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The Nobel Series: Exponent of behavioural economics

Richard H Thaler developed Herbert Simon’s concept of bounded rationality to recognise cognitive biases in decision making, apart from assessing the impacts of ‘fairness’ and ‘self-control’ on economic behaviour of agents

The Nobel Series: Exponent of behavioural economics
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The Nobel Prize in Economic Sciences for 2017 was awarded to Richard H Thaler, then at the University of Chicago, "for his contributions to behavioural economics".

Thaler completed his undergraduate studies in economics from Case Western Reserve University in 1967. He did his MA in economics in 1970 and PhD in economics in 1974 — both from the University of Rochester. His doctoral supervisor was Sherwin Rose and his thesis was titled 'The Value of Saving a Life: A Market Estimate'. After his PhD, Thaler taught at Rochester from 1974 to 1978, and then moved to Cornell University. He stayed at Cornell till 1995 when he was offered a faculty position at the Booth School of Business in Chicago University. Thaler also did visiting stints at the University of British Columbia, the Sloan School of Management at MIT, the Russell Sage Foundation and the Centre for Advanced Study in Behavioural Sciences at Stanford.

In this article, we will review the main works of Thaler and how those have helped in guiding public policy in various areas.

Main works of Richard Thaler

Thaler is known for his contributions to behavioural economics, which is a growing field of study and stands at the intersection of economics and psychology. Thaler actually stumbled into the area of behavioural economics. First, he changed his thesis topic from exploring differing infant mortality rates between African-Americans and whites to looking at how to value life. Thaler was not satisfied with the existing methods to value life, which basically calculated the loss in human capital that the death of an individual would entail. Instead, he looked at how much an individual would be willing to pay for changes in the probability of death (say a new cure). He was inspired by an article by Tom Schelling (1968) which proposed a framework based on willingness to pay for changes in the probability of death. While working on his thesis, Thaler did an informal survey of people's attitudes toward the risk of death and found that people did not react in ways that economic theory predicted. Thaler continued this exercise and decided to make a list of examples where people deviated from rational behaviour. This was the beginning of his long journey in behavioural economics. To quote Thaler:

While I followed Sherwin's (his thesis advisor) instructions to get back to work on my thesis, I was intrigued by my survey results, and it started a new interest. I began collecting examples of people behaving in ways that were inconsistent with economic theory and put a list of them on my office blackboard. The topics included other examples of buying and selling prices diverging, people failing to ignore sunk costs, and struggles with self-control problems. Most of the economists with whom I shared these examples found them more annoying than interesting, and I was not at all sure that there was anything resembling "research" that could come from this collection of stories.

As we have discussed in these columns, behavioural economics relaxes the assumption of rationality of neoclassical economics and instead uses findings of psychology and other social sciences in proposing an alternative model of decision making. Thaler looked at economic decision making by individuals and institutions and found that cognitive biases and limitations are important in such decision making. In a sense, Thaler was carrying forward the concept of bounded rationality, originally proposed by Herbert Simon, and refined further by Kahneman and Tversky.

Thaler had three main contributions in behavioural economics: taking forward the work on bounded or limited rationality, impact of social preferences such as fairness and reasonableness on economic behaviour and the impact of lack of self-control on economic behaviour.

On bounded rationality, Thaler was taking the insight given by Herbert Simon and Kahneman and Tversky that people are not rational in the manner of super-computers, simply because rationality was too demanding. It required that people have knowledge of all the alternatives, the ability to rank them in order of their preference — based on some metric (maximising expected utility) — and then choose the best alternative. Instead, people are boundedly rational, i.e., they make choices and predictions, which are based on 'heuristics' or rules of thumb and biases. While such choices are often suboptimal from a strict neoclassical point of view, they do provide satisfaction. Thaler gives the example of mental accounting, where people mentally divide their expenses into different categories, or accounts (e.g., mortgage, home maintenance, food, clothing, entertainment, and savings), and make spending decisions based solely on the effects on the relevant account rather than on total assets. In such a scenario, money is not fungible between various categories, which is contrary to the neoclassical world.

Kahneman and Tversky had made an important finding: that while using heuristics, people make systematic errors and that their behaviour is therefore 'predictably different' from what rational choice models tell us. To quote from Thaler's Nobel lecture:

The conclusion that the people make predictable errors was profoundly important to the development of behavioural economics. Many economists were happy to grant that people exhibited "bounded rationality", to use the term coined by Herbert Simon, but if bounded rationality simply leads to random error, economists could happily go about their business assuming that people make optimal choices based on rational expectations. Adding an error term to a model does not cause an economist to break a sweat. After all, random errors cancel out on average. But if errors are predictable, then departures from rational choice models can also be predictable. This was a crucial insight. It implies that, at least in principle, it would be possible to improve the explanatory power of economics by adding psychological realism.

