TheMarketForIdeas

Note: This is part of a larger article dealing with the effects of the coronavirus outbreak. The previous part provided an introduction on the current states of affairs and set the groundwork for a comparison between neoclassical economics and behavioural economics in order to analyse the ongoing situation.

This part picks up where the previous part left off, and will be centred on an analysis of economic behaviour by comparing the tenets of neoclassical economics with those of behavioural economics.

Finally, the third part will deal with the geopolitical and geoeconomic consequences of the outbreak. 

As we have reemphasized, neoclassical economics, with all its shortcomings, is still considered to be the mainstream wisdom and the reconciliating synthesis of ages-old advances in economic science. Behavioural economics, for its part, is a rather recent school of thought that aims at incorporating concepts from psychology, sociology and cognitive sciences in order to gain a better understanding of the decision-making process of economic agents, largely as a response to the limitations of some of the tenets of the neoclassical school, several of which it directly challenges. Below are some of its key concepts:

• Bounded rationality – decisions are often coloured by various cognitive biases, misconceptions and rules of thumb derived from their cultural and personal background. It does not purport that people do not act in their own interest, but that one’s decision-making ability is influenced by a variety of factors (e.g., time available, attention span, quality and quantity of information available, etc.);
• Insufficient information – following the notion of bounded rationality, economic agents either do not have access to all relevant information, lack the training to discern between relevant and irrelevant information, or do not have the time to analyse all of it, so they resort to heuristics and drawing truth from anecdotes and stereotypes. This, combined with bounded rationality, means that agents do not seek the optimal solution, but rather the one which is sufficient to their needs (thus, they are satisficers, not optimisers);
• Nudges – small modifications upon the presentation of choices that have the power to influence the ultimate choice of consumers;
• Time discounting – it is theorised that economic agents are more likely to accept an immediate reward rather than turn it down in favour of a greater gain in the long run;
• Prospect theory – the concept by Daniel Kahneman that earned the Nobel Memorial Prize in Economics in 2002 and which states that economic agents assess losses and gains in relation to a given reference point, and when confronted with a choice leading to potential losses, they would rather pick a lower gain with greater certainty;
• Anchoring – it asserts that people are highly susceptible to the first piece of information they receive and the manner in which it is presented.

Nevertheless, behavioural economics is not without its own criticisms. Although this paradigm includes a more experimental component, borrowing from psychology when it comes to controlled trials, interpreting the results of these trials needs to be done cautiously. For instance, Financial Times’ Tim Harford argues that some of the insights cannot be easily generalised to inform future policy and that the behavioural economist must solve the conundrum of incorporating psychological insights into economic mathematical models, meaning it is hard to reach a balance. In Harford’s opinion, it is important to ensure that the approach delivers “psychological realism without delving into a mess of special cases”. He further cites psychologist Gerd Gigerenzer of the Max Planck Institute for Human Development, who believes the endeavour to be a superfluous complication. In a similar vein, Colin Kuehnhanss states that insights from behavioural economics can be a powerful driver for economic policy, but stresses the necessity of awareness of both the assumptions underlying the behavioural insights as well as the limitations of their applicability. Furthermore, Philip Booth points out that elaborating policies based on the output of behavioural economics may be marred by the regulators lacking sufficient information about the market players to understand their motivation, plus they themselves can succumb to biases of their own, which means that their policies may well fall under the very deviations from rational behaviour that behavioural economics outlines. 

A personal touch 

My personal observation is that a certain level of wariness must be exercised against hyping their results, as is usually the case with a successful discipline (e.g., the enthusiasm for machine learning and all AI things). As is the case with all social sciences, it is important to remember that the insights yielded from research in behavioural economics and related experiments are not a cure-all for the limitations of economic theory. Furthermore, although experiments can yield incredibly valuable insights into human nature and economic behaviour, one must bear in mind that they are localised re-enactments of real-life situations carried out under constraints usually not met in real life. Proper experiment design and replication is crucial to the validation of the results of experiments. I personally consider it an advancement in the right direction, but one that needs to be addressed with appropriate caution so as not to create unnecessarily high expectations that, if not met, would eventually harm the field as interest would decrease and research speed would slow down. Lastly, much of the research in behavioural economics has focused on microeconomics – there is yet much development to be made in extending its scope towards macroeconomics.

When comparing the two outlooks, I believe it is best to regard neoclassical economics as a “normative” outlook, i.e., how economic agents should act if they were to pursue certain goals to maximise their own benefit, whereas behavioural economics aims at providing a more “positivistic” view of how people act, which can then be used as input for further decisions. The hero of neoclassical economic narrations is a rational optimiser, while the subject of behavioural economics is a satisficer with bounded rationality. Behavioural economics thus serves to adjust some of the theoretical notions of the neoclassical approach for a better approximation of market phenomena. 

