Thought Leader Interview:
You have described the goal of your research over the last 40 years as follows: “To introduce humans into Economics.” Please explain.
The truth is, the people who populate Economics textbooks bear very little resemblance to the humans we interact with on a daily basis. Standard economic models describe people who are as smart as the smartest economist, who are not affected by emotion, and who have no issues with self-control. That’s ‘Homo Economicus’; I call them ‘Econs’ for short — and I truly don’t know anybody like that. In reality, we do not have perfect willpower and we don’t always choose what is best for us — which is why obesity and insufficient retirement savings are so common today.
You have said that Daniel Kahneman and Amos Tversky’s Prospect Theory provides a ‘template’ for the type of theories we need today. How so?
As indicated, we struggle to determine what is best for us in the long run — and then, we struggle to have the willpower to implement that choice — especially if it entails delayed gratification. We sorely need economic theories that account for this, and the first such theory was Prospect Theory.
Traditionally, economists believed that every time we make a choice, the net effect of the gains and losses involved in that choice are somehow combined in our head to calculate whether a particular choice is desirable or not. However, Prospect Theory states that losses and gains are valued very differently by people — and this affects our decisions.
Simply put, we give losses far more weight than gains. So, if you were to gain $100 from one transaction but lose $80 in another, you would end up feeling worse off, even though you are $20 ahead. When it came out [in 1979], the great thing about Prospect Theory was that it proved that you could take a scientific approach to human behaviour.
Describe how Daniel Kahneman — who went on to be named a Nobel Laureate in Economic Sciences — became your mentor.
I first came across his work with the late Amos Tversky back in 1975. At the time, they were living in Israel, but I found out that
they were planning to spend a year at Stanford in 1977-78 — so I made it my business to get a posting there. I begged and pleaded, and somehow managed to get a research grant to fund my visit.
When Daniel and Amos arrived, I was already there — ready to pester them. Kahneman’s office was just up the hill from mine, so I made it a habit to wander up there to chat with him, and would often find Tversky there, as well. We had a glorious year together: They taught me Psychology and I taught them Economics, and it turned into a 40-year friendship. Sadly, Amos passed away in 1996.
Since Kahneman and Tversky’s work on biases like ‘availability’, ‘representativeness’ and ‘anchoring’, a long list of other biases has been identified (see page 17 for a sampling). You have called this “both a blessing and a curse”. Please explain.
It is a blessing in that every bias provides a small glimpse into how our minds work. To be clear, it was never Amos and Danny’s intention to suggest that people are stupid: They always said that they liked to study errors in judgment for the same reason some people study optical illusions: Because they teach us something about human perception.
The curse in having such a long list of biases is that it leads some people to think they can explain anything by ‘cherry-picking’ a bias to fit the facts. But that is not what behavioural science is about. It is a science: It’s about making predictions and testing them.
What is a ‘choice architect’?
A choice architect is anyone who has responsibility for organizing the context in which people make decisions. They create an environment that provides individuals the freedom to choose, but they still influence peoples’ behaviour. For instance, we advise governments on how to use choice architecture to help make citizen’s lives healthier or better in some way. But, of course, choice architecture can also be used to take advantage of people. No matter what industry you work in, if you indirectly influence the choices other people make, you are a choice architect.
Describe the ongoing battle between our two selves: The Planner and the Doer.
As Kahneman describes in Thinking, Fast and Slow, humans behave as if there were two distinct systems in their brains: One is automatic and the other is reflective. I have used a similar framework to describe how people deal with problems of self-control. In my model there is a long-sighted, reflective ‘Planner’ and a short-sighted, impulsive ‘Doer’. When he sees something he likes, he grabs it. The Planner, on the other hand, is the part of you that thinks ahead and budgets your resources appropriately. To-do-lists, grocery lists and alarm clocks are examples of our Planner taking steps to control the actions of our Doer.
Unfortunately, the Planner doesn’t always win. One the goals of my work has been to teach people how to alter their environments to give themselves the best chance to make good decisions for the long run.
What is your favourite example of successful nudging?
In my view, the domain in which nudging — and Behavioural Economics in general — has had the greatest impact to date is in the design of defined-contribution savings plans. It used to be that people had to fill out a pile of forms, but with default enrollments, they only have to fill out a form if they do not want to enroll. This has basically solved the enrollment problem: Opt-out rates are now very low — around 10 per cent.
When this started to happen, it was great, but we found that the plans were auto-enrolling people at very low savings rates — in the U.S., often at a rate of just three per cent. As a way to nudge people to increase their savings rates, Shlomo Benartzi and I introduced a plan called ‘Save More Tomorrow’. Under this plan, workers are offered the option to increase their savings rate at a later date — ideally, when they get their next raise. As such, once an employee enrolls in the plan, her savings rate continues to increase until she reaches some cap — or opts out. In our first study of this approach, savings rates more than tripled in three years.
The Save More Tomorrow plan is a collection of what I like
to call ‘supposedly-irrelevant factors’ (SIFS) — things that standard economic theory says should not influence choices: It should not matter that the savings rate is increased in a few months rather than right now; nor that the increases are linked to pay increases; nor that the default is to stay in the plan; but of course, all of these features matter. Putting off the increase in saving to the future helps those who are present-biased; linking to increases in pay mitigates loss aversion; and making staying in the plan the default puts status quo bias to good use. More than half of large plans around the world now use automatic enrollment and automatic escalation.
When are nudges most needed?
People need a nudge most when a choice and its consequences are separated in time, and as a result, both investment goods and sinful goods are prime candidates for nudges. ‘Investment goods’ include dieting, exercise and flossing your teeth. In each case, the costs are borne immediately, but the benefits are delayed, and as a result, people tend to err on the side of doing too little. ‘Sinful goods’ include things like cigarettes, doughnuts and alcohol; basically, you get the pleasure now and suffer the consequences later. Nudges are also needed most when decisions are difficult or rare — especially when there is no prompt feedback.
