Nudging economics forward, the Richard Thaler way

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The year is 2008, and I am in my first economics programme and (shamelessly enough) I ask for a digital watch I’ve wanted for the longest time. Nothing too fancy about the watch, except that I felt like I’d earned it—so it was no surprise that I wore it like clockwork (pun intended) for the next four years. However, when asked to give it up (possibly sell it), I first refused, and then put it up for an abnormally high price. Clearly, as any student of accounts would tell you, stock depreciates over time, particularly watches that have seen many scratches and bumps. It was only then that I realized my sentimentality for the watch might be driven by what Richard Thaler found in 1980 and co-authors Jack Knetsch and Daniel Kahneman called the “endowment effect” in 1991.

Thaler, an economist who contributed seminal theories to behavioural economics, has received the 2017 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. In essence, behavioural economics is the integration of psychological insights into economic science, often enriching models of economic decision-making. From the earlier anecdote, there is much to learn about why economic agents (students and professors of economics included) are often subject to psychological biases that were previously unexplored in economics.

Thaler joins a distinguished set of awardees of the Nobel Prize in Economics who have integrated insights or methods from other disciplines with economic science: Gary Becker (1992, who was also at the University of Chicago when he won and was known for his work in economic sociology), Daniel Kahneman (2002, a psychologist who worked with Amos Tversky on initially illuminating psychological biases in decision-making), and Alvin Roth (2012, for work on matching markets and market-based experiments).

Thaler received the Nobel prize for his contributions to behavioural economics. The specific ideas mentioned in the press release announcing the award are (i) limited rationality; (ii) social preferences; and (iii) lack of self-control. Limited rationality builds on work by another Nobel laureate in economics, Herbert Simon (1978), that suggests that a human being is not, as Thorstein Veblen famously remarked, “a lightning calculator of pleasures and pains, who oscillates like a homogenous globule of desire of happiness under the impulse of stimuli”. Thaler went beyond bounded rationality, and has worked on bounded willpower (with Harvard behavioural economist Sendhil Mullainathan), as well as bounded selfishness.

Thaler’s work in social preferences refers to his experimental extension of the popular ultimatum game in which one player offers an amount of money to another player, who must decide whether to accept or reject the offer—if she accepts, then the transaction is executed, and if she rejects, then neither player receives anything. Here, Thaler and his colleagues eliminated the ability of the second player to accept or reject the offer, thus providing no incentive for the first player to transfer any positive amount of money. This is contentiously referred to as the dictator game, but is in fact, not particularly a game since only one player makes a move. In what is now a well-established finding, there is a non-zero (about 40% of the endowment) transfer to the recipient, suggesting that individuals have other-regarding preferences, in addition to existing self-regarding preferences.

The self-control problem, which forms the basis for Thaler’s best-selling popular economics work (with Cass Sunstein), Nudge, is one that has many implications for policy. Other pieces in Mint have already covered the case for what Thaler and Sunstein call “libertarian paternalism”. Note that this is quite different from making nudge theory the basis for future policymaking or economic planning, one that is fraught with challenges that are yet to be sufficiently addressed. The self-control problem is best described as the conflict between two selves in inter-temporal decision-making.

Thaler suggested that there might be, in fact, two selves: a sophisticated planner who knows that she is likely to procrastinate in the future (say, put off savings for the future in favour of buying more today), and a naïve self who does not anticipate this behaviour and therefore might lack the self-control to ever save consistently. This stems from the psychological concept of delayed gratification—established in 1972 by Stanford University researchers. This has been increasingly incorporated into contemporary models of economic decision-making using present bias (that individuals prefer more today to more tomorrow). As Ariel Rubinstein notes, it is quite difficult today to write a paper in economics that does not make this assumption.

Of course, Thaler’s work is part of a burgeoning literature that is slowly taking centre stage in economics that includes work by Colin Camerer at Caltech (working in experimental game theory as well as use of neuroscience in economics), George Loewenstein at Carnegie Mellon University (his work in inter-temporal choice with Matthew Rabin is a remarkably clear model of the self-control problem), and Ernst Fehr (who with Klaus Schmidt suggested that fairness concerns may dominate strategic decision-making, also known as inequality aversion).

There are many other areas in behavioural economics that are now building on Thaler’s work, uncovering a larger set of implications for economic decision-making by looking at psychological biases. The Nobel Prize to Thaler is, foremost, the recognition that researchers attempting to study behavioural economics are no longer asked to do their best to make a correct prediction, like it was at a 1952 conference.

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