Nobel Prize recognizes pioneering work in behavioral economics

The prize committee emphasizes that by exploring the consequences of limited rationality, social preferences, and lack of self-control, by exploring the consequences of limited rationality, social preferences, and lack of self-control, the University of Chicago professor has shown how these human traits systematically affect individual decisions as well as market outcomes.

In a release announcing the winner, The Royal Swedish Academy of Sciences points out that Thaler developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each individual decision rather than its overall effect. He also showed how aversion to losses can explain why people value the same item more highly when they own it than when they don’t, a phenomenon called the endowment effect. Thaler was one of the founders of the field of behavioral finance, which studies how cognitive limitations influence financial markets.

The Academy also indicates that Thaler’s theoretical and experimental research on fairness has been influential. He showed how consumers’ fairness concerns may stop firms from raising prices in periods of high demand, but not in times of rising costs. Thaler and his colleagues devised the dictator game, an experimental tool that has been used in numerous studies to measure attitudes to fairness in different groups of people around the world.
Thaler has also shed new light on the old observation that New Year’s resolutions can be hard to keep. He showed how to analyze self-control problems using a planner-doer model, which is similar to the frameworks psychologists and neuroscientists now use to describe the internal tension between long-term planning and short-term doing. Succumbing to short-term temptation is an important reason why our plans to save for old age, or make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts.

Behavioral economics has also questioned rational behavior as it applies to areas such as financial mar¬kets. Richard Thaler, along with Laureate Robert Shiller, established the research area of behavioral finance, in which researchers have documented apparently unjustified market volatility that seems incompatible with the theory of effective markets. Thaler has also documented what amounts to negative market values for shares – which is unreasonable, because you can always discard a share that has no value. Experiments with test subjects who can choose between different investments show that people are sensitive to the choice of time horizon. Investors tend to prefer low-risk securities over short time horizons, but when they are presented with the potential results of various investments over a longer time horizon, they are more likely to choose higher risk securities, such as shares.

Common marketing practices can be understood as taking advantage of consumer irrationality. Discounts or exhortations of the type “buy three, pay for two” give consumers a sense of having gained and so move the reference point for evaluating the price. Lotteries and betting are marketed through overexposing the rare winners and covering up the multitude of losers. Many consumers are lured into taking loans with disadvantageous terms so they can buy an item they cannot actually afford. Thaler’s research is frequently cited in marketing literature and his insights, and those of other behavioral economists, can help us recognize marketing tricks and avoid unfavorable economic decisions.

In many situations, the planning self needs help to withstand temptation. Such considerations are behind many countries’ restrictions on alcohol and drugs, but in other contexts such restrictions are regarded as too far-reaching. Research in behavioral economics can be used by politicians and other decision-makers to design alternatives that provide benefits to society. Richard Thaler and Cass Sunstein have argued that, in more areas, both public and private institutions should actively (but with maintained freedom of choice) try to nudge individuals in the right direction. Among other things, this has led to the introduction of nudge units in several countries, including the UK and the USA, agencies that aim to reform public administration through the use of behavioral economic insights. Improvements often involve simple things, such as how the default option is defined – the one that is the result unless you actively choose something else. There are applications in fields such as pension savings, organ donation and environmental policy. People may feel it is difficult to save more than they currently do, because it directly reduces how much they can consume today. It is often easier to promise to save more in the future, particularly if they expect their salary to increase. This insight has been used in the “Save More Tomorrow” program, designed by Thaler and Shlomo Benartzi as a means of increasing individual occupational pension savings. The program, in which an individual commits to allocating a share of future salary increases to savings, has been successfully used at a number of companies in the USA. In some quarters, this type of program has been criticized for being paternalistic, but it is essential that joining the program is completely voluntary and that participants are free to opt out from it at any time.

The Royal Swedish Academy of Sciences emphasizes that, in total, Richard Thaler’s contributions have built a bridge between the economic and psychological analyses of individual decision-making. His empirical findings and theoretical insights have been instrumental in creating the new and rapidly expanding field of behavioral economics, which has had a profound impact on many areas of economic research and policy.