My number-one mantra for choice architects is, ‘Make it easy’. If you want to get someone to do something, make it easy to do that thing. For instance, if you want them to eat healthier food, put healthier options in your cafeteria, make them easier to find, and make them taste better.
Many people believe that the financial markets are the most efficient of all markets. Are they?
I would agree — but they will never be perfectly efficient, because like all markets, humans are involved. As a result, there are periods where they get overly excited and periods when they get overly depressed. Also, the lack of predictability in stock market returns does not imply that stock prices are ‘correct’. The inference that ‘unpredictability implies rational prices’ is what Robert Shiller once called “one of the most remarkable errors in the history of economic thought.”
What about the Efficient Market Hypothesis (EMH)?
EMH has been essential to the history of research on financial markets, but the danger it presents is when people consider it to be literally true. If policymakers believe bubbles are impossible, for instance, they will fail to take appropriate steps to dampen them. Looking back at what was happening in 2007, it would have been appropriate to raise mortgage-lending requirements
in cities where price-to-rental ratios seemed most frothy; instead, we saw a period in which lending requirements were unusually lax.
Of course, in the face of predictable human error, a firm can take one of two approaches: It can try to teach consumers about the costs of the error, or it can devise a strategy to exploit the error. The latter will almost always be more profitable. No one has ever gotten rich convincing people not to take out an unwise mortgage. My hope is that people ‘nudge for good’ — as I write in my book whenever someone asks me to sign it.
How do you define ‘mental accounting’, and what are some of your key findings in this area?
Simply put, mental accounting is the study of how people spend money. For me, this has involved observing the way people handle their financial affairs — and noticing all the various ways that they don’t do it like a professional would. For example, people often buy things simply because they seem to be a great deal — not because the product is going to provide enormous satisfaction. Deep in our closets, many of us have stuff that we bought at 50 per cent off — that we probably shouldn’t have bought even if it were free.
Another key finding is that people put their money into different categories; and then, they are often reluctant to spend money from one ‘pot’ when they need it for another pot. We behave differently in different circumstances: When we are on vacation, we easily spend money, even though it is the same money that will be scarce when we get home. Or, we might use different monthly budgets for groceries and eating at restaurants, for example, and constrain one kind of purchase when the budget runs out, while not constraining the other — even though both draw upon the same resource (i.e. your income). We also found that grocery shoppers spend less when paying with cash than with their debit or credit cards.
A recent study of CFOS found that they had no ability to predict stock market returns, and that they also had no selfawareness about this lack of predictive skill. What are the implications of this finding?
Sadly, it’s not clear what can be done about it: Overconfidence is a fact of life. That particular study asked the CFOS to forecast stock market returns and give an 80 per cent confidence limit — meaning a range that the correct answer would lie between the two numbers 80 per cent of the time. What they found is, their forecast included the right answer about one third of the time.
We see overconfident forecasts all the time. In last fall’s American election, some forecasters were saying that Hillary Clinton had a 99 per cent chance of winning — which, even without the benefit of hindsight, was a ridiculous forecast.
What is your message for the critics who feel that nudging is heavy-handed and unnecessary?
I would tell them that whether they like it or not, there is no avoiding nudging — or choice architecture. Take a school cafeteria, for example: Someone has to arrange and display the food; it can’t just be presented randomly — unless you want the kids to spend their entire time looking for something to eat. That is choice architecture in action, and it applies to just about everything in the economy and in society.
When nudges are used in the business arena, I do believe that companies need to be sure the choice architecture they use is transparent, and not a deliberate attempt to induce customers to make a poor choice. A key feature of responsible nudging is to make sure that all default options are easily reversible. If you are suggesting people enroll in a pension plan because you believe that they would do so if they had the knowledge and willpower to make a good choice — and if they can get out of it with one mouse click — then, little harm done. But if the user has to make three phone calls and then walk across town to find the office where they have to fill out a long form in order to undo something, that is not acceptable.
My Nudge co-author Cass Sunstein and I really hope that an understanding of choice architecture and the power of nudges will lead people to think of creative ways to improve human lives in all sorts of domains: Workplaces, corporate boards, universities and even families might be able to use, and benefit from, small exercises in what we call ‘libertarian paternalism’.
Looking ahead, you have said ‘Behavioural Macroeconomics’ is at the top of your wish list. Please explain.
In my view, Macroeconomics is stuck where Economics was 30 years ago, with models of Econs, even though the policies that emerge from it affect humans. Fortunately, this is beginning to change, and if we continue to apply Behavioural Economics tools to the study of Macroeconomics, we might be able to prevent the next global financial crisis. Or, at the very least, have a better sense of how to deal with it, when it happens.
You have also said that the term Behavioural Economics will likely vanish from our lexicon one day. Why is that?
Choice architecture applies to just about everything in the economy and in society.
I have the hopeful thought that Economics will soon become as behavioural as it needs to be. There is still plenty of room for models of rational actors: We still need to figure out, if we want to maximize profits, what is the best way to do it? Traditional Economics is good at finding optimal solutions to such problems. But, in lots of other situations, a more behavioural approach is required. I am looking forward to the day where economists just use the tools that seem best suited for the job at hand, and stop treating Behavioural Economics as a separate field.
Richard Thaler is the Charles R. Walgreen Distinguished Service Professor of Behavioural Science and Economics at the University of Chicago’s Booth School of Business. He is the author of Misbehaving: The Story of Behavioral Economics (W.W. Norton & Company, 2015) and the co-author of Nudge: Improving Decisions on Health, Wealth, and Happiness (Yale University Press, 2008).