Behavioural economist Richard Thaler is the 2017 recipient of the economics Nobel Prize. Yet despite having been president of the American Economic Association (AEA) in 2016, he is no regular economist. In fact, Stanford economist and past AEA president Robert Hall once characterised Thaler as his “favourite offbeat economist”.
The award marks Thaler’s transition from the fringe to the mainstream. But it is instructive to look back at the time when his views were regarded as offbeat by mainstream economists. To be sure, Hall is a mainstream economist and an excellent one at that. As chair of the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), Hall often makes the call on when the US officially enters and exits recessions. His academic work teaches us how to establish equitable and efficient consumption taxation in a world of rational actors.
By contrast, Thaler’s academic work teaches us to beware of the limits of assuming that the world is populated by rational actors. The Royal Swedish Academy of Sciences identified the following three areas to which he has been a major contributor: limited rationality; perceptions about fairness; and lack of self-control.1
In the mid-1970s, I began to work with Thaler on two of these issues and eventually applied his insights to the third. With this as context, I would like to provide a personal perspective on how these three key ideas developed.
Before getting down to details, I need to say something about what Richard Thaler does better than any other economist: he constructs simple and incisive thought experiments. Most economists, including me, are trained to think in terms of formal models. Thaler is more of a qualitative thinker. As I will explain, he is able to pierce through the formality to get right to the soft spot of where those models are unrealistic in key ways.
Lack of self-control
Cashew nuts are calorie-rich – and I like them a lot. I have in my office a bowl of cashews, which look very tempting, but fortunately for me, these cashews are not real, but ceramic. I got them as a souvenir at a gathering to celebrate Thaler’s 70th birthday. There is a self-control story behind the cashews.
In the 1970s, Thaler and his wife threw a dinner party for some friends. Before they served dinner, they placed a large dish of cashews in front of their hungry guests. The guests began to devour the cashews and soon realised that continuing to do so would interfere with their ability to enjoy dinner. But they couldn’t stop. The cashews were too tempting. So they begged Thaler to take the dish away.
What would you do if you were really hungry, the cashews were in easy reach and you knew that continuing to eat them would ruin your dinner? To a neoclassically trained economist, asking that the cashews be removed is puzzling – and Thaler was trained as a neoclassical economist.
Classical Greek philosophers taught that rational human beings choose the best means to achieve their desired ends. The neoclassical approach formalises ‘choosing the best’ as a problem in mathematical optimization. In the neoclassical approach, people are assumed to optimise without effort. If they think that eating more cashews is not optimal, they don’t need somebody else to prevent them from doing so; they can costlessly choose to do something other than eat more cashews.
Thaler realised that his dinner guests were not acting rationally in the face of temptation, at least not rationally in the sense of being neoclassically rational. He engaged in one of his thought experiments, asking himself what would prevent him from reaching for more cashews when he didn’t want to eat more cashews. That question led him to think about an internal dialogue within his brain between the part of his brain that was ‘planning’ to stop eating cashews and the part of his brain that was actually ‘doing’ the reaching and eating.
Like Thaler, my interest in self-control also stemmed from eating issues. But in my case, it was because I became intrigued by my wife’s research on the role of healthcare professionals in treating eating disorders – not as compelling as the cashew story!
In any event, Thaler and I managed to find each other and began to collaborate on a formal economic model that would capture how people make decisions when their internal planners and doers fail to agree (Thaler and Shefrin 1981, Shefrin and Thaler 1988).
Some credit unions offer a programme called Christmas Clubs. People who join such a club regularly deposit funds during the course of a year into a special account, with the goal of having a balance at year-end that will fund their Christmas gifts.
When Thaler and I first worked on our self-control model, Christmas Clubs were more popular, offered by many banks and, moreover, did not pay interest, even though interest rates on savings accounts were much higher than they are today. This meant that people who used the clubs to save for gifts earned less interest than they could have by just using a regular savings account.
