The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2017 has been awarded to Richard Thaler \”for his contributions to behavioural economics.\” What is behavioural economics, and why does it merit the prize? The Nobel committee offers some useful resources for addressing these questions, including a short and readable \”popular information\” essay
The committee writes: \”Richard Thaler has contributed to expanding and refining economic analysis by considering three psychological traits that systematically influence economic decisions – limited rationality, perceptions about fairness, and lack of self-control.\” Here, I\’ll say a few words about each of these, and about the state of behavioral economics as a whole.
As an example of limited rationality, consider a survey question from one of Thaler\’s studies.
\”(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 you would require to volunteer for this program? (You would not be allowed to purchase the cure.)\”
Notice that in both (a) and (b), you are asked to put a monetary value on facing a 0.001 probability of death. However, for people who took this survey in 1980, a common answer to question (a) was $200, while a common answer to question (b) was $10,000. But the scenarios are framed differently, and Thaler often finds himself digging into \”framing effects.\” He refers to this an example of an \”endowment effect,\” which is that that when you already have something, you tend to set a price differently than if you don\’t have something. If you are selling your own house, you ask for a higher price than you would offer if buying an essentially similar house.
\”Mental accounting\” is another example of a limited rationality. \”One example is how many people divide their household budget into one account for household bills, another for holidays, etc., with rules that prevent using money from one account to pay for something in another.\” As one example, may people have both a savings account, where they receive a low rate of interest, and a credit card overdraft, on which they are paying a high rate of interest. However, they don\’t use the savings account to pay off the credit card, because a \”savings account\” is separate in their minds from their consumption spending. And of course, this separation may be good thing, if it helps people discipline themselves to pay off their credit card debt without eliminating their saving.
In another well-known example of mental accounting, found that taxi drivers in New York City seem to think of each working day as a separate mental account, in which they try to earn a target amount of money. As a result, in days with high demand, taxi drivers reach their target daily income sooner and quit early, while in days with low demand, taxi drivers work longer hours. \”In other words, each working day seems to correspond to a separate mental account. Drivers therefore drive less on days with high demand and more on days with low demand, which is the opposite of what standard economic theory would predict.\”
On the importance of perceptions of fairness in economic transactions, there is a body of evidence pointing out that if workers feel that they are paid at an unfairly low rate, their motivation may decline in a way that reduces their productivity. The recent storms in Texas, Florida, and the Caribbean have offered an example of perceptions of fairness in consumer markets: should stores raise the prices of highly-desired items during a disaster? Of course, economic analysis sees both sides of these issues. Unmotivated workers with low productivity is problem, but in some cases, a firm that can\’t limit or cut pay will instead find that it needs to lay off substantial numbers of workers, or even go broke. Charging higher prices around the time of a storm may seem unfair, but if charging low prices means that the first wave of buyers completely empties the shelves, leaving nothing for those who come later, then that\’s a problem, too. As the Nobel committee writes:
\”Large-scale experiments conducted by Richard Thaler and other behavioural economists, have shown that notions about fairness play a major role in decision-making. People are prepared to refrain from material benefits to maintain what they perceive as just distributions. They are also prepared to bear a personal cost for punishing others who violate basic fairness rules, not only when they themselves are affected but also when they see someone else affected by injustice.\”
On the issue of self-control, \”we are tested by short-term temptations that threaten long-term well-being. This could be food and drink, smoking, consumption, saving for distant goals, or post-retirement planning. A person who chooses a longer education has a lower income during their studies, but can in return look forward to benefits in the future.\” Thus, rational people who know they have weak self-control may try to commit themselves to a course of action that they know will make them happier in the future. Signing up and pre-paying for an exercise class or a diet program are examples (after all, if you need to exercise or diet, why not just do it on your own?)
But probably the most prominent example of Thaler\’s work on self-control is about saving for retirement. Many people don\’t put aside nearly enough for retirement; of those who do put aside enough, many put a large share of their assets in something that is safe but has a very low return, rather than recognizing that a saver with a long-term perspective should probably put funds in the stock market–because over a long period of several decades they are extremely likely to come out ahead. To alter behavior, consider a policy in which instead of having people try to save on their own, they are instead automatically enrolled in a saving program, where the money is invested in a stock market index fund. Anyone who wants to opt out of the program would be allowed to do so! But the evidence strongly suggests that most people will stick with the automatic savings plan, and will end up later in life feeling very pleased that they did so.
