«People weigh losses more than gains of the same size,» UBS Center director Ernst Fehr says in an interview with finews.com. The idea behind this is that events or processes that are more readily available in our memory determine our decisions more strongly than memories that are less readily available.

The interview was conducted by Bernd Kramer, in charge of the economy and business section at Freiburg im Breisgau's «Badische Zeitung» (in German). Translated and adapted by finews.com.

Ernst Fehr is always on the list of candidates for the Nobel Prize in Economics. The professor for microeconomics and experimental economics at the University of Zurich is renowned for his work on behavioral economics, which examines what people do in economic situations. We don't always act rationally, according to Fehr and other economists.

Professor Fehr, philosophers of the Scottish Enlightenment said, «habit guides us through life.» People get up, go to the bathroom, have breakfast without giving it much thought. The emphasis on habit by the Scots was no accident. They wanted to distinguish themselves from French philosophers who emphasized that human actions were always preceded by reason-driven deliberation. Who was right? The Scots or the French?

Habits aren’t necessarily unreasonable. They often have a rational basis. We brush our teeth every evening without thinking because we know that this is good for our health. There are however also habits that are unreasonable. We might eat too late, which can affect our sleep negatively. Habit is not unreasonable per se.

In economics studies of the early 1990s, the homo economicus was the standard assumption. A reasonable, rational, self-interested being who attempts to maximize their utility for both monetary and non-monetary gains. Is this assumption tenable?

Not all teachers explain homo economicus correctly. By homo economicus is not meant that people run around with a utility meter that tells them which products bring the highest utility in their local supermarket. The approach is only useful as a way to map behavior.

If a consumer prefers an apple over a pear, then the apple is assigned a higher number, which we call utility. This has nothing to do with substantial utility maximization. But that is not the whole answer to your question. Individuals do not, in fact, always behave rationally. People may want to act rationally, but they can only do so to a limited extent. Hardly anyone is irrational on purpose. However, many things are too complex for fully rational decisions.

Can you give some examples of this?

If there was no government obligation to make financial provisions for old age, more people would fall into poverty in retirement. Who at the age of 28 thinks about what the world will look like when they are 70? Many people are deceived by promises of high returns in financial markets that cannot be kept. Although this does not apply to everyone, of course.

You talk about bounded rationality. What do you mean by this?

One example is availability heuristic. Behind this is the idea that events or processes that are more readily available in our memory determine people's decisions more strongly than memories that are less readily available. For example, most people believe more murders than suicides occur in Berlin or New York, even though usually there are more suicides than murders. Murders get a lot of media coverage, while suicides get hardly any.

The whole advertising industry is based on this kind of bounded rationality. It wants to create these readily available memories. Another example is loss aversion. People weigh losses higher than equally large gains.

What does all this mean for economic policy?

Workers, for example, are more willing to accept real wage losses through inflation than through direct reductions in nominal wages. This means an employee is more likely to cope with wage deterioration due to inflation than due to an employer imposing a wage cut.

The outcome however is exactly the same: loss of purchasing power. Such behavioral patterns also help to understand the euro crisis. Before the introduction of the euro, countries could lower the real purchasing power of wages by devaluing their currency and thus adapt to changing economic conditions. In a monetary union, however, this is no longer possible. Real wage reductions can only be achieved by nominal wage reductions.

People feel that imposed wage cuts are unfair. A devaluation of the currency, however, is more likely to be accepted, even if it also represents a loss of purchasing power.

Should the state take advantage of people's small weaknesses for the common good? U.S. economists Richard Thaler and Cass Sunstein have called for such «nudging». They say company pension plans are useful for society and everyone should get one unless they object. This leads to there being more company pension plans than if the employees had to actively go about setting them up.

I welcome this kind of nudging.

But does it not encroach on our freedom?

I cannot understand this criticism, seeing as nudging restricts freedom much less than government bans or taxes. Besides, those who voice this criticism should first take a look at the marketing industry. It's one nudging event that doesn't always benefit the consumer, to say the least.

When the state engages in nudging, it is based on a democratically legitimized process. If, on the other hand, companies engage in nudging, then this legitimacy is lacking and private corporate interests are at play.

Is there such a thing as freedom? Or are we slaves to our weaknesses?

Human behavior is not determined by unchangeable external forces. One can become aware of one's weaknesses. In tennis, players sometimes mourn lost points. However, nothing is worse than them doing so because it stops them from concentrating on the next point. On the same note, you can adjust your personal attitude to fully concentrate on the next point.