The eco­nomics of Richard Thaler

The win­ner of the eco­nomics No­bel has chal­lenged the way we think about the econ­omy, and has helped rev­o­lu­tion­ize the field

Mint Asia ST - - News - BPY RAMIT B HATTACHARYA

The win­ner of the No­bel Prize in eco­nomics this year, Richard Thaler of Chicago Univer­sity is widely rec­og­nized as one of the chief pro­tag­o­nists of the be­havioural eco­nomics rev­o­lu­tion that has chal­lenged some of the stan­dard as­sump­tions and the­o­ries of eco­nomic the­ory.

Along with the 2002 No­bel Prize win­ner in eco­nomics Daniel Kah­ne­man, his co-au­thor Amos Tver­sky (who would have likely shared the prize with Kah­ne­man had he not died in 1996) and Jack Knetsch, Thaler has pi­o­neered a new way of look­ing at eco­nomics by draw­ing on in­sights from psy­chol­ogy and psy­cho­log­i­cal ex­per­i­ments.

Un­like sev­eral other ge­niuses in the field who have gone on to win the ul­ti­mate recog­ni­tion in the pro­fes­sion, Thaler had a rather tame be­gin­ning to his aca­demic life. His doc­toral the­sis was on eval­u­at­ing the mone­tary value of a hu­man life—which is of­ten used by reg­u­la­tors to mea­sure the ben­e­fits of in­ter­ven­tions that pre­vent deaths, say on high­ways or from air pol­lu­tion. Based on his the­sis, Thaler pub­lished in 1976, a fairly in­flu­en­tial re­search pa­per on the the­ory and tech­niques of valu­ing a life sta­tis­ti­cally.

Thaler’s dis­ser­ta­tion su­per­vi­sor, the renowned Sher­win Rosen, de­spite co-au­thor­ing the 1976 pa­per with him, was not quite im­pressed with the young econ­o­mist, later telling The New York Times, “We did not ex­pect much of him.”

Per­haps Rosen’s dim view of Thaler sprang from what he saw as Thaler’s diver­sions away from the core ques­tion of his re­search. In the words of his col­league and col­lab­o­ra­tor, Cass Sun­stein, Thaler had an “un­fail­ingly mis­chievous mind”.

The “value of a sta­tis­ti­cal life” that Thaler was es­ti­mat­ing was based on as­cer­tain­ing the amounts that peo­ple are ac­tu­ally paid to in­cur risks in the work­place. When work­ers face an ad­di­tional mor­tal­ity risk of 1 in 100,000, how much more money do em­ploy­ers give them? Even as he was writ­ing a “math-heavy” dis­ser­ta­tion to ar­rive at the an­swer, he be­gan tweak­ing the ques­tion it­self to see if it pro­duced a dif­fer­ent re­sponse, wrote Sun­stein in a 2016 es­say on Thaler’s work.

“He started ask­ing peo­ple two ques­tions,” wrote Sun­stein. “The first: How much would you pay to elim­i­nate a mor­tal­ity risk of 1 in 100,000? The sec­ond: How much would you have to be paid to ac­cept a mor­tal­ity risk of 1 in 100,000? Ac­cord­ing to stan­dard eco­nomic the­ory, peo­ple’s an­swers to the ques­tions should be es­sen­tially iden­ti­cal. But they weren’t. Not close. The an­swers to the sec­ond ques­tion were much higher (of­ten in the range of $500,000) than the an­swers to the first (of­ten in the range of $2,000). In fact, some peo­ple re­sponded to the sec­ond ques­tion, ‘there is no amount you could name.’ Ac­cord­ing to stan­dard eco­nomic the­ory, that’s se­ri­ous mis­be­hav­ing.”

Thaler showed his re­sults to Rosen, who told him to stop wast­ing his time. But it was th­ese re­sults rather than the the­sis he ended up writ­ing that paved the way for Thaler’s sem­i­nal con­tri­bu­tions to be­havioural eco­nomics. This was not the first time how­ever that a fu­ture No­bel lau­re­ate’s work had been sum­mar­ily dis­missed by his or her guide. The early writ­ings of the In­dian No­bel lau­re­ate in eco­nomics, Amartya Sen, were dis­missed by his the­sis su­per­vi­sor, Joan Robin­son, at Cam­bridge Univer­sity as a “heap of eth­i­cal rub­bish”.

Thaler met much the same fate at Rochester Univer­sity. But soon af­ter fin­ish­ing his dis­ser­ta­tion, he teamed up with the psy­chol­o­gists Kah­ne­man and Tver­sky to pro­duce a se­ries of path-break­ing re­search pa­pers that es­tab­lished the quirks of hu­man be­ings when faced with eco­nomic choices. Thaler’s later work showed that the stark dif­fer­ences in re­sponses to the two ques­tions about pay­ments on mor­tal­ity risk sprang from the “en­dow­ment ef­fect”: peo­ple value goods that they have more than they value ex­actly the same goods when they are in the hands of oth­ers. As such, they placed a much higher value on ac­cept­ing a mor­tal­ity risk than they did on elim­i­nat­ing that same risk.

