Decisive work that won Richard Thaler the 2017 economics Nobel prize
Richard Thaler, an economist at the University of Chicago Graduate School of Business, won the 2017 Nobel Prize in economics for his contributions to behavioural economics. What is “behavioural economics,” and what is its importance?
To answer this, let’s take a step back and think about scientific modelling. In science, a key goal is to learn about the relationships between different phenomena, sometimes out of abstract intellectual curiosity, and other times to inform policymakers that are striving to improve the lives of everyday people. This latter category is of particular interest to economists, who ask questions about the effect of education on earnings, the effect of unemployment insurance on the rate of unemployment, and so on.
The problem is these relationships are almost exclusively embedded in environments whose complexity is beyond what the human brain can handle.
We have good reason to believe that education affects earnings, for example; but many other factors are at play as well, such as experience, race, gender, height, strength, intelligence, sociability, the job type, and so on. Rather than giving up, scientists – including economists – develop “models,” which are simplified descriptions of otherwise complex environments.
Thus an economist trying to understand earnings may decide to focus on the effect of education and experience only, and to ignore the other variables. This makes the problem cognitively digestible, or “tractable”: by cutting down on the dimensionality of the environment, to simple levels, a scientist can muster the mental resources necessary to analyse the relationships, and to make predictions about what would happen in real life if one of the variables was changed.
When you were in high school, you used models in science all the time. In physics, when you wanted to predict the speed with which a ball would roll down a slope, you built a model which assumed there was no friction or air resistance. In chemistry, when you wanted to predict which elements could form compounds, you used a model that characterised atoms in terms of electrons, neutrons and protons.
Both models are fundamentally inaccurate descriptions of reality, but for certain environments they did a pretty good job of predicting outcomes. As you acquired more skills, you were taught more complex models that allowed for more nuanced predictions. However, at no point did you use a model whose assumptions were even close to being accurate.
What does this have to do with Richard Thaler and behavioural economics? Loosely speaking, modern “neoclassical” economics is the study of decision-making, which is subject to three modelling assumptions.
Firstly, people have a notion of how their actions affect their own well-being, and they make decisions based on that. Secondly, people’s well-being depends on their own outcomes, not the outcomes of others. Thirdly, people’s well-being is determined by their financial income.
Mr Thaler, building on the work of former Nobel Prize winner Herbert Simon, and working alongside fellow laureate Daniel Kahneman, imported alternative assumptions about human behavior from the field of psychology to improve predictive accuracy.
One line of inquiry challenged the first assumption, and suggested that limitations to people’s cognitive abilities prevented them from maximising their well-being. For example, humans can only remember and retrieve so many pieces of information, and so they rely on rules of thumb (such as keep 50 per cent of your portfolio in stocks, save 10 per cent of your monthly income, always look left then right when crossing the road, etc) as a substitute for often more complicated decision-making processes.
Mr Thaler and his colleagues also posited alternative assumptions about people’s interactions with others: they asserted that humans care about their well-being relative to others, especially neighbours and colleagues.
Finally, non-financial factors also affect a human’s well-being, such as how liked they are by their family, or how much power they wield over others.
This new field was behavioral economics, and it has afforded us a better understanding of why people struggle to lose weight, why employers prefer layoffs to wage cuts, and why we rarely see large, anonymous charitable donations. The fruits of Mr Thaler’s work can be seen in the behavioural “nudge” units operating in the governments of many of the world’s richest countries.