Back to the virus at hand 

Now, let us relate the framework of behavioural economics to what happened as a result of the coronavirus outbreak. Should we judge things by the theoretical tools of the neoclassical school, neither the observed consumer nor producer behaviour would fit what we understand as economically rational. First off, why would people stockpile goods in the first place? It might seem rational and sensible at first glance to ensure they are well supplied for fear of a lack of access to staple goods caused by the containment measures, but this notion does not stand up to scrutiny. Not only have such measures never been instated even in the hardest struck countries, but it would not be logical for the authorities to take such measures, given that people would eventually run out of supplies and need to restock, so nobody should expect this scenario to come about. Plus, few democratic governments are willing to risk losing favour with their electorate and needlessly produce a social crisis, aside from the very high risk of a steep economic crisis that would ensue if most companies went out of business.

Moreover, even in the darkest scenario where the virus mutates to a more aggressive, highly contagious, highly lethal and incurable form, with proper isolation and containment measures, it would eventually die out as the virus kills its last hosts, making it impossible for the strain to further spread and evolve, as was the case with the Spanish flu in the early 20^th century. Thus, people rushing to the stores to buy as many items as possible are in fact acting against their own interests, since the increased demand puts pressure on the price to grow, causing inflation while the population’s income does not increase to meet it. An interesting example of how the assumption of full and relevant information fails even when agents possess it is that of alcohol-free hand sanitisers. Despite the fact that the World Health Organisation and numerous specialists have recommended that the product must contain at least 60-70% ethanol in order to be effective against the virus, it appears that alcohol-free sanitisers have been bought in droves. Why would a rational consumer buy a product when reputable sources with no vested interest have explicitly stated that it is completely ineffective for the purpose it is bought for? On the other hand, there has been a marked decrease in the sales of products containing the word “Corona” in their brand names for fear of contamination with the coronavirus, despite there being absolutely no such relationship between the virus and the products other than the name.

On the producer’s side, raising the prices of goods in high demand is economically rational at first sight, but the picture gets murkier when one begins to look at the larger implications. As stated, in many countries and sectors of economic activity, employees are laid off, go temporarily out of work or their wages are cut. In other words, the consumers’ income at best stays the same and at worst decreases, but their fixed expenses (utilities, bills, loans, etc.) do not; unemployment rises, but so do prices while available income stagnates or follows a downward trend. A retort to this argument would be that, since demand increases in certain sectors, people left unemployed could migrate to those sectors instead; however, that implies a high degree of occupational and geographic mobility which, owing to the current movement restrictions and other barriers (e.g., lack of training or connections), is highly unlikely. Keeping in mind that the situation is dependent upon the persistence of the spread of the virus, and that for now there is no reliable estimate on when it would cease, the consumers would be forced to save as much as possible to ensure that they may satisfy their most urgent necessities, and would be discouraged from borrowing money from banks since they would likely be unable to pay it off. Not only that, but any rational consumer would prioritise ensuring their subsistence and health if their budget is tight, meaning they would rather default on bank loans they had already contracted before the outbreak than risk remaining without food or medicine.

Consequently, assuming the pattern does not change, this leads to consumers restricting their purchase of goods and services even further save for the most basic requirements, which would then result in several businesses failing as consumer spending becomes a zero-sum game (where some sectors stand to gain at the expense of other sectors), which would then result in further unemployment as well as a banking crisis as businesses and regular people alike would struggle to pay back loans, leaving banks in dire straits and causing pessimism from investors which would ultimately be harmful for the entire economy in the long run as banks are important in rebooting the economy. Even relying on the state for aid is a double-edged sword since, with businesses shutting down, governments would no longer have people and companies paying taxes, but unemployed people to support with welfare programs from the public budget, meaning that, in order to be able to restart the economy, they would likely have to resort to austerity measures.

Another problem is for medical supplies, such as face masks and antibacterial products. Raising prices in worsening economic circumstances risks producing two undesirable outcomes: a black market for medical supplies, backed by agents who anticipated the crisis and bought large amounts of those items in order to sell them at a higher price (e.g., higher than before the outbreak, but still not as high as on the mainstream market), as well as a tendency in consumers to seek substitute goods. The problem is that the population at large is mostly untrained in biology generally and virology specifically to understand what would help fight off the virus and what would not work. With this information asymmetry as the backdrop, it is all too easy for vendors to attempt to masquerade otherwise unremarkable or even potentially harmful products as useful in warding off the virus, with all the health effects it could have. Economically, this combination of rising prices and misinformation would result in a diversion of the consumer’s budget from the purchase of legitimate goods to that of deceitful products before the market has had the time to correct this dysfunction (especially since, with an increase in online shopping, consumers would be unable to verify the product before buying it), which would leave consumers with even fewer resources to manage. 

Behaviourism 1 - Neoclassicism 0 

With all this said, the lens of behavioural economics does change the view of the situation. The economic phenomena we have witnessed thus far can be explained through concepts such as uncertainty avoidance, loss aversion, framing, anchoring, social proof, negativity bias and memetic behaviour. For a start, there have been two main reactions towards the virus: one was indifference and underestimation, especially at first, as the virus was portrayed as either on par with the common flu, isolated to a specific geographic area or “too far away” to be a real threat and not all that dangerous. As it began to spread and its infectious nature became more evident, it began to elicit more attention and concern, especially once it crossed borders and reached Europe; suddenly, it was no longer too far away. Naturally, one of the first questions asked was how to cure the virus. These questions were addressed to the scientific community and healthcare authorities. However, the honest scientific answer is “we don’t know yet” given that, as the virus has never before been encountered, no known treatment or vaccine has been shown to neutralise it, and research is currently underway to uncover a vaccine. This has understandably generated the second reaction, at the opposite end of the spectrum, i.e., anxiety and uncertainty which began to grow slowly but surely. These two opposite behaviours are the effect of anchoring – that is, assigning greater weight to the first pieces of information received on a subject. That is likely part of the reason why people from many of the countries where the infection spread failed to take proper safeguards against it – they failed to take it seriously enough because of poor understanding of the virus and the impression that it was not a big deal.

