The 2017 Nobel: Richard Thaler

A true surprise this morning: the behavioral economist Richard Thaler from the University of Chicago has won the Nobel Prize in economics. It is not a surprise because it is undeserving; rather, it is a surprise because only four years ago, Thaler’s natural co-laureate Bob Shiller won while Thaler was left the bridesmaid. But Thaler’s influence on the profession, and the world, is unquestionable. There are few developed governments who do not have a “nudge” unit of some sort trying to take advantage of behavioral nudges to push people a touch in one way or another, including here in Ontario via my colleagues at BEAR. I will admit, perhaps under the undue influence of too many dead economists, that I am skeptical of nudging and behavioral finance on both positive and normative grounds, so this review will be one of friendly challenge rather than hagiography. I trust that there will be no shortage of wonderful positive reflections on Thaler’s contribution to policy, particularly because he is the rare economist whose work is totally accessible to laymen and, more importantly, journalists.

Much of my skepticism is similar to how Fama thinks about behavioral finance: “I’ve always said they are very good at describing how individual behavior departs from rationality. That branch of it has been incredibly useful. It’s the leap from there to what it implies about market pricing where the claims are not so well-documented in terms of empirical evidence.” In other words, surely most people are not that informed and not that rational much of the time, but repeated experience, market selection, and other aggregative factors mean that this irrationality may not matter much for the economy at large. It is very easy to claim that since economists model “agents” as “rational”, we would, for example, “not expect a gift on the day of the year in which she happened to get married, or be born” and indeed “would be perplexed by the idea of gifts at all” (Thaler 2015). This type of economist caricature is both widespread and absurd, I’m afraid. In order to understand the value of Thaler’s work, we ought first look at situations where behavioral factors matter in real world, equilibrium decisions of consequence, then figure out how common those situations are, and why.

The canonical example of Thaler’s useful behavioral nudges is his “Save More Tomorrow” pension plan, with Benartzi. Many individuals in defined contribution plans save too little, both because they are not good at calculating how much they need to save and because they are biased toward present consumption. You can, of course, force people to save a la Singapore, but we dislike these plans because individuals vary in their need and desire for saving, and because we find the reliance on government coercion to save heavy-handed. Alternatively, you can default defined-contribution plans to involve some savings rate, but it turns out people do not vary their behavior from the default throughout their career, and hence save too little solely because they didn’t want too much removed from their first paycheck. Thaler and Benartzi have companies offer plans where you agree now to having your savings rate increased when you get raises – for instance, if your salary goes up 2%, you will have half of that set into a savings plan tomorrow, until you reach a savings rate that is sufficiently high. In this way, no one takes a nominal post-savings paycut. People can, of course, leave this plan whenever they want. In their field experiments, savings rates did in fact soar (with takeup varying hugely depending on how information about the plan was presented), and attrition in the future from the plan was low.

This policy is what Thaler and Sunstein call “libertarian paternalism”. It is paternalistic because, yes, we think that you may make bad decisions from your own perspective because you are not that bright, or because you are lazy, or because you have many things which require your attention. It is libertarian because there is no compulsion, in that anyone can opt out at their leisure. Results similar to Thaler and Benartzi’s have found by Ashraf et al in a field experiment in the Philippines, and by Karlan et al in three countries where just sending reminder messages which make savings goals more salient modestly increase savings.

So far, so good. We have three issues to unpack, however. First, when is this nudge acceptable on ethical grounds? Second, why does nudging generate such large effects here, and if the effects are large, why doesn’t the market simply provide them? Third, is the 401k savings case idiosyncratic or representative? The idea that the homo economicus, rational calculator, misses important features of human behavior, and would do with some insights from psychology, is not new, of course. Thaler’s prize is, at minimum, the fifth Nobel to go to someone pushing this general idea, since Herb Simon, Maurice Allais, Daniel Kahneman, and the aforementioned Bob Shiller have all already won. Copious empirical evidence, and indeed simple human observation, implies that people have behavioral biases, that they are not perfectly rational – as Thaler has noted, we see what looks like irrationality even in the composition of 100 million dollar baseball rosters. The more militant behavioralists insist that ignoring these psychological factors is unscientific! And yet, and yet: the vast majority of economists, all of whom are by now familiar with these illustrious laureates and their work, still use fairly standard expected utility maximizing agents in nearly all of our papers. Unpacking the three issues above will clarify how that could possibly be so.

