“Humans aren’t rational.”
The message of behavioral economics as a subfield, and Thaler’s work in particular, is sometimes summarized as “humans aren’t rational.”
Unlike the field of classical economics — whereby decision-making is based on cold-headed logic — behavioural economics allows for irrational actions and attempts to understand why this happens to be the case.
The main contribution of Thaler and other behavioral economics researchers, like psychologists Amos Tversky and Daniel Kahneman (a 2002 Nobel laureate), was identifying specific kinds of irrationality that could be predicted and modeled ahead of time.
Lets take a look at a few of the more famous concepts.
1) Mental Accounting
In his landmark 1985 paper on mental accounting, Thaler explained the concept with the following example.
Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account.
Now, they are buying a new car for $11,000 and are planning to finance it with a three-year car loan at 15%.
Why don’t Mr. and Mrs. J just use some of their $15,000 in savings to buy their new car in cash? That would save a significant amount of money, as the interest they’re paying on the car loan outstrips the interest they’re getting from their savings account.
The answer, Thaler argues, is that people tend to make economic decisions by budgeting certain money for certain purposes. That $15,000 isn’t just $15,000; it’s the $15,000 for the home down payment. It’s a violation of that mental accounting process to pilfer the funds for a car
Exploiting mental accounting, gives us the ability to implement a more effective and yet less intrusive program on people. This is what Thaler and Sunstein call a “nudge”: a subtle, noncoercive (government) intervention that can have outsize impacts because of human cognitive biases. In recent years, development economics researchers have experimented with “labeled” cash transfers, wherein recipients get money that can be used for anything but are told it’s meant for a specific purpose. The idea is to trigger recipients’ mental accounting process, and use it to ensure the funds are directed toward the intended purpose. And, it turns out, that’s what happened in most of the cases.
2) The Endowment Effect
(a) Assume you have been exposed to a disease which if contracted leads to a quick and painless death within a week. The probability you have the disease is 0.001. What is the maximum you would be willing to pay for a cure?
(b) Suppose volunteers were needed for research on the above disease. All that would be required is that you expose yourself to a 0.001 chance of contracting the disease. What is the minimum payment you would want, to volunteer for this program? (You would not be allowed to purchase the cure.)
For traditional economists, the answer to these two questions should be identical. If gains and losses are felt equally, then the amount you’d pay to reduce your risk of death by 0.1 percent should be identical to the amount you’d have to be paid to increase your risk of death by 0.1 percent.
That, suffice it to say, is not the result Thaler gets; he found that people would be willing to pay $200 for the cure and would demand $10,000 to participate in the study. The endowment effect is so powerful, people value their existing level of health so much, that they’d pay 50 times more to preserve their current level of health than to get a little healthier.
Another example is that an investor in the stock market does not define a deal as a profit or loss until the shares are actually sold.
This leads to investors generally holding on to losing shares for a long time in the hope that “it’ll get better”, and selling winning shares too soon in order “to bring home the profit”, despite it often being more advantageous to do things the opposite way (for tax reasons, for example). The endowment effect is related to the concept of loss aversion.
3) Social preferences: What is fair
Unexpected rain can create an unexpectedly high demand for umbrellas, but if a shopkeeper then raises their price to match the high demand, many consumers react negatively and feel that the shopkeeper has behaved greedily
Additionally, there are strong feelings about what is fair when it comes to paying someone, which affects wage setting on the labour market through comparisons between different employee groups.
In total,
Richard Thaler’s contributions have connected 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 behavioural economics, which has had a profound impact on many areas of economic research and policy.
-Pushpita Patil
Sources:
https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2017/
https://www.vox.com/policy-and-politics/2017/10/9/16447752/richard-thaler-nobel-explained-economics
https://www.theguardian.com/world/2017/oct/09/nobel-prize-in-economics-richard-thaler
