For his contributions to behavioral economics, Richard Thaler has been awarded this year’s Nobel Prize in Economics. Every year, the Nobel Prize is awarded to someone whose ideas and research have increased our understanding of important issues in economics and related areas. Thaler certainly meets and exceeds these criteria.
Selection criteria used by the Royal Swedish Academy of Sciences include the originality of the contribution, its scientific and practical importance and its impact on scientific progress. The effects of the work on society and public policy may also factor into the process. Dr. Thaler’s work is outstanding on all counts. When told that he won, he indicated that he would try to spend the prize money “as irrationally as possible,” a fitting synopsis of his life’s work.
Before Thaler and his colleagues came along a few decades back, it was common for economists to assume that consumers, workers, investors and others were basically rational. It was certainly recognized that we are human and made mistakes but, taken as a group, we were generally thought to be, on average, pretty reasonable. Well, it turns out situations arise where we are not. By knowing this, we can better model and explain economic actions and at times even change them in positive ways.
One primary example of Thaler’s work is “limited rationality,” a theory related to how people make financial decisions by focusing on the impact of the individual decision rather than its overall effect. It’s a way for individuals to simplify such decisions and it can lead to results that aren’t optimal from an overall perspective. As an example, when investors have portfolios of strong stocks and weak stocks and need to liquidate some of the assets, they almost invariably sell the good ones and keep the bad. The end result is that they are left with a bundle of bad stocks. The reason is that they think of each stock individually and feel like they need to hold the bad ones to “make their money back.”
Thaler was a founder of the field of behavioral finance, which deals with how cognitive limitations of individuals influence financial markets. He also looked at how firms may set prices in response to consumer concerns about fairness, which could stop them from raising prices during high demand (such as for bottled water after a disaster) in contrast to market theory.
Perhaps his most famous work is the idea that he calls “nudging.” With a little short-term incentive, people may make better long-term decisions. Given a lack of self-control (which most of us suffer from at times), it can be difficult to take actions to achieve long-term plans or goals. With a little incentive in the short term (or a “nudge”), people will be more likely to do what they need to do for long-term success, whether saving for retirement or living a healthier lifestyle.
Nudging is essentially encouraging but not compelling appropriate actions. For example, something as simple as requiring people to opt out of rather than into a program, such as a retirement savings plan, can actually increase participation. Helping with paperwork to obtain student loans can increase college enrollment. There are many public policy applications and governments around the world are studying and using Thaler’s theories.
Much of the study of economics is rooted in mathematical theories and models. However, economic actions are taken by humans. While traditional economic theories assume that people and firms are rational, this is not always so. Thaler’s work has helped us better understand and incorporate the consequences of the psychological aspects of people and their thought processes on markets and the economy.
By combining psychology with economic and financial theory, he opened the door to a rapidly growing area of research and analysis. His ideas are not only academically thought-provoking but also extremely relevant. He has helped us bridge the gap between a purely mathematical model and the humans actually making decisions (who are not always perfectly rational). In fact, some of us now even build that irrationality into our systems. Congratulations to Dr. Thaler, a man who has truly changed the way we think about economics and finance in important and fundamental ways.