Richard H Thaler, who is credited with having developed the field of behavioural economics, has been awarded the 2017 Sveriges Riksbank Prize in Economic Sciences, more popularly known as the Nobel Prize in Economics. It may be par for the course today to say that all economics is behavioural but it was nowhere near the dominant paradigm when Mr Thaler, a 72-year-old professor of behavioural sciences and economics at the University of Chicago Booth School of Business, started work almost four decades ago. In essence, Mr Thaler’s contribution goes to the very heart of economic modelling and has had a profound impact on many areas of economic research and policy.
Most economic theories are based on a certain set of assumptions without which it would be difficult to talk in a coherent fashion about any theory. These assumptions simplify the complex everyday reality. So an economic model could assume that economic agents have perfect information or that the transaction costs are zero. In a similar vein, one of the dominant assumptions has been about economic agents being rational. That is to say, they only act in self-interest. But often enough there are gaps between the behaviour as predicted by the model and as it is in reality. Why? Mr Thaler’s work has tried to answer this. He has refined economic analysis by taking into account three psychological traits — limited rationality, perceptions about fairness and lack of self-control.
Limited rationality was a concept that another Nobel laureate, Herbert Simon, had developed and it underlined that it was not realistic to assume that individuals could be completely rational and think of all possible effects of their choices. Mr Thaler built on this insight to come up with his theory of mental accounting, which describes how people organise, formulate and evaluate financial decisions. For instance, this tendency to create separate mental accounts for day-to-day expenses and holiday expenditure explains why individuals might not dip into their long-term savings and instead use a credit card to tide over some imbalances in daily expenses. Similarly, the full rationality assumption of traditional theories cannot explain behaviour when it deviates to accommodate an individual’s sense of fairness. Through large experiments, Mr Thaler and other behavioural economists have shown how people can set aside personal gain and concern themselves with questions of fairness. For instance, consumers judge negatively a company which is seen to be unjustly raising prices in times of duress. Similarly, actual human behaviour has shown that people may, contrary to notions of rationality, choose something that goes against their interest. Take any addict, say, a smoker, who chooses to yield to an immediate temptation instead of favouring better health in the longer term.
Since this field of economics concerns itself with how human behaviour explains the deviations from the established theoretical model, it has had wide-ranging impact. Studying the so-called “irrationalities” has implications for financial behaviour (for instance, unjustified market volatility); marketing (the “buy two get one free” schemes providing a sense of having gained); and public policy making (wherein politicians “nudge” individuals towards a societal improvement, say, a less polluting environment). In fact, today there are “nudge” units in several countries such as the UK and the US.