From a neoclassical perspective, someone who joins a Christmas Club and forgoes interest is operating in the interior of his or her budget set, a clear violation of neoclassical rationality. Were these people that stupid?
Some people choose to have too much of their income withheld to pay income tax, in order to get a large tax refund. Less money withheld means more money to invest for a return. Do people not understand the time value of money? Are they that stupid? How about you? Would you withhold at the lowest rate allowable by law?
In a neoclassical world, the answer to the previous two questions is yes, people are that stupid. But hold on a minute. In a world where planners need to deal with difficult doers, which can lead to a lack of self-control, it might be perfectly sensible for people to join Christmas Clubs and for people to have too much tax withheld in order to receive large tax refunds.
Both behaviours might lead to higher savings than would otherwise occur and, if higher savings is the goal, then such behaviours might be eminently reasonable. In theory, the behaviours might not be neoclassically rational, but in practice they might well be ‘good enough’; and as the late economics Nobel laureate Herbert Simon noted, going for what’s good enough is “satisficing behaviour” that is “boundedly rational”.
Christmas Clubs and tax over-withholding are not foolproof. People can rob their Peters to pay their Pauls. Someone with a severe self-control problem might borrow heavily during the year using her credit card, to the extent that when the year-end arrives, she finds herself compelled to use the proceeds from her Christmas Club to pay her credit card balance rather than to purchase gifts. Perverse? Yes. Boundedly rational? I don’t think so.
People need enough impulse control to prevent perverse behaviour. There are at least three ways for doing so:
- The first way is using willpower. Of course, if willpower were easy to exert, then there would be no need for Christmas Clubs or tax over-withholding.
- The second way is through external enforcement: no credit cards at all, which raises all kinds of issues, not the least being the consequences of not having a credit history.
- The third way is through internal enforcement, using habits.
Planner-doer theory suggests that people segregate their wealth into separate ‘mental accounts’, such as take-home pay, liquid assets, future income and home equity. Mental accounting habits are ‘pecking order’ rules that specify the order in which different accounts are accessed.
Many people find it easiest to spend first from take-home pay. If they wish to spend more than their take-home pay, the first place they go is to their liquid assets (such as checking or savings account balances, bonds and stocks). If these are insufficient, then people can borrow or, as a last resort, dip into their home equity by borrowing or selling their property.
Mental accounts can be somewhat arbitrary. Their levels are not finely tuned. Therefore, following mental accounting rules can lead people to appear as if they are not operating at the margin. But operating at the margin is not the goal – someone can operate at the margin and overspend very easily.
Thaler pointed out that people use all kinds of mental accounts. One of his thought experiments involves a person who mows their own lawn, but would never mow any part of their neighbour’s lawn for compensation.
Thaler suggests that such behaviour is unlikely to involve operating at the margin by setting marginal benefit equal to marginal cost. By this he means that the property line is arbitrary and, in a neoclassical sense, he might be right. But people might use boundaries as rule parameters, just as much as they use boundaries to separate types of wealth (take-home pay, liquid assets, etc.).
Thaler wrote: mental accounting matters (Thaler 1980, 1985). Now mental accounting might not be neoclassically rational. But given the limits of the human mind, it might be sensible – and good enough. Moreover, striving for perfect rationality might be counterproductive, with the end result being an outcome that is not good enough.
Perceptions of fairness
In the late summer of 2017, a series of hurricanes struck the Caribbean, the Gulf of Mexico, Houston and Florida. After Hurricane Irma, which struck Florida, local residents registered over 8,000 complaints of price gouging with the state Attorney General’s office.2 These complaints mostly related to excessive prices being asked for water, ice, food, and fuel.
Why are Florida residents complaining about price gouging? Do they not realise that keeping a lid on prices in these circumstances means that demand will exceed supply and that, as a result, some would-be purchasers will be rationed? Do they not realise that keeping a lid on the prices of these items lowers incentives to increase supply? From a neoclassical point of view, preventing the increase of prices to perceived gouging levels, irrationally induces rationing and insufficient supply.
