Thaler brought common sense to economics
Unlike others, the Nobel Prize winner’s work is predicated on people acting in an irrational manner
Richard Thaler has been awarded the Nobel Prize in economics for his pioneering work on decision-making that lies in the space between economics and psychology. The 72-year-old American economist is Charles R Walgreen distinguished service professor of behavioral science and economics at Chicago Booth School of Business. Thaler co-authored the global bestseller Nudge in 2008 with Cass Sunstein, which shows that by knowing how people think, “choice environments” can be designed that make it easier for individuals to choose what is best for themselves, their families, and society without restricting freedom of choice. The Nobel committee has credited him with bringing the somewhat controversial field of behavioural economics from the fringes to the mainstream of academic research.
In 1983, when reporters asked Nobel laureate Gerard Debreu to explain his General Equilibrium Theory in plain English, economists were amused as it was a near impossible task and indeed, Debreu told them so. In a similar situation, Thaler can not only easily explain his work to a man on the street but that person might remark, “This is just common sense”. Thaler brought common sense to economics no mean achievement.
Standard economic theory is based on the simplifying assumption that people always behave rationally. Thaler considers the more realistic possibility that people sometimes act “human” and irrational. However, they deviate from rationality in consistent ways, which implies that behaviour can be predicted, and there are opportunities to design public policy in a way that desired outcomes are attained.
The Indian experience bears out the salience of human behaviour in public policy. Traditionally, the thinking has been that as long as ‘rational’ policies are designed and implemented, all will be well. For instance, if adequate sanitation infrastructure is built, people will use it, and open defecation will be eliminated. In reality, the effective- ness of policy is often constrained by behaviours that are shaped by cultural norms and social conditioning, and are difficult to change in the short run. Many view latrines as ritually impure and prefer to defecate in the open. In such a context, investing in latrines by itself will not improve sanitation people have to be nudged to use them. Incidentally, a well-known example of Thaler’s “nudge” is how etching flies in porcelain near urinal drains in the men’s rooms at Amsterdam airport reduced “spillage” by 80% as men like to aim at targets!
Some of what we call irrational traits are nothing but simple human frailties like procrastination, lack of self-control, and sheer inertia. A simple nudge may help us overcome these problems and also achieve social good. A study by Duflo et al (2011) on fertiliser use by farmers in Kenya showed that despite clear evidence that using fertiliser at the right time could significantly increase yields as well as their incomes, farmers procrastinate and lose potential gains. Bringing fertiliser to their doorstep at the right time solved the problem, and was shown to be more effective than subsidising fertiliser.
Another important application is savings behaviour. People just lack the willpower to save. Designing schemes for people to commit themselves to savings plans in advance has been found to significantly enhance savings. Thaler’s redesign of 401(k) retirement plan for many American companies changed the default option to automatic enrolment, greatly increasing savings.
Thaler’s work with Sunstein triggered a philosophical debate on “libertarian paternalism”. On one hand, we do not like an intrusive government that limits individual freedoms. On the other hand, we want a government that maximises wellbeing of citizens. What should be done when individuals are making decisions that are detrimental to their own interests? In other words, how can government help individuals make the best choice for themselves without taking over the executive function? Their answer is by giving a gentle nudge in the right direction. Some governments like the Obama administration and the present British government have tried to use insights from behavioural economics in policymaking.
Thaler once remarked to Robert Barro, a mainstream economist and strong defender of the assumption of perfectly rational behaviour: “The difference between us is that you assume people are as smart as you are, while I assume people are as dumb as I am.” Today Thaler is a Nobel laureate and Barro is yet to be one.