and behavioral science; some say it also uses elements of psychology. Unlike traditional economics, it presumes that people are not rational and do not act only based on considerations of price and utility, but that our irrational behavior isn’t entirely random, and tends to follow certain rules.

Behavioral economics has many applications. Companies can use it to make more money – by encouraging consumers to buy more, for instance. Countries can use it to raise the chances that their citizens behave in desirable ways, benefitting both the country and the citizens themselves.

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One of the most popular tools in behavioral economics is called the nudge – a small push to encourage people to behave in a certain way. “You can ‘push’ people toward a choice that would be better for them, without mandating it and without significantly changing the incentive system” – in other words, without enforcement measures, and without imposing new stipends or taxes, say Israel Democracy Institute researchers Omer Selivansky and Prof. Yuval Feldman in a report on the use of behavioral economics in Israel.

Nudges are defined as measures that don’t inflexibly limit public behavior. Subsidies and taxation are not considered nudges.

Ideally, behavioral economists craft policy by conducting a test with a control group to determine whether certain measures lead to desired behavioral outcomes. In the United Kingdom, for instance, the government launched a department called the Behavioral Insights Team in 2010 to research and draft behavioral economics policy and improve government services; that department has now been expanded into a nonprofit with branches around the world.

The Israeli government has also sought to implement behavioral economics. Five years ago it set up an inter-ministerial team to investigate how to conduct behavioral economics experiments in Israel, and how to implement international findings. Ultimately, responsibility for the field was placed with the Finance Ministry’s Budgets Division, working in partnership with American-Israeli Prof. Dan Ariely’s company Kayma Labs (Kayma Labs is also a partner in the behavioral economics conference TheMarker is hosting next week).

Behavioral Economics professor Dan Ariely.
Meged Gozani

The exclamation mark of Cain

Tools of behavioral economics have already been implemented in Israel in small but surprising ways.

For instance, the Israel Securities Authority was concerned about the appeal of risky mutual funds to consumers who presumably did not understand the possible perils. In 2010, it mandated that mutual funds that invest in risky bonds – including junk bonds, unrated bonds and those with a rating under BBB – be marked with an exclamation mark.

In a follow-up report called “The Exclamation Mark’s Mark of Cain,” researchers at the Bank of Israel found that this small change in punctuation brought a sharp drop in investments in these high-risk funds. Furthermore, the change impacted the behavior of the funds’ investment managers, they said.

“Mutual funds ‘stained’ with the mark of Cain of an exclamation mark actually increased their exposure to the risky assets highlighted by the regulator,” the report found.

In another example, Prof. David Leiser of Ben-Gurion University of the Negev found that a small change in terminology was enough to keep workers from withdrawing their pension savings as severance pay.

In Israel, the government mandates that employers set aside funds for severance pay; this money goes straight into the employee’s pension fund, and accounts for some 30% of the fund’s savings. However, when employees are dismissed, many choose to withdraw their severance, without realizing the extent to which this will later affect their pension.

“In our research we found that people were more interested in withdrawing money when it was termed ‘compensation’ versus a more neutral term that conveyed that this was money being saved on their behalf,” Leiser said. Renaming the action “early withdrawal of pension funds” would make people think twice and be less quick to take the compensation money, he said.

People were also less quick to withdraw the money when they were told that it would hurt their pension fund, as opposed to when they were told that the money would not be deposited into their pension fund, he said – even though this is two ways of saying the same thing.

The former statement had more of an impact due to the human desire for loss aversion.

Kayma achieved a similar result as part of an experiment to encourage drivers to avoid entering city centers by car. The drivers who were given a sum of money from which a fee would be withdrawn should they head downtown by car were less likely to do so than those who were paid a certain sum every time they decided to use public transport.