Let’s discuss ethics first. Simply arguing that organizations “must” make a choice (as Thaler and Sunstein do) is insufficient; we would not say a firm that defaults consumers into an autorenewal for a product they rarely renew when making an active choice is acting “neutrally”. Nudges can be used for “good” or “evil”. Worse, whether a nudge is good or evil depends on the planner’s evaluation of the agent’s “inner rational self”, as Infante and Sugden, among others, have noted many times. That is, claiming paternalism is “only a nudge” does not excuse the paternalist from the usual moral philosophic critiques! Indeed, as Chetty and friends have argued, the more you believe behavioral biases exist and are “nudgeable”, the more careful you need to be as a policymaker about inadvertently reducing welfare. There is, I think, less controversy when we use nudges rather than coercion to reach some policy goal. For instance, if a policymaker wants to reduce energy usage, and is worried about distortionary taxation, nudges may (depending on how you think about social welfare with non-rational preferences!) be a better way to achieve the desired outcomes. But this goal is very different from the common justification that nudges somehow are pushing people toward policies they actually like in their heart of hearts. Carroll et al have a very nice theoretical paper trying to untangle exactly what “better” means for behavioral agents, and exactly when the imprecision of nudges or defaults given our imperfect knowledge of individual’s heterogeneous preferences makes attempts at libertarian paternalism worse than laissez faire.

What of the practical effects of nudges? How can they be so large, and in what contexts? Thaler has very convincingly shown that behavioral biases can affect real world behavior, and that understanding those biases means two policies which are identical from the perspective of a homo economicus model can have very different effects. But many economic situations involve players doing things repeatedly with feedback – where heuristics approximated by rationality evolve – or involve players who “perform poorly” being selected out of the game. For example, I can think of many simple nudges to get you or me to play better basketball. But when it comes to Michael Jordan, the first order effects are surely how well he takes cares of his health, the teammates he has around him, and so on. I can think of many heuristics useful for understanding how simple physics will operate, but I don’t think I can find many that would improve Einstein’s understanding of how the world works. The 401k situation is unusual because it is a decision with limited short-run feedback, taken by unsophisticated agents who will learn little even with experience. The natural alternative, of course, is to have agents outsource the difficult parts of the decision, to investment managers or the like. And these managers will make money by improving people’s earnings. No surprise that robo-advisors, index funds, and personal banking have all become more important as defined contribution plans have become more common! If we worry about behavioral biases, we ought worry especially about market imperfections that prevent the existence of designated agents who handle the difficult decisions for us.

The fact that agents can exist is one reason that irrationality in the lab may not translate into irrationality in the market. But even without agents, we might reasonably be suspect of some claims of widespread irrationality. Consider Thaler’s famous endowment effect: how much you are willing to pay for, say, a coffee mug or a pen is much less than how much you would accept to have the coffee mug taken away from you. Indeed, it is not unusual in a study to find a ratio of three times or greater between the willingness to pay and willingness to accept amount. But, of course, if these were “preferences”, you could be money pumped (see Yaari, applying a theorem of de Finetti, on the mathematics of the pump). Say you value the mug at ten bucks when you own it and five bucks when you don’t. Do we really think I can regularly get you to pay twice as much by loaning you the mug for free for a month? Do we see car companies letting you take a month-long test drive of a $20,000 car then letting you keep the car only if you pay $40,000, with some consumers accepting? Surely not. Now the reason why is partly what Laibson and Yariv argue, that money pumps do not exist in competitive economies since market pressure will compete away rents: someone else will offer you the car at $20,000 and you will just buy from them. But even if the car company is a monopolist, surely we find the magnitude of the money pump implied here to be on face ridiculous.

Even worse are the dictator games introduced in Thaler’s 1986 fairness paper. Students were asked, upon being given $20, whether they wanted to give an anonymous student half of their endowment or 10%. Many of the students gave half! This experiment has been repeated many, many times, with similar effects. Does this mean economists are naive to neglect the social preferences of humans? Of course not! People are endowed with money and gifts all the time. They essentially never give any of it to random strangers – I feel confident assuming you, the reader, have never been handed some bills on the sidewalk by an officeworker who just got a big bonus! Worse, the context of the experiment matters a ton (see John List on this point). Indeed, despite hundreds of lab experiments on dictator games, I feel far more confident predicting real world behavior following windfalls if we use a parsimonious homo economicus model than if we use the results of dictator games. Does this mean the games are useless? Of course not – studying what factors affect other-regarding preferences is interesting, and important. But how odd to have a branch of our field filled with people who see armchair theorizing of homo economicus as “unscientific”, yet take lab experiments so literally even when they are so clearly contrary to data?

