Here’s how Richard Thaler combined psychology with economics to win a Nobel Prize

Here’s how Richard Thaler combined psychology with economics to win a Nobel Prize

Richard Thaler’s Nobel Prize-winning economic theory argues that people don’t act with logic or rationality when it comes to money


U.S. economist Richard Thaler work won him this years Nobel Prize for economics.
Photo: Reuters

This year’s Nobel Prize in Economics was awarded to Richard Thaler, a University of Chicago economist who pioneered the path-breaking field of behavioural economics – a discipline at the intersection of economics and psychology.

Economists have traditionally eschewed psychology in their models of human behaviour, insisting that humans are fundamentally rational. Much of mainstream economic theory is premised on the notion that humans systemically make choices leading to optimal self-benefit, and that all decisions we make can be defended on purely logical grounds.

This assumption has been problematic; many observable economic and behavioural phenomena sit uneasily with explanations grounded solely within the realm of rationality. Of course, the simple statement that humans are irrational does not provide much value to economics in and of itself: models cannot automatically incorporate the notion. For irrationality to be academically useful, it is essential that behavioural biases be measurable, predictable and durable.

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That is where Thaler – and fellow researchers like Daniel Kahneman, who won the Nobel for Economics in 2002, and the late Amos Tversky – made his most important contributions. Thaler’s explorations of such phenomena began in the early 1970s, at a time when economics sought to distinguish itself from other social sciences by a rigorous application of mathematical principles and formal models.

During his time in graduate school, and early in his career as an economist, Thaler began building a list of behaviours he observed that were fundamentally inconsistent with assumptions of rationality. Among his favourite was the observation that ownership increases the perceived value of a good, what Thaler labelled the “endowment effect”. Given a particular good, you somewhat absurdly demand more to sell your unit of the good than you would offer to buy the same good from someone else. Unsurprisingly, Thaler’s work brought him little instant popularity within the profession. He often mentions that his thesis adviser noted of Thaler’s graduate student career that: “We did not expect much of him.”

Within academic circles, Thaler’s most cited paper discusses whether the stock market overreact. An affirmation of market overreaction fundamentally undermines a core tenet of orthodox financial economics, the Efficient Market Hypothesis (EMH). The EMH theorises that markets always perfectly and instantaneously incorporate all relevant information about a stock, showing pure rationality. Thaler ultimately found that psychological biases do indeed result in pricing anomalies within the market. Following this, a colleague at the University of Chicago, a strong proponent of the EMH, refused even to make eye contact with Thaler for decades.

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In an interview with The New York Times, Thaler said he was perhaps best known for his work on “mental accounting”. Classical economics assumes that money is fungible; in simplest terms, that “money is money” – spending decisions should not be impacted by the source of the money or by emotional factors that earmark money for use only in particular ways. However, Thaler discovered that people irrationally allocate spending based on “mental accounts” – for example, by refusing to divert money from a holiday fund to pay down high-interest credit card debt.

Although behavioural economics remains contentious among some economic purists, Thaler’s work eventually won him acclaim in the academic community and brought him a high public profile. He was elected president of the American Economic Association in 2015.

His popular recognition was elevated by his work with Harvard scholar Cass Sunstein, with whom Thaler co-authored Nudge. I read Nudge a couple years ago, and was perhaps most struck by its philosophical prescriptions for public policy. In matter of policy, Nudge advocates for what its authors refer to as “libertarian paternalism”.

Pure libertarianism advocates for the preservation of individual choice at all costs, and abhors the limitation of freedom, even if it is in the individual’s supposed best interest. Paternalism, on the other hand, holds the view that individual freedom can, and should, be restricted to promote “objectively” superior outcomes.

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How are these seemingly opposed ideologies reconciled? The idea put forth by Thaler and Sunstein is that predictable behavioural tendencies can be exploited to preserve individual choice while “nudging” people to make a decision that may be more personally and socially optimal. The book was deeply influential, even inspiring the creation of a “Nudge Unit” in the British government, which has been involved with policy prescriptions targeted at everything from raising tax collection to increasing organ donation rates.

Misbehaving, which Thaler wrote in 2015, further expounds upon his career and the development of behavioural economics. In the book, Thaler tears into the assumption that we live in a world of perfectly rational beings, homo economicus or Econs, as he somewhat mockingly refers to the beings of economic theory. He also criticises the intellectual arrogance of economics as a field, noting that it is untenably resistant to integration with other social sciences. As someone greatly interested in economics, the book had a strong impact on me. It was an anecdote in Misbehaving that led me to write a research paper examining the rationality of punters in Hong Kong’s horse-race betting market.

Richard Thaler helped lead the charge for the integration of economics with other social sciences, particularly psychology. Because of his work, economics – fundamentally the study of human behaviour – is just a bit more human. In Misbehaving, Thaler espouses a vision that behavioural economics will cease to exist as a distinct field. Instead, he hopes that behavioural insights will become part and parcel of economic orthodoxy. With this Nobel, he is a step closer to that vision.

Edited by Ginny Wong

This article appeared in the Young Post print edition as
Psychology meets economy


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