Richard H Thaler: behavioural economics fetches him Nobel

Richard H Thaler—the Charles R Walgreen distinguished service professor of behavioral science and economics at the University of Chicago Booth School of Business—who is engaged in researching behavioral economics and finance and the psychology of decision making has been awarded the 2017 Nobel Prize in Economics “for his contributions to behavioral economics” that built a “bridge between the economic and psychological analyses of individual decision-making”, paving the way for “the new and rapidly expanding field of behavioral economics.”  

Reacting to the award of Nobel Prize, Thaler said that his major contribution to economics is “the recognition that economic agents are human, and economic models have to incorporate that [factor]”. And perhaps, as an acknowledgement of his argument about the sometimes-unreasonable behavior of humans, he jocularly said, “I intend to spend the prize money ‘as irrationally as possible’”.

Jokes apart, what Thaler meant when he said “economic agents are human” is: traditionally, economists assuming that each person makes totally rational choice in pursuit of their own self-interest, built elaborate theoretical and mathematical models to explain how markets work to efficiently allocate capital and set prices. But Thaler along with Daniel Kahneman and Amos Tversky challenging this underlying premise of the models, demonstrated how often individuals make illogical choices that sabotage their economic interests, that too, believing that they are totally rational. Citing Brexit as a classic example of behavioral economics in action, Thaler observed that British voters chose an economically irrational route while considering the options offered to them by the elites.       

Studying the underlying reasons for people to behave irrationally, he came up with three propositions: one, ‘limited rationality’; two, ‘social preferences’; and three, ‘limited control’. The concept of limited rationality is explained through ‘endowment effect’ where individuals value an item more when they own it rather than when they do not. To test this hypothesis, he gave coffee mugs at random to half of a group of test subjects asking them to sell them, if they wish, to the other mug-less half of the group. Rationality demands that people from both the groups must, on average, value them the same, and accordingly, half of the mugs should change the hands. Contrary to this expectation, the have-nots valued the mug less while the haves have valued it high and as a result few mugs have changed hands.   

   

Moving to the role of ‘social preferences’ in economic decisions, Thaler says that individuals do not necessarily make choices driven solely by selfish interests. For instance, in an experiment conducted by him, he asked a randomly selected student to divide a $20 bill between himself and another subject. Rarely had he noticed any student retaining the whole amount with himself, as pure rationality would suggest. Similarly, his studies revealed that people find practices like overcharging for a good under duress as unfair.

Along with Hersh Shefrin, Thaler developed the third idea, namely, ‘limited control’ that emanates from the conflict between two competing cognitive forces of an individual: ‘doing-self’ which is more concerned with short-term happiness and ‘planning-self’ that values long-term goals more. To resolve this dichotomy, he says that the planning-self perhaps offers fewer choices to the doing-self that lie in the immediately upcoming future. And this phenomenon runs contrary to the economic theory of rationality, for more the choices, the better would be the decision. It otherwise means, presenting people with a “choice architecture” which favors the planning-self than the doing-self can impact people’s behavior in a big way.

It is perhaps taking a cue from this phenomenon that Thaler came up with his now famous “nudging” theory. He co-wrote the global best-selling book, ‘Nudge: Improving Decisions about Health, Wealth and Happiness’ in 2008 with Cass Sunstein that nudged governments to explore his ‘nudging’ theory to achieve better outcomes in the financial behavior of people—of the society at large. For instance, we are all aware that we need to save more for our retired life. But under most of the hitherto operating schemes one has to voluntarily choose: you need to first decide to save, then decide how much to put aside, in which scheme and for how long? It is too much for most of the people and thus many in the US were found under-saving.

 

Then came Thaler with a paper, “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving” jointly with Shlomo Benartzi of UCLA that revolutionized designing pension schemes. Under this new design, employees of the company are automatically enrolled in the plan, that they will contribute an initial percentage of their salary, that this contribution will increase each year by a certain percentage of their salary increase, and if the employees make no further choices, they will be assigned to a target date fund that is designed to automatically control asset allocation along the way towards assumed date of retirement of the respective employee. There is, of course, a provision for the employees to always opt out of any of these provisions. Intriguingly, thus default-enrolment proved to nudge employees to save for their retired life more effectively, for seldom anyone opted out. With the result, people in the automatic plans found saving more than those outside of them. And an obvious improvement is: the quality of life for future retirees.

He thus came up with the concept of improving “choice architecture”—an architecture that does a favor to their planning-self over their doing-self, so that it can result in better financial behavior. For instance, suppose a prospective client of credit card is provided with all the charges and fees to be paid under its usage right at the time of his choosing the card, would it not enable him to make a better choice rather than to struggle with loads of fine print later and crib at the decision already taken? 

Working for over three decades in association with a group of behavioral economists around psychology of decision making, economics and sociology, Thaler has simply nudged even the hardnosed rationalists to look differently at how people think when it comes to money and the decision making thereof and importantly nudged rationalists to appreciate that there exists deviations in human behavior, for human agents act fallibly. And all this happily nudged him to pocket his much deserving  Nobel Prize too.