To take one final example, consider Thaler’s famous model of “mental accounting”. In many experiments, he shows people have “budgets” set aside for various tasks. I have my “gas budget” and adjust my driving when gas prices change. I only sell stocks when I am up overall on that stock since I want my “mental account” of that particular transaction to be positive. But how important is this in the aggregate? Take the Engel curve. Budget shares devoted to food fall with income. This is widely established historically and in the cross section. Where is the mental account? Farber (2008 AER) even challenges the canonical account of taxi drivers working just enough hours to make their targeted income. As in the dictator game and the endowment effect, there is a gap between what is real, psychologically, and what is consequential enough to be first-order in our economic understanding of the world.

Let’s sum up. Thaler’s work is brilliant – it is a rare case of an economist taking psychology seriously and actually coming up with policy-relevant consequences like the 401k policy. But Thaler’s work is also dangerous to young economists who see biases everywhere. Experts in a field, and markets with agents and mechanisms and all the other tricks they develop, are very very good at ferreting out irrationality, and economists core skill lies in not missing those tricks.

Some remaining bagatelles: 1) Thaler and his PhD advisor, Sherwin Rosen, have one of the first papers on measuring the “statistical” value of a life, a technique now widely employed in health economics and policy. 2) Beyond his academic work, Thaler has won a modicum of fame as a popular writer (Nudge, written with Cass Sunstein, is canonical here) and for his brief turn as an actor alongside Selena Gomez in “The Big Short”. 3) Dick has a large literature on “fairness” in pricing, a topic which goes back to Thomas Aquinas, if not earlier. Many of the experiments Thaler performs, like the thought experiments of Aquinas, come down to the fact that many perceive market power to be unfair. Sure, I agree, but I’m not sure there’s much more that can be learned than this uncontroversial fact. 4) Law and econ has been massively influenced by Thaler. As a simple example, if endowment effects are real, then the assignment of property rights matters even when there are no transaction costs. Jolls et al 1998 go into more depth on this issue. 5) Thaler’s precise results in so-called behavioral finance are beyond my area of expertise, so I defer to John Cochrane’s comments following the 2013 Nobel. Eugene Fama is, I think, correct when he suggests that market efficiency generated by rational traders with risk aversion is the best model we have of financial behavior, where best is measured by “is this model useful for explaining the world.” The number of behavioral anomalies at the level of the market which persist and are relevant in the aggregate do not strike me as large, while the number of investors and policymakers who make dreadful decisions because they believe markets are driven by behavioral sentiments is large indeed!


11 thoughts on “The 2017 Nobel: Richard Thaler

  1. I don’t buy some of your criticisms. I think you’re spot on on questioning which are first-order effects and which not, but many of the biases may help to explain inequality for instance. Imagine that the small business ran by people who pay more to their workers because they think it’s fair will be in problems when facing competitions of big corporations that behave more like homo economicus. This is important and may help explain the huge number of small business who fail. And it has consequences for the lives of people.

    I’m not saying there is evidence for these effects (external validity), but the jury is still out. And whitout such evidence, the uncertainty of standard theory is too much to put too much weight on its predictions.


    • afinetheorem says:

      Agree completely with your examples of small businesses – this would be a useful place to look at behavioral effects.

  2. As always, this is a really well written and thoughtful post. But: those three issues you mention that need to be unpacked, they have been raised from the start, back in the 80ies, and they have been addressed in many and very convincing ways (see e.g. Shleifer’s noise trader model, or Camerer’s experiments, and many, many more). By reiterating these old critiques, and ignoring all the work that has accumulated to address it in the past 40 years, your post seems unduly biased… (but let’s grab coffee sometimes, I’m on the the 8th floor at Rotman.)

    • afinetheorem says:

      Indeed, none of those criticisms are new by any stretch! (And yes, we should grab lunch – Chipotle on Bloor at noon??) I wanted to talk mainly about Thaler and not behavioralism writ large, so here is a clearer version of what I believe on this issue:

      1) The behavioral folks have completely won the argument that individuals are susceptible to systematic deviations from irrationality, which are often predictable, and which do not necessarily disappear with aggregation and selection (noise trading is a good example). This is why there have been 5 Nobels given for this field of work!

      2) We should take these deviations, in terms of predictive behavior, as similar to risk aversion or time discounting, while noting that behavioral biases cause some unique problems when it comes to talking about welfare since they imply, e.g., time inconsistency.

