Why Thaler and behavioural economics are so important

03 November 2017

  • Four WBS academics cited in supporting document for Thaler's Nobel prize
  • It is the third Nobel prize for the field of behavioural economics
  • Professors Isoni, Vlaev and Read discuss Thaler's importance
  • Behavioural economics is a "counter-revolution" debunking standard theory

With Richard Thaler receiving the Nobel Memorial Prize for Economic Sciences many now believe behavioural economics has become the mainstream of economics.

This has been coming for many years. Herbert Simon, who coined the term 'bounded rationality' - where our rationality is limited by the information we have and the finite time to make a decision - won the prize in 1978 and Daniel Kahneman - a frequent collaborator with Thaler - won it in 2002 for his work on prospect theory - which found losses and gains are valued differently thus affecting our decisions - and judgemental heuristics and biases.  

But Thaler’s prize is important because while his scientific work made a huge contribution to economics and psychology, it is possible his greatest impact has been on policymakers. 

Policies that change the context or ‘nudge’ people in particular directions have captured the imagination of policymakers at the same time as the limitations of traditional approaches have become apparent. 

The theory underpinning many of the policy suggestions are built on decades of research in the behavioural sciences, and particularly the fast-growing field of behavioural economics.

Behavioural economics - which uses insights from psychology, sociology and increasingly neuroscience to explain people’s decisions that traditional economic theory can’t - provides new ways to think about the barriers and drivers to a range of behaviours, such as health insurance take-up and the tendency to contribute to retirement savings. 

Thaler is Professor of Behavioral Science and Economics at Chicago Booth School of Business, which has the biggest behavioural science department in the world, while Warwick Business School boasts the largest behavioural science department in Europe.

Indeed, four WBS academics had their work cited in the scientific background document accompanying the Nobel committee’s awarding of the prize to Thaler, whose book Nudge paved the way for Behavioural Insight Teams or ‘Nudge Units’ in governments across the world.

One of them, Andrea Isoni, Professor of Behavioural Science, believes behavioural economics, has changed the way economists and policymakers think about real world problems.

“It builds a bridge between economic theory and reality, a bridge that is based on scientific evidence coming from neighbouring disciplines in behavioural science,” says Professor Isoni.

“Thanks to Thaler's work, behavioural economics is having a considerable impact in the policy arena. The UK has been the pioneer, with David Cameron's institution of the Behavioural Insight Team in his cabinet office, but similar bodies can now be found in the US, the EU, the OECD, and in many other countries and governments at all levels.

“Many of our own WBS graduates are leaders in this sector, and can be found working in government, in industry and in the non-profit sector. The main goal of these 'behavioural insights specialists' is to use findings from behavioural economics in the design of public policy.

“Knowing how different information affects decision-makers, or how different aspects of choice architecture influence what they do, we can design policies so that they are more likely to achieve their intended objectives.”

One example cited in the Nobel Prize document is from Ivo Vlaev, Professor of Behavioural Science at WBS, who used nudging to boost tax compliance for the UK Government.

“Traditionally, behaviour change policies and interventions have tended to focus on providing new information, which seek to change the way people think about their behaviour or they have used different financial or legal incentives that change the consequences of behaviour,” says Professor Vlaev.

“These interventions can only get us so far. Take smoking for example, while rises in the tax on tobacco have been seen to reduce overall levels of smoking, they may also serve to increase the proportion of smokers using potentially more harmful smuggled tobacco - it is estimated that 21 per cent of tobacco used in the UK is now smuggled.

How does behavioural economics differ from traditional economics?

“Moreover, while further information campaigns may facilitate people quitting, they could increase the disparity in the prevalence of smoking between higher and lower educated members of society."

Professor Isoni adds: “Behavioural economics is now being described as a revolution because we got used to the idea of economics being grounded on abstract axioms of rational choice, the psychological plausibility of which went unquestioned for most of the last century.

“In this respect, I am more of the view that it is a counter-revolution, which takes economics closer to its roots, based on psychological intuition and introspection (as in the work of Adam Smith himself, the father of modern economics), with the difference that now psychology exists as a scientific discipline and can offer us much more than intuitions and introspection.”

Isoni’s work with WBS colleague Graham Loomes, Professor Behavioural Science, and cited by the Nobel Prize committee, built on the endowment effect, one of Thaler’s greatest contributions.

