Nudge Theory - Why Richard Thaler won the 2017 economics Nobel Prize

The 49th Sveriges Riksbank prize in economic sciences – commonly referred to as the Nobel Prize for economics – has been awarded to Richard H Thaler for his contributions to behavioural economics.

He was a key proponent of the idea that humans do not act entirely rationally. By applying insights from psychological research, he helped the world better understand people’s economic decision-making in particular.

Thaler published extensively in the field of finance. He pinpointed the difference between the predictions in financial literature, which assume that people act perfectly rationally to maximise their expected profits (the idea of the homo economicus), and what actually happens on the markets.

Thaler was on many people’s list of Nobel favourites. But since the award already went to Daniel Kahneman in 2002 for behavioural economics and then jointly to Eugene Fama, Lars Peter Hansen and Robert Shiller in 2013 for financial markets, his chances seemed relatively slim. But the Great Recession – caused by financial markets seeming to behave “irrationally” – brought a lot of attention to research that extensively cites Thaler’s 40-year long academic career. He even made a guest appearance in the film The Big Short to explain why banks kept buying and selling bad debt to their detriment.

People are not perfect computers, and Thaler’s research on limited rationality demonstrates this. For instance, people tend to be loss averse: they’d rather expect a smaller payoff with the same risk, but cap their losses. This obviously has implications for financial markets: financial products based on the binary options of profit or loss, for instance, rely heavily on advertising that any potential losses are limited.

Mental accounting

Another contribution of Thaler was the concept of mental accounting: people don’t, it turns out, think about their total lifetime welfare when making financial decisions. Instead they focus on the performance of individual decisions and are less concerned with making savings if they are a small percentage of what’s being spent. This idea led to the development of the field of behavioural finance, which addresses the implications of limited rationality.

For instance, if you could save £1 on a burger by going elsewhere, you’d probably go for it. But if you could save the same amount of £1 on exchanging your currency for a holiday, you will not – even if the time you lose to go to another currency exchange is the same as the time you would lose to go to another burger joint.

Related to this, Thaler has conducted a lot of research to show how bad humans are at long-term financial planning. Despite the fact that we now expect to live a long time, left to our own devices, most people will not plan sufficiently for retirement. The growing problem of obesity also shows how bad humans are at serving their best interests.

To understand this, Thaler proposed that it’s necessary to view each individual as two people: one side of you that plans, the other that does (or doesn’t do) what is planned. The planner side of you might see perfect sense in signing up for a yearly gym membership – it expects you to go to the gym everyday and get fit. But the doer side of you might not follow through with this; it makes perfect sense for the doer side of you to repeatedly postpone the gym trip to when it’s more convenient, until the year is up.

That’s how gyms make their money – by appealing to the planner side of your personality. We need to understand the planner and the doer side of our personalities in order to follow through with our intentions. Similarly, governments might be interested in regulating contracts that exploit this disconnect between people’s long-term interests and everyday decision making.

Nudge theory

These psychological insights also play an important role in nudge theory – another concept developed by Thaler. Nudging is where small stimuli are provided to influence people’s behaviour. Nudges work at an individual level, but are also used by companies.

For example, Thaler showed how companies could use strategies to present buying options in the most favourable way to customers. Small nudges in the way that sales people operate or present their goods can influence people’s spending. For instance whether or not a company should offer a complete version of its software versus a cut-down version for free. Or when a car salesman gives you a discount: they will often quote a 20% higher price first and then lower it to frame the price as a personal discount just for you.

Governments, to try and ensure their citizens are better prepared for the future, have also adopted nudge theory. For example, by automatically enrolling people into pension schemes, making them opt-out instead of opt-in, has massively increased the number of people with plans, compared to if they had to actively elect into one.

I hope this Nobel Prize award will attract the public’s attention and encourage many to acknowledge the irrationality of their decision-making. As well as seeing the value in regulating financial markets so they are not susceptible to irrational behaviour, by acknowledging this tendency, we can make better plans for our futures – ones that our “doer” sides are happy to follow.

Image: Sveriges Riksbank prize 

This article was originally published on the Conversation.