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3 ideas of Richard Thaler that changed the way we think

The 2017 Nobel Prize in economics was awarded to Richard Thaler, an American economist who introduced a more realistic understanding of human behavior into the science of economics and to improve public policy and regulation by taking into account human behavior.

Richard Thaler, now 72, is a professor at the University of Chicago. He is known as the father of behavioral economics — a field of research combining the knowledge about human behavior in explaining the economics of behind the decision making.

The Nobel Prize Committee noted that in his research R. Thaler managed to show how various human traits systematically affect individual decisions and market outcomes. This Prize shows how greatly R. Thaler contributed to bringing the importance of emotional and rational aspects to the decision-making, laying foundations for shaping public policy and government more efficient.

Recognizing Thaler’s work with the Nobel prize should be seen as a tribute to the significance of people working in the area of behavioral economics. In fact, R. Thaler is not the first behavioral economist who received this recognition: in 2002, Prof. Kahneman was the first behavioralist who was awarded the Nobel prize, and Schiller followed in 2006.

However, while previous behavioral economists laid theoretical foundations, it was R. Thaler who did most of the organizational work to make sure that behavioral economics achieve this broad recognition and public respect. R. Thaler worked so that students studying behavioral aspects of decision making could receive scholarships for Ph.D. studies, and that this field of research could lay the foundations to establish institutions that would lead towards the improvement of peoples lives.

In other words, R. Thaler did not aim to destroy traditional economics, but, rather, he wanted to draw more attention to the weird ways how people think.

“In order to do good economics, you have to keep in mind that people are human.” (R. Thaler)

Here are those 3 ideas developed by Richard Thaler, that change the way we think and behave: bounded rationality, lack of self-control and nudges.

1. Bounded rationality

At the time when R. Thaler started his work as a phd student at Case Western Reserve University, the mainstream economic theory was largely based on the assumption that people behave rationally. Richard Thaler began challenging this idea and in many resulted studies showed that humans behave irrationally.

When economics started to be highly mathematical in 1950s, rational models were the models which people could solve, it was where the light was. Trying to put in all the complexities of emotions, lack of willpower and salience makes these models a lot messier. The economists like things to be neat and tidy. And, of course, the world isn’t that neat and tidy. (R. Thaler)

In his numerous publications, Thaler offered many examples showing that human irrational behavior is systematic. Moreover, Thaler suggested irrational behavior can be anticipated and controlled.

Thaler developed a notion of “mental accounting” which means that in making decisions humans tend to simplify things. In other words, people give more emphasis to separate decisions rather than seeing them in broader context.

E.g., in personal finances people tend to make budgets for daily expenses, rent and vacation which oftentimes leads to extra cost rather than helping to build on long-term savings. Similarly, taxi drivers tend to set daily targets for driving income (this often means that drivers finish earlier when the demand is high, and drive longer when the demand is low).

In addition, Thaler introduced the notion of “endowment effect” which focuses on how people tend to deal with positive and negative feelings. When it comes to ownership, people tend to place greater value on their own ownership. This leads to the situation where people are less willing to give away the possessions they have (loss-aversion).

This helped R. Thaler make a more broader observation how people behave in making purchase and sale decisions. For example, investors are holding on to depreciating shares hoping that the situation will be better; and rushing to sell valuable shares willing to recoup profit.

2. Lack of self control

According to Thaler, people suffer from various mental illusions that cause people to make blunders. The classical example is could be described as the dilemma of Odysseus’ which permeates every single aspect of our life: we are tempted to dive into the pleasures of consumption here and now rather than saving for more exciting experiences (or rent) in the future.

Illustration ©Johan Jarnestad/The Royal Swedish Academy of Sciences

The classical example is could be described as the dilemma of Odysseus’ which permeates every single aspect of our life: we are tempted to dive into the pleasures of consumption here and now rather than saving for more exciting experiences (or rent) in the future.

R. Thaler showed that experiences that are close in time take up more of our awareness than those that are further off; hence spending $100 now seems to bring more value now than saving it for the future. Thus, R. Thaler devised “planner-doer” model where the planner-self thinks about long term objectives, where as the “doing-self” cares about what is here and now.

Due to the lack of self control, people are more willing to become adhere to various pre-commitment strategies such as, diet or non-smoking plans, AA, drug abuse centers, etc.

3. Nudges

Thaler’s research opened the gates to great number of provocative findings. He showed that people are willing to penalize unfair behavior even if such penalty does not benefit them (or even if they have to pay for that); or that people choose not to make choices because they are afraid of the consequence.

Various real-world findings inspired R. Thaler to venture into an exploration about possible improvements in human decision making. He started to investigate how public agencies and institutions could assist humans in making more rational and informed decisions.

This led R. Thaler to propose that governments should utilize nudges — various tools which governments could use to alert, remind, or mildly warn their citizens. The intrinsic idea of nudge is to help people make good decisions without coercing them to make any particular choice.

My main goal in the book Nudge was to help people understand how we can deal with highly complex things like mortgages. (R. Thaler)

I was introduced to the notion of nudge by Cass Sunstein —together with R. Thaler he co-authored a book with the same title. While I was studying at the HLS, I took two classes taught by Prof. Sunstein: Administrative Law and Inside Government. In those classes, Sunstein constantly asked questions on possible improvement of government policies based on various findings about irrational human behavior and finding ways to improve efficiency and quality of public services.

In particular, Thaler and Sunstein argue that nudges is the best form of libertarian paternalism.

Some nudges are relatively simple: adding a photo on the speed ticket increases the fine payment rate because traffic violators are more willing to pay the fine if they see a photo of their car attached to the bill.

Other forms of nudges could have wide-ranging ramifications. For instance, Thaler developed the idea of “Save More Tomorrow” which refers to a situation where employees are asked if they prefer some portion of their future wage increases to be devoted to retirement savings. This is based on the findings of psychologists which show that (i) people are quite reluctant to lose access to current earnings, but (ii) are less concerned about future savings.

So if you currently have a job and are automatically enrolled in retirement savings plan, you say thanks to R. Thaler and his work.

R. Thaler and C. Sunstein developed a further insights about the role of nudges and default rules (e.g., automatic enrollment into donor list upon signing up for a driver’s license, or various nudges in terms making information accessible to citizens).

Thaler’s Invaluable Contribution to Development

German physics scientist Max Planck once said that “science progresses funeral by funeral”. Does it mean that behavioral economics mark the death of contemporary models based on cost & benefit analysis and rational choice models? Certainly not.

Image by Anne Ryan/University of Chicago, via Reuters

Thaler’s contribution the development of economic theory and bringing real-word findings about human behavior has been monumental. Behavioral economics has become a widely-acknowledged line of thought in economics and has spurred various initiatives to make governments around the more efficient.

In fact there is an increasing number of countries where behavioral scientists are invited to the table with policy makers. In the UK, for example, a special government agency was established with a task to make the government more efficient based on the findings on human behavior. The Organization for Economic Cooperation and Development (OECD) released already two reports with multiple exemplary cases from various countries on the application of behavioral insights in public government. There is no doubt that the role of behavioral studies and their application will greatly increase in the future.

Asked how he would spend the Nobel Prize money, Thaler replied: “This is quite a funny question. … I will try to spend it as irrationally as possible.” Together with other notable economists such as D. Kahneman, A. Tversky and Cass Sunstein, Thaler is one of those public thinkers whose work makes us positively look forward to the future.

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