On the issue of fairness of choices, Thaler pointed out that individuals' perception of fairness influences their economic behaviour. This can even lead to irrational acts such as making choices that are detrimental to oneself, provided that it would be fair. Thaler and Knetsch undertook telephonic surveys in Canada in the 1984-85 to assess individual reactions to what is fair, and found that fairness is indeed an important factor in people's choices. They also found that contrary to economists' prediction that firms will always maximise profits, firms are also conscious about doing the fair or right thing. Citing the example of stores such as Walmart and Home Depot, they stated that these stores cut prices on emergency supplies such as water and plywood after a hurricane or natural disaster. At the same time, Uber had to face regulatory battles when it indulged in surge pricing since it was perceived to be unfair. Further, consumers also wanted to punish unfair firms. To quote Thaler from his Nobel lecture:

Although many of our findings might be considered intuitive, that intuition is absent in at least two groups: economists and business school students. To an economist, raising the price of snow shovels after a snowstorm is the obviously correct decision, allowing the market to efficiently allocate the shovels to those who value them most. Students in my MBA classes agree. In a recent class to which I posed this question, 72 percent found raising the price to be acceptable. This is not surprising, since that was the correct answer in their microeconomics class. In contrast, smart businesses have learned these lessons. After a hurricane or other natural disaster, big box retailers like Walmart and Home Depot offer emergency supplies such as water and plywood at discount prices (or free) in the affected region. They are smartly playing a long game; maintaining a reputation for fair dealing after the crisis will assure they receive a good share of the business to come when the process of rebuilding begins. Other businesses can stub their toes in such situations. For example, Uber allowed their "surge pricing" algorithm to raise prices to high multiples of the usual price during a snowstorm in New York. They were later sued by the New York State Attorney General for violating a law that bans "unconscionably excessive prices" and agreed to a settlement in which surge pricing is capped during emergency situations. For a company that is fighting regulatory battles to gain entry in markets all around the world, making people mad is unlikely to be a wise business strategy.

Finally, on the issue of self-control, Thaler found that lack of self-control led people to neglect long-term financial decisions and focus more on the present. Thaler collaborated with Shefrin to propose a Planner-Doer model. According to this model, people are long-term planners and short-term doers and the goal of smart financial planning or social policy should be to isolate the planner from the doer. Quoting from Thaler's Nobel lecture:

Shefrin and I proposed a theory of self-control that models individuals as organizations with two components: a long-sighted "Planner" and a myopic "Doer". In providing a two-self model, Shefrin and I were following in the footsteps of Adam Smith in his 'Theory of Moral Sentiments' (1759). He characterized self-control problems as a struggle between our "passions" and what he called our "impartial spectator". In our model the Doer has fierce passions and cares only about current pleasure whereas the Planner is trying to somehow tame the passions and maximize the sum of Doer utilities over time. The question is how does the Planner get the Doer to be better behaved? Our approach was to borrow an existing theoretical framework, namely a principal-agent model (where the boss [the principal] tries to get her agents [workers] to act properly) and apply it to this new context of intra-personal conflict. Here the Planner is the principal and the Doer is the agent. The Planner has two tools at her disposal. First, she can employ commitment strategies where feasible. (These are similar to "rules" in an organizational context.) Had I been farsighted enough at that dinner party, I would have brought out the optimal number of nuts the first time and let us keep eating until the bowl was empty. The other possibility is to try to get the Doer to exert willpower, and the only tool the Planner has for this strategy is something resembling "guilt". (This is similar to "incentives" in the organizational setting.) If the Doer can be made guilty enough, he will stop consuming before exhausting all available resources. The problem with this strategy is that it is costly. Guilt acts as a tax on consumption, reducing the pleasure from each bite. Still, commitment strategies may not be available or may be too inflexible, so in general we will see people use a mix of the two tools: commitment and guilt.

Thaler has written a number of books on behavioural economics that are easily accessible to the general reader, including 'Quasi-Rational Economics' and 'The Winner's Curse'. While 'Quasi-Rational Economics' deals with problems of the neoclassical assumption of rationality and how limited rationality is a better description of the real-world behaviour, 'The Winner's Curse' is a compilation of his column titled Anomalies where Thaler recounts instances of individual behaviour that contradict traditional microeconomic theory.

Thaler also wrote 'Misbehaving: The Making of Behavioural Economics', which is a history of the development of behavioural economics.

However, the book for which he became most famous was 'Nudge: Improving Decisions About Health, Wealth and Happiness', which was published in 2008 and was co-authored with Cass Sunstein. The authors argue that people often make poor choices and when they look back, they can't believe that they made those choices. This was because of the routine biases that everyone has. The book was based on the principles of libertarian paternalism and choice architecture, which basically says that people need to be nudged towards making the right choices in their decisions on finance, health etc. To quote from Thaler's Nobel lecture:

The book Nudge is based on two core principles: libertarian paternalism and choice architecture. It is true that the phrase libertarian paternalism sounds like an oxymoron, but according to our definition it is not. By paternalism we mean choosing actions that are intended to make the affected parties better of as defined by themselves. More specifically, the idea is to help people make the choice they would select if they were fully informed and in what George Loewenstein (1996) calls a "cold state", meaning unaffected by arousal or temptation. (For instance, we ask you today how many cashews you would like to eat during cocktails tomorrow.) Of course, deciding what choices satisfy this definition can be difficult, but the concept should be clear in principle. The word libertarian is used as an adjective to modify the word paternalism, and it simply means that no one is ever forced to do anything.

Conclusion

Thaler is counted among one of the foremost behavioural economics along with Kahneman, Vernon Smith and Tversky. It is no accident that he collaborated with the other great behavioural economists on a number of projects, as we saw above. Thaler's unique contribution was in incorporating principles from psychology into economic models to make them more realistic and better able to explain human behaviour in the real world. His work on limited rationality, fairness and lack of self-control has helped guide public policy in areas such as social security, financial planning and regulating firms.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal. Views expressed are personal

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