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Richard Thaler: Nobel economist changing our behaviour

The Nobel Memorial Prize in Economic Sciences has been awarded to Richard Thaler of the University of Chicago, Booth School of Business, "for his contributions to behavioural economics". He has introduced the study of human irrationality into a discipline that prides itself on rationality.

This is an excellent choice that reflects an important shift in economics during the past three decades, to take human psychology seriously when thinking about economic decision-making. The work has implications for everything from basic individual choices, to retirement savings, to the operation of financial markets. (Disclosure: I was a colleague of Thaler's at Chicago Booth.)

Outside the teaching rooms at Chicago Booth there are a number of large posters of various luminaries and their contributions, including other Nobel Laureates. On his, Thaler perhaps summarised his own approach best. His quotation reads:

"I think it is possible to strengthen economics by incorporating the idea that some people behave like humans, at least some of the time."

Witty, but also deep. And, beginning in the 1980s, Thaler did just that. In a first set of contributions, Thaler showed that people systematically deviate from the standard ‘expected utility theory’ of von Neumann and Morgenstern that is the workhorse economic model of how people make choices.

Dramatic difference between ‘buying’ and ‘selling’ 

A now classic example is the so-called ‘endowment effect’:

"(a) Assume you have been exposed to a disease which if contracted leads to a quick and painless death within a week. The probability you have the disease is 0.001. What is the maximum you would be willing to pay for a cure?

(b) Suppose volunteers would be needed for research on the above disease. All that would be required is that you expose yourself to a 0.001 chance of contracting the disease. What is the minimum [amount of money] you would require to volunteer for this program? (You would not be allowed to purchase the cure.)"

A typical answer from respondents is about $200 for (a) and $10,000 for (b). Yet the standard model says the answer should be precisely the same. People, it seems, are willing to pay a relatively small amount to ‘buy health’ compared to what they require to be paid to ‘sell health’.

This turns out to be a pervasive phenomenon. Thaler showed it is consistent with people valuing losses and gains differently (‘loss aversion’) as in the Prospect Theory of former laureate Daniel Kahneman and his collaborator Amos Tversky.

And he showed that firms take advantage of this commercially, as they often frame things as ‘cash discounts’ rather than ‘credit card surcharges’. Moreover, it holds in experiments with real stakes, not simply survey questions.

A recent meta-study showed that in more than 337 estimates in 76 different experiments the willingness to accept is more than triple the willingness to pay.

Implications for financial markets

Thaler's concept of ‘mental accounting’ holds that people put expenditures into distinct categories (such as food, housing, clothing, etc). This also has strong empirical support, and far-reaching implications. When people behave like this they do not take advantage of the ability to smooth decisions across categories, and they can behave in ways that are not optimal.

One well-documented example is that taxi drivers routinely set a target amount of earnings and stop once they have reached it. This ‘satisficing’ behaviour – rather than optimising – has broad implications for the labour market generally.

Now, one might think that all these defects in individual decision-making wash out in large markets. Indeed, this was the routine critique of behavioural economics in seminars in the early 2000s. A huge body of scholarship in behavioural finance has shown that this is not the case.

Psychological factors and limits to arbitrage can have huge implications for the operation of financial markets, creating mis-pricing and excess volatility.

Thaler also pioneered the concept of ‘social preferences’ where people care about fairness. In an elegant experiment – the ‘dictator game’ – one subject is given $20 and can propose a split with the other subject. If the other accepts the offer then that's what they both get. If they reject, both get nothing. Subjects routinely reject an $18/$2 split – or often even $15/$5 – and prefer to get nothing.

This both contradicts the standard model, and shows that fairness can be a vital consideration in economic settings.

Finally, the self-control problems Thaler documented in other work mean that individuals can benefit from a kind of ‘soft paternalism’ in everything from quitting smoking to managing their retirement savings.

With Nudge: Improving Decisions about Health, Wealth, and Happiness (co-author Cass Sunstein), Thaler has been the driving force behind designing public policy in a way that recognises and remedies this. Default options in retirement savings are a good example.

From the US to Britain and now Australia ‘behavioral insights units’ have been set up in government to guide public policy in diverse areas on the basis of Thaler's work.

Thaler has enriched our understanding of economics by introducing psychological factors within a coherent and tractable framework. And his work continues to have far-reaching implications for how we get people to make better decisions.

 

Richard Holden is a Professor of Economics and AGSM Scholar at the UNSW Business School. A version of this article appeared in The Conversation. Cuffelinks is an alliance partner of the Business School.

3 Comments
SMSF Trustee
October 19, 2017

Interesting. People didn't need a price of $2.00 to bet on Black Caviar in most of her races and they haven't needed it to bet on Winx for a while now either. (Essentially the same possibility set - the horse either wins or it doesn't; if it does you get paid the odds, if doesn't you lose your outlay.)

Does that mean that people don't really reveal such a significant degree of 'loss aversion' as behavioural economics believes? Does this mean that the empirical research on which a Noble Prize has been awarded is flawed?

Probably not. People betting on BC and Winx didn't/don't look at it as a 50/50 random outcome, but more like a sure thing.

Doubt that answers your question Graham, but I hope it's an entertaining contribution!

Graham Hand
October 19, 2017

Yes, SMSF Trustee. Never having placed a bet on Winx, I'm only guessing at the motivation, but it's probably that if the horse pays $1.10 for $1 outlay, they see it as a sure thing. Certainly not a coin toss. People are also paying to participate, to be part of the fun, and no doubt seeing your $1 turn into $1.10 is a lot more exciting than watching a coin toss (except 2Up). Just hope the oats were good that morning.

Graham Hand
October 19, 2017

My favourite Thaler (and others) example is loss aversion. Many studies have asked people to bet on a coin toss, where heads means they win $x but tails means they lose $100. Most people require around $200 to take the bet. They need $200 to offset the risk of losing $100. Do you need this much?

 

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