Nobel in Economics Is Awarded to Richard Thaler

Nobel in Economics Is Awarded to Richard Thaler

- in World Biz

The economics prize was established in 1968 in memory of Alfred Nobel and is awarded by the Royal Swedish Academy of Sciences.

Mainstream economics for much of the 20th century was based on the simplifying assumption that people behaved rationally. Economists understood that this was not literally true, but they argued that it was close enough.

Professor Thaler has played a central role in pushing economists away from that assumption. He did not simply argue that humans are irrational, which is obvious but also unhelpful. Rather, he showed that people depart from rationality in consistent ways, so their behavior can still be anticipated.

For example, he showed that people do not regard all money as created equal. When gas prices decline, standard economic theory predicts that people will use the savings for whatever they need most. In reality, people still spend much of the money on gas. They buy premium gas even if it is bad for their car. In other words: they treat a certain slice of their budget as gas money.

Professor Thaler also showed that people place a higher value on their own possessions. In a famous experiment, he and two co-authors distributed coffee mugs to half the students in a classroom and then opened a market in mugs. In general, the students who had randomly been given a mug regarded it as being twice as valuable as did the students who were not given a mug.

Professor Thaler named this phenomenon, since documented across a wide range of human experience, an “endowment effect.” One of his co-authors, Daniel Kahneman, was awarded the Nobel prize in economics in 2002. At the time, some argued that Professor Thaler should have shared in the award.

The importance of fairness is another key area of Professor Thaler’s research. He showed that people care deeply about fairness and will penalize behavior they regard as unfair even if they do not benefit by doing so.

This has important economic implications. It explains, for example, why an umbrella store may not raise prices during a rainstorm.

It also illuminates the mechanics of economic recessions. Standard economic theory predicts that during an economic downturn, employers will cut wages to a level consistent with the demand for goods or services, so there is no reason to think a downturn will produce unemployment.

Why then does unemployment rise during downturns? Workers regard wage cuts as unfair. Employers, seeking to avoid angering the workers they keep, prefer to eliminate people rather than cutting the wages.

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The Nobel committee described how Professor Thaler’s theory of “mental accounting” explained how people simplify financial decisions by focusing on the narrow impact of each decision rather than on its overall effect. He also showed how aversion to losses can explain why people value the same item more highly when they own it than when they do not, a phenomenon called the endowment effect.

Professor Thaler’s theories also shed light on why New Year’s resolutions can be hard to keep and on the tension between long-term planning and short-term doing.

Succumbing to short-term temptation is an important reason many people fail in their plans to save for old age, or to make healthier lifestyle choices, according to Professor Thaler’s research. He also demonstrated how seemly small changes in how systems work, or “nudging” — a term he invented — could help people exercise better self-control when, for example, saving for a pension.

Professor Thaler had a cameo appearance, alongside the actress and singer Selena Gomez, in the film “The Big Short,” in which he used behavioral economics to help explain the causes of the financial crisis. Asked about his “short Hollywood career,” he joked that he was disappointed his acting prowess had not been mentioned during the summary of his achievements when the award was announced.