      3) That said, it is not “unscientific” to write a model where firms are risk neutral, even if agents are risk averse. And not “unscientific” to abstract away from heterogeneity in the discount rate in certain models. The framing of psychology-based research as “scientific” and decision theoretic as “unscientific” is infuriatingly common, and a complete misunderstanding of how economic models are used.

      4) Anomalies in the lab are, as I and many others have noted, very easy to shift by changing settings, and often deviate in remarkable ways from observed behavior. Many “real world” examples of irrationality turn out to have sensible, alternative rationality-based explanations. This doesn’t mean there aren’t behavioral biases or that they are unimportant: rather, it means that the movement from “individuals show X effect of irrationality” to “this implies X at the firm level, or the economy level” is incorrect. Thaler is good at avoiding this; many students are not.

      5) As to what the baseline model in economics should be: rational choice retains many benefits. Open a journal. Where is the behavioral model of growth? Of patent policy? Of double marginalization? Of first mover advantage? Of international trade? We *all* agree with point 1 above. We disagree on how much it matters in most aggregated situations.

      6) As an example (since Thaler was in “The Big Short”): the financial crisis was *not* caused by the irrational overconfidence of individual buyers (they need to borrow: see Simsek Econometrica 2013). It was caused by a bank run in the shadow banking sector generated by imperfect information about bank asset holdings, and by mistakes in lending by financial institutions – perhaps behavioral, but in my read much more driven by incorrect incentives. Were individual buyers overconfident? Of course! Who would deny this? Is that first order for understanding how the Fed should respond? This is much less clear, and the posture one gets from behavioral folks that it is unscientific to abstract away from individual biases when modeling this problem – it rankles.

      • I agree with you on all of this; and in particular that there’s lots of confusion about the use and value of simplifying assumptions amongst students and non-professionals. I also share your experience that people are often too quick to jump to the conclusion that some behavior must be irrational or due to behavioral factors, just because on its face it seems plausible it might. I actually believe that the term “loss aversion” is an ingenious and misleading marketing device — what way too many people erroneously think is that “loss aversion” simply means that people don’t like losses. The latter is an explanation for many behaviors that have nothing to do with loss aversion whatsoever.

        But I do disagree with the following:

        1. One assumption that you implicitly seem to make is that economics only cares, or should only care, about aggregates. For anyone concerned with welfare, individuals also matter directly, regardless of whether their behavior affects aggregates or not (e.g. household finance, consumer protection, etc.)

        2. It’s too easy to do bad experiments which, without proper consideration of their flaws, appear to prove any point you wish to make. And there are too many experiments that are not done carefully enough, are confounded, take rejection of the null as evidence for their favored alternative without properly distinguishing between alternatives etc. But a careful experiment will study the robustness of its claims with respect to situational determinants, will carefully explain how and why it is likely to generalize to other situations, and will make clear which situations it does not generalize to. Nobody doing such an analysis carefully would claim, for instance, that dictator-game experiments imply that one should expect see office workers give away parts of their bonus to random others (and there’s in fact a very large literature studying under precisely what conditions one should expect dictator-game behavior (not) to generalize).

  3. FN says:

    Exactly this. Your reviews and blog posts are usually very nice and informative, but this time you sound full of old and disproven prejudices.

    This is maybe the reason why many “behavioralists” feel non-mainstream: it is still totally acceptable in academia to criticize behavioral research using old and disproven arguments. That’s a pretty unscientific and biased attitude!

    • afinetheorem says:

      I am open to hearing which claims are “disproven”. See my reply to Sandro above – I and essentially everyone buy the argument that individuals have systemic biases, and not all of these go away with aggregation and selection. I also think it is clear that these biases often do, in fact, go away with learning and aggregation and selection and endogenous institutional design (hell, ESS and Nash are so closely related that you don’t need *any* rationality assumptions to motivate many of our economic models!)

  4. Couldn’t be more excited to hear that Thaler was selected! I got interested in robo-advisors because of his work and am definitely a proponent of them among friends and family. I think I’ve said the phrase “set it and forget it” more times than I can count! I actually just detailed the basics and getting started with robo-advisors on my blog!

  5. Ashok Korwar says:

    Excellent points.. second order effects sound more interesting precisely because they are out of the common run..but that doesnt mean they are important.. they seem to have effects between 5 and 10% at most

  6. Sam Seitz says:

    Reblogged this on Politics in Theory and Practice and commented:
    An excellent discussion of Richard Thaler’s work, nudge, and behavioral economics.

  7. Per Kurowski says:

    Should Richard Thaler be concerned if pensioners one day accused him of nudging them into the wrong decisions?

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