The 2017 Nobel prize in Economic Science has been awarded to Richard H. Thaler. He was a Professor of Economics at the University of Chicago.
Thaler has been recognised for his ‘contributions to Behavioural Economics.’
Economists make simplified assumptions about the economy to develop economic models. A common assumption is that individuals are perfectly rational and make rational economic decisions.
However, individuals do not make decisions in an entirely rational manner. Behavioural economists use insights from psychology and sociology to understand economic decision making.
Richard Thaler explored the influence of these three psychological traits on individual decisions and market outcomes-
- Limited rationality
- Social Preferences
- Lack of self-control
People have limited cognitive abilities. It affects their ability to make rational decisions.
Thaler has developed two ideas which are based on the concept of limited rationality: Mental Accounting Theory and Endowment effect.
Mental Accounting theory
This theory explains how people make financial decisions. We tend to simplify decisions by creating separate accounts in our minds for different decisions. He enunciated this idea in a seminal paper written in the year 1985.
One of the anecdotes used in the paper is: A family saved $ 15,000 to buy their dream vacation home in five years and the savings earned an interest of 10%. The family bought a car for $ 11,000 through a three-year car loan at 15%.
The family could have saved a substantial amount of money had they purchased the car out of their own savings intended to buy the house. But, it will not use the house savings for buying a car.
Thus, we create separate mental accounts in our minds and group expenditures in different categories. We make decisions based on the impact of individual decisions rather than the overall economic welfare.
2. Endowment effect
Another factor that governs our decision making is the ‘endowment effect’. Individuals value an item much more when they own it. He had explained this idea in a paper co-authored with Jack Knetsch and Daniel Kahneman in the year 1990.
Thales conducted an experiment to demonstrate the idea. He distributed mugs to half of the students in the classroom and asked the whole class to assign a value to the mug. Students who had a mug considered it twice as valuable to those who did not. This was in violation of rationality.
Another important factor that influences decisions is the notion of fairness. People take into account what is fair when making decisions. This is the reason why companies may not increase the price of an item even when the demand increases.
Lack of self-control
People lack self-control. We know that consuming more today will mean saving less and consuming less in the future. But, people prefer current consumption over future consumption. This is the reason why people do not save adequately for their retirement.
Based on this, Thaler developed the planner-doer model in 1981. A person has two sides to his behaviours- myopic doer, who makes decisions for their current utility and far-sighted planner, who is concerned with lifetime utility. He applied this model to understand the savings behaviour of individuals and households.
Thus, individuals have limited rationality and lack self-control. They will not always act in their best interests and hence make sub-optimal decisions.
Therefore, Thaler proposed the idea of nudge theory in a book written in the year 2008. He showed that people can be nudged to make better choices by making changes in the choice architecture. He coined the term ‘libertarian paternalism’
His work has important implications for public policy across the globe. ‘Nudge’ can be used to improve savings by changing the default option. It has been observed that the people usually stay with the default option. So, to encourage savings, employees can be made to uncheck the box and opt out of savings while filling forms with the employer.
Similarly, there may be an automatic enrolment for organ donation.
Some countries like the UK, USA, Singapore and Australia have developed ‘nudge units’ or ‘Behavioural Insights Team’ to study the application of the nudge theory in policy-making. The nudge units have worked to improve tax collection, health decisions, voter turnouts, etc.
A recent study investigating the global spread of nudging found that “51 countries have crafted policies that have been influenced by the new behavioural sciences.
To sum up, Richard Thaler has made an immense contribution to the field of behavioural sciences. He developed the idea of mental accounting, endowment effect, planner-doer model and the nudge theory
Note: The Nobel prize in Economics is officially called the Sveriges Riksbank Prize in Economic services. It was established in the year 1968.
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