Thaler along with his pioneering col­leagues showed that the mis­takes that peo­ple made— con­trary to what main­stream econ­o­mists be­lieved—were not ran­dom. In­stead, some such mis­takes were pre­dictable and led to sys­temic so­ci­ety-wide is­sues, which could be cor­rected by cor­rect­ing in­cen­tives, or “nudg­ing” peo­ple to slightly mod­ify their be­hav­iour.

For in­stance, Thaler showed that peo­ple are far more likely to opt in for retirement sav­ings plans when opt­ing in was the de­fault op­tion in such schemes. In an in­flu­en­tial 1991 pa­per, Kah­ne­man and Thaler listed sev­eral such “anom­alies” where the ac­tual out­comes dif­fered starkly from what stan­dard eco­nomic the­ory pre­dicted.

Thaler’s work has been par­tic­u­larly in­flu­en­tial in fi­nance, help­ing ex­plain why mar­kets may of­ten over-re­act to dra­matic news. Along with an­other re­cent No­bel lau­re­ate, Robert Shiller, Thaler has been one of the pi­o­neers in the area of be­havioural fi­nance, help­ing us un­der­stand mar­ket phe­nom­ena that con­ven­tional eco­nomics could not ex­plain well.

It is not sur­pris­ing that Thaler is one of the few econ­o­mists who was not en­thused by the “surge pric­ing” fea­ture of the cab-hail­ing ser­vice Uber. Surge pric­ing refers to the ex­tra charge that kicks in dur­ing peak hours in ar­eas when de­mand for cabs spikes sharply.

Surge pric­ing is based on the cen­tral tenets of eco­nomics, and yet it has faced the ire of cus­tomers in sev­eral mar­ket economies across the world. Many cus­tomers who ac­cept surge pric­ing when they are faced with that op­tion end up com­plain­ing about the firm, of­ten on so­cial me­dia. The re­ac­tion is even more se­vere when there is an emer­gency, such as dur­ing the De­cem­ber 2014 hostage cri­sis in Syd­ney, when a masked gun­man held peo­ple cap­tive in a café.

Thaler was an early critic of this model. In his 2015 book Mis­be­hav­ing: The Mak­ing of Be­hav­ioral Eco­nomics, Thaler ar­gues that tem­po­rary spikes in de­mand, “from bliz­zards to rock star deaths, are an es­pe­cially bad time for any busi­ness to ap­pear greedy”. He ar­gues that to build long-term re­la­tion­ships with cus­tomers, firms must be seen as “fair” and not just ef­fi­cient, and that this of­ten in­volves giv­ing up on short-term prof­its even if cus­tomers may be will­ing to pay more at that point to avail them­selves of its prod­uct or ser­vice.

“I love Uber as a ser­vice,” writes Thaler. “But if I were their con­sul­tant, or a share­holder, I would sug­gest that they sim­ply cap surges to some­thing like a mul­ti­ple of three times the usual fare. You might won­der where the num­ber three came from. That is my vague im­pres­sion of the range of prices that one nor­mally sees for prod­ucts such as ho­tel rooms and plane tick­ets that have prices de­pen­dent on sup­ply and de­mand. Fur­ther­more, th­ese ser­vices sell out at the most pop­u­lar times, mean­ing that the own­ers are in­ten­tion­ally set­ting the prices too low dur­ing the peak sea­son.

“I once asked the owner of a ski lodge why he didn’t charge more dur­ing the Christ­mas week hol­i­day, when de­mand is at a peak and rooms have to be booked nearly a year in ad­vance. At first, he didn’t un­der­stand my ques­tion. No one had ever asked why the prices are so low dur­ing this pe­riod when prices are at their high­est. But once I ex­plained that I was an econ­o­mist, he caught on and an­swered quickly. ‘If you gouge them at Christ­mas, they won’t come back in March.’ That re­mains good ad­vice for any busi­ness that is in­ter­ested in build­ing a loyal clien­tele.”

Thaler’s in­sights are based not just on anec­dotes, but spring from a long body of re­search on th­ese is­sues. In a land­mark 1986 study con­ducted jointly with Kah­ne­man and Knetsch, Thaler showed that com­mu­nity stan­dards of fair­ness dic­tated when and how far firms could raise prices.

Mar­kets of­ten failed to clear in the short term be­cause such no­tions of fair­ness pre­vented com­pa­nies from rais­ing prices when de­mand rose, they pointed out. The study was based on in­ter­views that elicited the views of peo­ple on sev­eral sce­nar­ios where a firm changed prices or wages. For in­stance, an over­whelm­ing ma­jor­ity of par­tic­i­pants con­sid­ered it un­fair of a hard­ware store to raise the price of snow shov­els when faced with a sud­den in­crease in de­mand the morn­ing af­ter a snow storm.

Af­ter defending surge pric­ing early on, Uber has tried to tweak this fea­ture in its app. Thaler’s crit­i­cism may be prompt­ing a re­think within Uber. Even the In­dian govern­ment, in its reg­u­la­tions re­lat­ing to cab-ag­gre­ga­tors such as Uber and Ola, seems to have stuck to Thaler’s thumb rule of cap­ping prices to three times the base fare (dur­ing day­time rides).

RAMESH PATHANIA/MINT

Eco­nomic be­hav­iour: Thaler and his col­leagues showed that peo­ple’s mis­takes—con­trary to what main­stream econ­o­mists be­lieved—were not ran­dom.

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