Behavioural Economics for Better Policies

When economists generally make models, they assume that people always make rational decisions. But, that is not true in the real world. People aren’t rational decision making machines, they are humans who make impulsive, irrational decisions influenced by their cognitive biases.

This is where nudge theory and behavioral economics come in. It proposes that small changes or nudges can influence the choice of individuals.

This can be applied in real life to solve problems and make better policies. One such problem is that people are not saving enough money. As a default, the responsibility to make a decision in savings was falling mostly on employees. Employees would not participate or barely participate in savings. To solve this problem, economists Richard H Thaler and Shlomo Benartzi proposed a solution called “save more tomorrow”, also called SMarT. They wanted SMarT plan to be an assistance to the employees. SMarT plan would auto-enroll employees into savings accounts by taking a set percent of their income from their company. This would be a default that the employees can opt out of but the economists predicted most people won’t opt out of such a default and this plan would encourage savings.

They first implemented this program in a mid-size manufacturing company. The employees here had low participation rates as well as low savings rates. To increase the savings rate, the company hired an investment consultant and offered his services to every employee eligible for the retirement savings plan. Out of 315 people, 286 agreed to meet the consultant. Of the 286 employees who talked to the investment consultant, only 79 (28 percent) were willing to accept his advice. The remaining 207 people were offered the SMarT plan as an alternative and the majority, 162, accepted it. In the SMarT plan, the individuals would contribute a greater percent of their income if they get a pay raise. Only 20% would drop out after their first, second, and third pay raise but even those who withdrew from the plan did not reduce their contribution rates to the original levels; they merely stopped the future increases from taking place. So, even these workers are saving significantly more than they were before joining the plan.

The results were as follows - the company had a savings rate of 4.4% at the beginning. The ones who didn’t contact the consultant had their savings around 6.5%. The ones who accepted the advice got around 9%. The ones who accepted the SMarT plan initially were saving just 3.5%because they were the people who wouldn’t even want to accept the consultant’s advice but they eventually managed to pay 13.6%, far exceeding other groups. This was quite a positive result for the researchers.

SMarT program has been adopted by many companies and has helped over 15 million people put money in their savings. It is estimated that this has added 29.6 billion dollars to retirement accounts. Shlomo Benartzi himself called the program “embarrassingly simple”. The small nudges can have a large impact. And that just goes to show how powerful behavioral economics can be.