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Richard Thaler, one of the founders of modern behavioral economics and the winner of the 2017 Nobel Memorial Prize in Economic Sciences, is obsessed with how people make decisions — not just investors or policymakers but everyday consumers and taxpayers. He’s tried to explain why people won’t sell wine they own for more than they paid for it, why people take out big loans even when they have plenty of savings, and how to encourage people to sock away more of their paychecks toward retirement.
That’s made him an unusually public intellectual, as Nobelists go. He writes prolifically for the New York Times, his book Nudge with Cass Sunstein was a best-seller and remains widely influential, and he even had a brief cameo in 2015’s The Big Short, where he and Selena Gomez explained how synthetic collateralized debt obligations (CDOs) work :
The message of behavioral economics as a subfield, and Thaler’s work in particular, is sometimes summarized as “humans aren’t rational.” Economics has historically relied heavily on models of behavior where individual agents rationally pursue their goals, and so challenging that central assumption was crucially important, especially when Thaler’s most influential papers on the subject came out in the 1980s.
But “people aren’t rational” is, on its own, a pretty obvious point. The real contribution of Thaler and other behavioral economics researchers, like psychologists Amos Tversky and Daniel Kahneman (a 2002 Nobel laureate), was identifying specific kinds of irrationality that could be predicted and modeled ahead of time. Rationality was always a simplifying assumption in economic models, and even if that assumption is implausible, it’s hard to dislodge without different, usable assumptions to put in its place. Thaler and his fellow researchers helped identified durable biases that could be modeled and used to supplement a purely rational model of human behavior.
People do accounting differently than economists — and that matters
Thaler is perhaps most famous for his work on two kinds of economic irrationality: “mental accounting” and the endowment effect. Both of these explain behaviors that are hard to make sense of through traditional economic theory, but which should be familiar to anyone who has been, like, a human walking around in the world for a while.
In his landmark 1985 paper on mental accounting, Thaler opens with four anecdotes explaining the concept. The third is perhaps the clearest:
Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to buy the home in five years. The money earns 10% in a money market account. They just bought a new car for $11,000 which they financed with a three-year car loan at 15%.
To an economist, this is pretty baffling behavior. Why wouldn't Mr. and Mrs. J just use some of their $15,000 in savings to buy their new car in cash? That would save a significant amount of money, as the interest they’re paying on the car loan outstrips the interest they’re getting from their savings account.
The answer, Thaler argues, is that people tend to make economic decisions by budgeting certain money for certain purposes. That $15,000 isn’t just $15,000; it’s the $15,000 for the home down payment. It’s a violation of that mental accounting process to pilfer the funds for a car. And what's more, Thaler notes that while economically irrational, this kind of accounting serves important purposes for people. It comes, he writes, from “the household's appreciation for their own self-control problems. They are afraid that if the vacation home account is drawn down it will not be repaid, while the bank will see to it that the car loan is paid off on schedule."
This has important implications for analyzing, say, how an increase in income is going to change someone’s behavior. It means that people will respond to a raise at their job very differently from a lottery payout or a tax refund or a gift card given as a present. These sources of income get sorted into different mental budgets, and are saved or spent differently in turn.
That, in turn, has important ramifications for public policy. In recent years, development economics researchers have experimented with “labeled” cash transfers, wherein recipients get money that can be used for anything but are told it’s meant for a specific purpose. The idea is to trigger recipients’ mental accounting process, and use it to ensure the funds are directed toward the intended purpose. And, it turns out, that’s exactly what happens. A study of such a program in Morocco found that when fathers were given money and told it was meant for school support, their children were far likelier to go to school and less likely to drop out. Actually requiring that recipients enroll their kids in school hurt rather than helped; merely labeling the money as school money was more effective than requiring that recipients put their kids in school.
Exploiting mental accounting, then, enabled a more effective and yet less intrusive program. This is what Thaler and Sunstein call a “nudge”: a subtle, noncoercive government intervention that can have outsize impacts because of human cognitive biases.
You actually do know what you’ve got before it’s gone — a little too much so, in fact
The endowment effect, a term Thaler coined in 1980 and explored in a famous 1991 paper with Kahneman and Simon Fraser University economist Jack Knetsch, has similarly profound implications. The basic idea is that people are strongly averse to giving up goods they already have, to the point of refusing to sell the goods for a price higher than what they paid for the goods to start with.