“Due to our disproportionate dislike of losses - what Kahneman and Tversky call 'loss aversion' - we value things much more once they become part of our endowment - ie once we own them,” says Isoni.

“That is the endowment effect and it has attracted a great deal of attention in economics, because it questions some of its very basic assumptions, such as the reversibility of indifference curves, and some important results, such as the Coase theorem, which stated that when there are no transaction costs people naturally gravitate towards most efficient and mutually beneficial outcome.

“In 2005, Charles Plott and Kathryn Zeiler published an article arguing that the disparity between Willingness-to-Accept (WTA) and Willingness-to-Pay (WTP) - one of the typical manifestations of the endowment effect - wasn't a real phenomenon, but rather an artefact of the particular experimental procedures used to elicit WTA and WTP valuations.

“The evidence provided in Plott and Zeiler's experiment was not very solid. We showed this in our article, where we replicated their experiment and conducted a new one, showing that the WTA-WTP gap persisted even within the same set of procedures that Plott and Zeiler claimed made it disappear by removing misconceptions about the experimental procedures. In short, we have re-established the status of the WTA-WTP gap as a legitimate and robust experimental regularity, which was being questioned by people over-interpreting Plott and Zeiler's results.”

Another of Thaler’s major contributions has been 'mental accounting', the idea that in order to keep track of our activities we mentally subdivide our resources using a system of 'accounts'.  If the resources are money, then we might set aside money for rent, money for food, money for entertainment etc.

Related courses: Executive MBA

But this violates important economic rationality principles such as that of 'fungibility', whereby identical units of a good are interchangeable, in the same way as one kilogram of gold is the same as any other kilogram of gold. However, mental accounting often doesn’t follow this, as people do not feel entitled to spend the money in an account for purchases that the account is not intended for. 

Daniel Read, Professor of Behavioural Science, is cited in Thaler’s supporting document for finding empirical evidence for mental accounting, with his 1999 paper coining the term ‘choice bracketing’ to describe the extent to which our choices are separated or grouped together in our mental accounts. 

"Problems often arise when people bracket choices narrowly, rather than broadly, and so do not consider the implications of the choices they make now on other choices they will or even have made," says Professor Read.

"Narrow bracketing can lead us to underestimate the risks of repeated choices, because we focus on the trivial effects of individual ones. For instance, a smoker who chooses each cigarette separately (narrow bracketing) might consider the health effects of a single cigarette as trivial and not worth giving up smoking, but if the same smoker were to think about a lifetime of smoking (broad bracketing) they might well want to avoid the health effects even at the cost of being a non-smoker.

"Narrow bracketing is one way to understand the equity premium puzzle, a phenomenon which Thaler has studied extensively with his colleague Shlomo Benartzi.

"The finding is that investments in stocks produce much higher returns in the long run than bonds, and it seems to make little sense for anyone to invest in bonds, but, in fact, they do.

"Thaler and Benartzi argued that if people consider their returns over very short intervals, such as weekly or monthly, stocks will show a great deal of volatility and so appear to be very risky compared to bonds. But if these same investors looked at their portfolio less frequently, stocks will show much less variability and if the ‘time bracket’ is long enough, will seem no riskier than bonds but much more profitable."

As well as spotting these biases and heuristics, behavioural economics is now finding ways to use them to help people achieve their desired goals. 

“Behavioural economics and its influence is now being felt, not just in economics, but in society and how it is being shaped, says Professor Vlaev.

“In contrast to economic models of rational choice suggesting that we respond to information and price signals, insights from across the behavioural sciences, and Thaler's work in particular, suggest that human behaviour is actually led by our very human, emotional and fallible brain, and influenced greatly by the context or environment within which many of our decisions are taken.

"A better understanding of human decision-making, its rational as well as irrational aspects, provides us with opportunities of influencing choices that take better account of how people actually respond to the context within which their decisions are made - the ‘choice architecture’ - as it is called in Nudge. The same errors that trip people up can also be used to help them make better choices.”

Read the papers cited:

Andrea Isoni and Graham Loomes' paper The Willingness to Pay—Willingness to Accept Gap, the "Endowment Effect," Subject Misconceptions, and Experimental Procedures for Eliciting Valuations: Comment.

Daniel Read's Choice Bracketing.

Ivo Vlaev's The behavioralist as tax collector: Using natural field experiments to enhance tax compliance.

 

Join the conversation

WBS on social media