Thaler, together with his colleagues Daniel Kahneman and Jack Knetsch, suggest an alternative way of thinking about market clearing prices (Kahneman et al. 1986a, 1986b). The alternative stems from Thaler’s concept of ‘transaction utility’ – the psychological pleasure or pain associated with how good of a deal a person associates with a transaction.
In the fairness framework, people have notions of reference transactions that they deem to be ‘fair’. Media reports indicate that some Florida hotels doubled their hotel rates in the wake of Hurricane Irma. Paying double for the normal price of a hotel room generates the experience of loss – negative transaction utility, if you like – if there is no corresponding increase in the costs that the hotel incurs as a result of the hurricane.
According to the fairness framework, hotels that charge double but do not incur higher costs are acting unfairly. In contrast, hotels that charge double to cover higher costs and do not reap additional profits as a result are acting fairly.
These are the rules of fairness that people follow. Fairness matters, just as mental accounting matters. Many people would rather be rationed and arrange for alternative accommodation than be gouged. If they feel pain from perceived unfair treatment, it is by no means obvious that the maintenance of fair prices that do not clear markets is necessarily irrational.
Psychologist Daniel Kahneman received the 2002 economics Nobel Prize for his work on ‘prospect theory’, a way of understanding how people make decisions under conditions of risk and uncertainty. The Royal Swedish Academy of Sciences noted that Kahneman had done this work together with the late Amos Tversky. Prospect theory, first published in 1979, was foundational for the development of behavioural economics and finance. That said, without Thaler, I am not sure that prospect theory would have had the traction it ultimately had.
There is much to say about Thaler’s accomplishments, beyond the three specific issues discussed above. Thaler was the first economist to reach out to Kahneman and Tversky, and he did so in the mid-1970s. It was Thaler who saw the connection between his fledgling thought experiments, such as the lawn-mowing example, and prospect theory.
It was Thaler’s entrepreneurial talents that found ways to bring open-minded economists together with Kahneman, Tversky and their psychology colleagues. In part, he did so through his efforts to secure support from the Sloan Foundation, the Russell Sage Foundation and eventually the NBER.
It was Thaler who wrote an ‘Anomalies’ column for the Journal of Economics Perspectives, which regularly piqued economists’ interest about the shortcomings of neoclassical thinking.
It was Thaler who, together with Shlomo Benartzi, ingeniously applied our work on self-control to help people save more, through their Save More Tomorrow (SMT) programme.
And it was Thaler who, together with Cass Sunstein, extended insights gained from SMT to develop ‘nudging’, the idea of using ‘choice architecture’ based on behavioural insights to induce people to make better decisions. This concept has had widespread influence in both US and UK public policy.
Richard Thaler’s accomplishments certainly merit his being awarded the 2017 economics Nobel Prize. For those accomplishments, we are all the better.
Kahneman, D, J L Knetsch and R H Thaler (1986a), “Fairness and the Assumptions of Economics”, Journal of Business 59(4): S285-300.
Kahneman, D, J L Knetsch and R H Thaler (1986b) “Fairness as a Constraint on Profit Seeking: Entitlements in the Market”, American Economic Review 76(4): 728-41.
Shefrin, H M and R H Thaler (1988), “The Behavioral Life-Cycle Hypothesis”, Economic Inquiry 26(4): 609-43.
Thaler, R H (1980), “Toward A Positive Theory of Consumer Choice”, Journal of Economic Behavior and Organization 1(1): 39-60.
Thaler, R H (1985), “Mental Accounting and Consumer Choice”, Marketing Science 4: 1999-214.
Thaler, R H and H M Shefrin (1981), “An Economic Theory of Self-Control”, Journal of Political Economy 89(2): 392-406.