Thaler, Kahneman, and Knetsch offer the following example:
A wine-loving economist we know purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only $10 when purchased would now fetch $200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price.
The endowment effect is closely related to loss aversion — the finding that people try to avoid losses in their well-being, money, and so on, more than they try to pursue gains.
Experiments run by Thaler, Kahneman, and Knetsch over the years found evidence for endowment effects in a variety of markets. My favorite example was a survey Thaler first conducted in 1974 and later explained in his 1980 paper on the endowment effect, asking two questions:
(a) Assume you have been exposed to a disease which if contracted leads to a quick and painless death within a week. The probability you have the disease is 0.001. What is the maximum you would be willing to pay for a cure?
(b) Suppose volunteers were needed for research on the above disease. All that would be required is that you expose yourself to a 0.001 chance of contracting the disease. What is the minimum payment you would require to volunteer for this program? (You would not be allowed to purchase the cure.)
For traditional economists, the answer to these two questions should be identical. If gains and losses are felt equally, then the amount you’d pay to reduce your risk of death by 0.1 percent should be identical to the amount you’d have to be paid to increase your risk of death by 0.1 percent.
That, suffice it to say, is not the result Thaler gets; he found that people would be willing to pay $200 for the cure and would demand $10,000 to participate in the study. The endowment effect is so powerful, people value their existing level of health so much, that they’d pay 50 times more to preserve their current level of health than to get a little healthier.
The endowment effect helps explain why businesses don’t engage in rational behavior if it’s likely to enrage their customers. Take, for instance, concert venues that know their events are likely to sell out quickly, and yet do not jack up ticket prices to hundreds or thousands of dollars to control the demand. Because jacking up the price would entail taking away something people are used to — reasonable ticket prices — it prompts a strong feeling of repulsion and injustice, which can lead to consumers turning on businesses and hurting them more than raising prices would help.
One Kahneman/Knetsch/Thaler survey asked Toronto and Vancouver residents to evaluate the fairness of two ways a car dealer could react to a shortage on a new model:
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If the dealership has been selling the car at list price and then jacks up the price by $200 to cope with demand, people find that unfair. If, however, it’s been selling the cars at a $200 discount and then stops, people are fine with that. It’s a flagrant contradiction according to basic economic theory, but it makes sense when you consider the endowment effect. Going from a discount to list price doesn’t take away something consumers already have right now. Raising the list price does.
Like mental accounting, the endowment effect has powerful policy implications. To boost retirement savings, Thaler and fellow behavioral economist Shlomo Benartzi have proposed a system called Save More Tomorrow, in which participants commit themselves to increase their regular savings whenever they get a pay raise.
"By synchronizing pay raises and savings increases, participants never see their take-home amounts go down, and they don't view their increased retirement contributions as losses," Thaler and Sunstein write in Nudge. While simply increasing savings at once is painful for people, because it reduces their take-home pay, Save More Tomorrow takes into account loss aversion and only boosts savings when it won’t be felt as a loss.
Read more
- Binyamin Appelbaum’s write-up of the award to Thaler in the New York Times is excellent, and includes interviews with both Thaler and his frequent collaborator Sunstein.
- Economist Tyler Cowen runs through Thaler’s most influential papers, and argues that his and Sunstein’s nudge approach to policy holds significant promise for social conservatives.
- Sunstein’s review of Thaler’s autobiography also serves as an excellent overview of Thaler’s career.
- Thaler and Sunstein’s suggestion that nudges can be used as part of a “libertarian paternalist” approach to policy has understandably raised concerns in pure libertarian circles. Thaler responds to some of these critiques here.
- For a case for more “pushes” and fewer nudges, see NYU law school professors Ryan Bubb and Richard Pildes’s “How Behavioral Economics Trims Its Sails and Why.”
- NYU philosopher Tamsin Shaw has argued that Thaler’s brand of behavioral econ leads to attempts at mass public persuasion by governments, politicians, and corporations that can be coercive, and are harder to call out and hold accountable than blunter methods those powerful actors use.
