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An economist who recognises that human behaviour is not always strictly
rational
THE credit-card bill arrives. You have enough money in a savings account to pay
it off the sensible thing to do, arithmetically speaking, since the interest
rate on the credit-card balance far exceeds that earned on the savings. Yet you
leave the savings untouched, and pay only as much of the bill as your
current-account balance allows. What looks a daft choice to most economists
made perfect sense to Richard Thaler, who on October 9th was awarded the Nobel
prize for economics for his work in behavioural economics. Mr Thaler helped
demonstrate how human reasoning diverges from that of the perfectly rational
homo economicus used in most economic modelling. The world, and the field of
economics, is better for his contributions.
Economists mostly recognise that normal people their friends and family fall
short of omniscience and perfect rationality in making day-to-day decisions.
Economic modelling requires simplification, however, and economists generally
suppose that theories assuming people are well-informed and rational offer the
best available description of economic activity. Over time, however, scholars
have built up an imposing list of the ways in which humans systematically
refuse to behave as the models predict. Economists such as Herb Simon (who won
the Nobel in 1978), Daniel Kahneman (2002) and Robert Shiller (2013) are
celebrated for their contributions to this effort. But perhaps more than any
other scholar, Mr Thaler lifted behavioural economics to prominence, and helped
put its lessons into practice.
Mr Thaler, an American born in New Jersey in 1945, spent most of his early
career at Cornell University before moving to the University of Chicago in
1995. Unusually for an economist, he is known for the clarity of his ideas and
the quality of his writing. His academic and popular articles alike are
accessible and entertaining. Nudge , a book co-written with Cass Sunstein, is
both an extraordinarily influential work and a best-seller. Its lessons have
been adopted by governments across the world; nudge units in America and
Britain studied how to boost saving and taxpaying, encourage healthy behaviour
and reduce energy usage.
Nudge drew on years of work by Mr Thaler and co-authors identifying oddities
in human behaviour. Setting out to explore why people feel losses more keenly
than gains, he helped uncover the endowment effect: a tendency to value
something more highly just because one owns it. To detect it, he distributed
coffee mugs at random to half of a group of test subjects, who were then
invited to sell the mugs, if they wished, to the other, mugless half. Theory
would predict that those with and without mugs should value them the same, on
average, and so about half of the mugs should change hands. In fact, those with
mugs valued them more than those without. Offers to buy the mugs by the
have-nots were usually too low to convince the haves to sell, and relatively
few transactions took place. This finding, since replicated many times,
suggested that the context of an economic choice matters. That, in turn, means
that the way choices are framed, by firms or governments, can influence how
people respond.
The importance of context also arose in Mr Thaler s work on mental accounting
. In thinking about money, people tend to compartmentalise, grouping certain
types of spending or income together. In some cases this might amount to a
strategy for managing imperfect self-control (as in the credit-card debt
example). More broadly, it reflects the human tendency to tackle cognitive
problems in pieces, rather than as a whole. When petrol prices fall, for
example, drivers sometimes switch from regular grade petrol to premium (rather
than use savings out of the petrol category somewhere else). Because of this
mental pigeonholing, taxi drivers who aim to earn a certain amount each day may
stop work early on busy days and later on slow ones, though the opposite
approach would maximise earnings per hour.
Mr Thaler, with his colleague Hersh Shefrin, understood choices as battles
between two competing cognitive forces: a doer part of the brain focused on
short-term rewards, and a planner focused on the long-term. Willpower can
help suppress the doer s urges but exercising restraint is costly. This
internal struggle is continuous, so individual preferences are not constant
over time (whether one has another beer may depend on the state of the brain at
a given moment). It also means that presenting people with a choice
architecture which favours the planner over the doer can have big effects on
behaviour. That insight became the basis for nudging . Making enrolment in
pension plans the default for new employees (ie, they must decide to opt out
rather than opt in) dramatically increases the share of employees saving
through such programmes, for example.
Mr Thaler, with Mr Kahneman and Jack Knetsch, also worked to understand the
role of fairness in judging economic outcomes. They conducted experiments in
which a student chosen at random was asked to divide $20 between himself and
another subject. Only rarely would the student keep most of the money, as pure
rationality suggests he should. Similarly, the authors used surveys to show
that people find practices like price gouging in the wake of disasters unfair.
In some multi-round experiments players chose to punish participants who acted
selfishly in early rounds, even if that meant accepting a lower payout
themselves.
Best laid plans
These insights that people care about fairness, find self-control hard and hate
losing what they already have might seem trivial outside of the strange world
of economics. In fact, behavioural economics greatest contribution may have
been to nudge the field away from attempts to extrapolate grand economic
theories from basic rules of individual behaviour. Today ambitious economists
are quite likely to immerse themselves in empirical work focused on specific
policy questions. That is a legacy worth treasuring, however one does the
mental accounting.