Given people’s inherent desire to avoid uncertainty and avert losses, this poor understanding and lack of a readily available treatment made people and producers gradually distance themselves from the source of the virus – China. For example, early on before the virus arrived in Great Britain, British consumers were reported as shunning products shipped from China for fear of being contaminated. This was not an isolated case – several countries such as Spain, Turkey and the Netherlands have also refused Chinese-made products, including medical equipment. This pattern of behaviour is primarily driven by the desire to avoid uncertainty as well as loss aversion, both of which are compounded by framing (i.e., the virus has been strongly associated with China, thus anything originating from China is judged in this light). A more disturbing side effect is how it fomented racism in several parts of the world against people of Asian descent. 

Informational siege 

In the same note, this has made people susceptible to misinformation and the negative influence of fake news. It is also unfortunate that many mainstream media outlets were quick to seize the opportunity and spared no effort in painting an extremely sordid picture of the situation, even more so than the numbers would suggest, thereby further increasing panic and eliciting attention. Another factor is the widespread use of social media. As people typically associate online with people and groups they identify with, they will be more susceptible to information propagated within those channels. If this is coupled with a lack of certain knowledge about the virus and a touch of distrust towards authorities and the information they relay, the more people will be inclined to give credence towards conspiracy theories, fake news and misinformation, which can give way to geopolitical threats in the form of cyber-attacks and social engineering.

Even in the absence of online social media, people still cluster in informal networks through which information travels. Rumours that the situation will get exceedingly worse get more credibility because people are predisposed towards a negativity bias (i.e., giving greater weight to negative information), especially when it is shared among people who trust one another. In the context of rumoured food shortages, economic crises, city-wide lockdowns and unemployment, the consumers’ attention was directed towards ensuring their most basic necessities as per Maslow’s pyramid in order to outlast the crisis. This sparked panic buying of essential supplies, much of it driven by heuristics (i.e., rules of thumb, educated guesses and mental shortcuts) and spread via memetic behavioural patterns in order to compensate for unsatisfactory knowledge about the outbreak, e.g., buying lots of paracetamol-containing pills as it is a known treatment when one is down with the flu, even though its clinical effectiveness against the coronavirus is at the moment unsupported by evidence.

Therefore, stockpiling on essentials is for many consumers a means for alleviating anxiety related to uncertainty, giving them a sense of surefootedness in uncertain times as consumers know for certain that, by being well-stocked, they can ensure their subsistence at least for a while (as opposed to having no certainty at all and waiting for the outbreak to end with no way to foresee what measures will further be taken). This, in behavioural economics, is what we defined earlier as time-discounting. Perhaps unsurprisingly, this is also influenced at least partially by cultural factors: Business Insider reported panic buying in Japan, France, Poland and the Netherlands. According to Geert Hofstede’s cultural dimensions model, all of these countries have in common a moderately high to very high levels of uncertainty avoidance and high levels of individualism (except Japan). With the exception of Poland, all countries have high levels of long-term orientation (Poland does, however, have the strongest tendency towards uncertainty avoidance) and, with the exception of the Netherlands (which scores highly in long-term orientation and individualism), all countries have low levels of indulgence (n.b., the dimension of indulgence has to do with impulse gratification and socialisation, where low levels are associated with a preference for controlling one’s impulses as per social requirements and a tendency towards cynicism and pessimism). Clues to understanding panic buying and such behaviours can therefore be derived from analysing the interplay of cultural dimensions. Of course, this is also dependent upon other factors, such as citizens’ faith in the ability of the government and the healthcare system to combat the crisis as well as their assessment of the economy.

A similar tendency was observed on the supply side; with economic uncertainty looming over the mid-term and long-term future, this has been a chance to accumulate greater profits, which would serve as a welcome reserve. With supply lines being cut off and more restrictive measures, many companies – especially small and medium-sized companies – have found themselves forced to either temporarily suspend their activities or shut down altogether. Raising prices for in-demand goods is, therefore, the best decision as these profits may be all there is to obtain before new measures can force their business to close shop as well. Plus, the profits obtained can serve as a buffer for harder times, a reserve to fall back on in order to restart the business once the economic climate stabilises, or simply to pay back debts. In other words, this too is a strategy driven by uncertainty avoidance. At the same time, it is likely companies may also be expecting the governments to bail out banks to abate a recession. 

In the next part, we will highlight the geopolitical and geoeconomic risks that governments face as a consequence of the economic effects of the coronavirus as discussed in this part.