Thaler and a co-author have pushed for what they call the “Save More Tomorrow” (SMarT) plan, where after you sign up, the contribution you make to your retirement savings increases gradually each year. For example, the plan could specify that when you get a raise, half of the raise goes into additional saving, until your saving has increased to some desired level.
Behavioral economics and the interaction of psychology and economics has been offering a rich array of insights across many areas of economics for several decades. Indeed, some of the early exposure for Thaler\’s work happened though a series of columns he wrote in the late 1980s and into the 1990s for the Journal of Economic Perspectives, where I labor in the fields as Managing Editor. The Nobel committee even gives a little shout-out to JEP, writing about the \”well-known `Anomalies\’ series in the Journal of Economic Perspectives.\” The existence of behavioral effects in economics is extremely well-established, and research in this area has also opened up some ongoing big-picture questions.
For a first example, the subject of economics has for a long time offered a battleground between those who emphasized the advantages of market forces and those who countered with the situations where government intervention seemed potentially useful. It may seem at first glance that behavioral economics should offer a substantial boost to those arguing for additional government intervention, which might aim at helping people accomplish what they would actually prefer–if they weren\’t struggling with issues of self-control, fairness, mental accounting, endowment effects, and other issues. In a 2008 book called Nudge: Improving Decisions About Health, Wealth, and Happiness
Thaler and co-author Cass Sunstein discussed these possibilities. In earlier work, they had referred to a philosophy of \”libertarian paternalism,\” which may sound like an oxymoron, but refers to a policy of thinking seriously about the default options and information that will be offered to people–and then letting people make up their own minds after that.
But the insights of behavioral economics–like limited rationality and lack of self-control–apply with equal force to the actions of legislators, regulators, and politicians. For an example, I\’ve written about a study of behavioral biases among development professionals in \”Focusing Behavioral Economics on Development Professionals\” (December 10, 2014). In \”Who Will Nudge the Nudgers?\” (July 21, 2015), I describe an essay arguing that less-than-rational biases may well be even prevalent among government decision-makers. Cass Sunstein, a frequent co-author of Thaler\’s, has made similar points. The case that behavioral economics should lead us toward rethinking a lot of government policy is easy to make; the case that it should lead to a greater degree of intervention in markets is far from proven.
A second big-picture topic is that while psychology and behavioral economics is often focused on the decision-making of individuals, the field of economics typically looks at the outcomes when individuals interact in markets, which may be rather different. For example, consider a person who for some psychological and behavioral reason would be willing to pay triple the market price for any food that is labelled \”fat-free.\” If we conducted a study, we might find a few such people. But for economists, the key point is that just because such people would be willing to pay triple the market price doesn\’t mean they have to do so; instead, such people can just pay the market price, like everyone else. In other words, market forces resulting from the large-scale interaction of buyers and sellers will in some cases make behavioral leanings moot. An active area of research looks at markets that have some behavioral participants and some rational participants, and considered what outcomes arise.
Finally, in many cases, the effects from behavioral economics are meaningful, but small. For example, consider the issue that many people buy the extended service warranty on large appliances like refrigerators or washing machines. Viewed strictly as insurance policies, these are often a bad deal, but people are paying for peace of mind and to reduce a fear of a later case of buyer\’s regret. This phenomenon is interesting, but it\’s a relatively small-scale. Similarly, the observation that retail stores or gas stations are more likely to post a \”cash discount\” sign than a \”credit card surcharge\” sign is an interesting application of applied psychology, but it probably doesn\’t have a big effect on quantity or price of gasoline in the market as a whole. Many of the insights of behavioral economics can be viewed as a very useful warning to be wary of how choices and information are framed and presented, of how marketing is trying to influence your behavior.
To this point, the \”killer app\” for behavioral economics–that is, the area of the economy where these effects are especially large and meaningful–are the settings in financial market, like how much people save, how they save it, and how financial markets can at times act irrationally. But researchers are on the lookout for other killer apps for behavioral economics, and I wouldn\’t be at all surprised if others emerge over time.
Those who follow this blog will have some prior familiarity with Thaler and his work. For example, interviews with Thaler and one of his talks were discussed at: