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.

Source: economist
Richard Thaler wins the Nobel prize for economic sciences