Why Thaler matters: A rational look at behavioural economics

The 2017 Nobel Prize in Economics was awarded to Professor Richard Thaler for his contributions to behavioural economics.

Prof Thaler's work essentially questions the economic dogma of the so-called "rational man" as defined by classical economic theory, who makes decisions based on weighing the additional benefits against the additional costs of every single option.

Through a series of experiments, Prof Thaler and his colleagues (chiefly another Nobel laureate, Daniel Kahneman, and the late Amos Tversky) showed that people simplified decision-making using mental shortcuts or heuristics. For example, they hold separate mental accounts for different types of income and expenditure, such as "bills" and "savings". He termed this mental accounting. Prof Thaler showed that people made decisions rigidly along each of these accounts.

This explains why there is irrational asset allocation in investments where investors purchase too little of one asset when it is doing well because the money has been mentally earmarked for another class of assets.

Another significant contribution is his work on social preferences. He showed that, unlike standard economic assumptions, people value fairness and reciprocity.

This is shown in many experiments and empirical work. One such experiment is known as the simple ultimatum game between two persons.

The first person, or the allocator, is given a sum of money from which he or she is to share with the other person, the recipient. If the recipient refuses the amount being shared, there is no payoff for both parties. Conventional economics predicts that the recipient should accept any amount offered because of the marginal gain (since having a sum of money, no matter how small, is better than none).

However, the experiment revealed that most recipients will not accept just any amount - it must be a high enough amount. If the first person has $100 and offers to share $1, the second person is likely to reject it, although it is irrational to reject free money.

Experiments show that when the offer is closer to parity, or about half of $100 in this case, the second person is more likely to accept it. Behavioural economists associate this behaviour with an innate sense of fairness, so that people would rather have no money than accept a disproportionately tiny share.

It is interesting to note that Prof Thaler's approach to using experiments in studying individual decision-making is not new. It is commonly used in in psychology and had been used earlier by economists Vernon Smith, John Kagel, and others, to test microeconomic theory.

However, until the 1970s, there were very few interactions between the scholarly works of economists and psychologists. The brilliance of Prof Thaler was to recognise that insight from psychology could be incorporated into the study of various anomalies in economics.

Thus, the fruitful association began among Prof Thaler, psychologists Daniel Kahneman and Amos Tversky (who died in 1996), and with Canadian professor Jack Knetsch, who is known in Singapore and the region for championing behavioural economics to both governments and the academia.

NUDGES

In understanding the ways where people were predictably irrational (a term coined by Duke University economist Dan Ariely), Prof Thaler saw the opportunity to influence people to make better choices by exploiting these behavioural biases. Such influences became popularly known as behavioural nudges after the publication of his influential 2008 book co-written with Harvard law professor Cass Sunstein, titled Nudge: Improving Decisions About Health, Wealth, And Happiness.

In it, a nudge is defined as any aspect of the choice architecture that alters people's behaviour in a predictable way without forbidding any options or significantly changing their economic incentives. An example would be using defaults and making the choice of opting out available. People will often stick with the default, even though the choice to opt out is preserved.

Prof Thaler's work has augmented classical or "rational" economics, not overhauled it. In the wake of the behavioural revolution, economists have studied how to incorporate behavioural effects into existing economic models. And when some of these effects are accounted for, rationality again provides a good basis for explaining behaviour.

Since then, many governments have warmed to the idea of nudges and its potential as a cheap, effective and politically palatable instrument of intervention. Singapore will be no exception.

RATIONALITY IS STILL KEY BEHAVIOUR

However, in our embrace of behavioural economics and its applications, we must be careful not to throw the baby out with the bathwater.

Prof Thaler's work has augmented classical or "rational" economics, not overhauled it. In the wake of the behavioural revolution, economists have studied how to incorporate behavioural effects into existing economic models. And when some of these effects are accounted for, rationality again provides a good basis for explaining behaviour.

For example, behavioural economists speak of choice overloading where a consumer will avoid making a purchase when faced with too many options. One might see this as an issue where a rational consumer is facing high transaction costs in decision-making.

In various versions of the ultimatum game, people make seemingly irrational choices that involve accepting a lower payoff to oneself in exchange for a fairer distribution of payoffs. These actions may be considered rational once the innate benefits from fairness are considered - essentially fairness is treated as a good with a value on it. Different individuals may set a different value on fairness. Likewise, transaction costs will differ among individuals. Seen in this light, behavioural economics is not necessarily in conflict with "rational" economics.

Thus, policymakers must remain rationally agnostic in selecting the right policy tools. They must neither worship at the temple of rationality nor at the shrine of behavioural economics. Economists have not thrown out standard economic models in response to behavioural economics. They have simply updated them.

Similarly, nudges ought to augment existing public policy tools, not replace them. A rational approach of weighing the relative merits of each tool for a given purpose is required.

To do so, policymakers need to consider the stakes of non-compliance against the cost-effectiveness of each policy tool. Where stakes are low and nudges are more cost-effective, nudges should be the preferred tool.

A good example of this is Copenhagen's choice to paint bright green footprints on the ground leading to litter bins to nudge people into throwing their litter into bins, instead of posting public servants at every street corner to catch litterbugs and prosecute them. In this example, the stakes of non-compliance are quite low (litter on the streets is unpleasant but not exactly dangerous) and the nudge seems to be more cost-effective than legislation and enforcement.

However, if the stakes are sufficiently high, such as in the treatment and disposal of toxic waste; or if conventional policy tools are more cost-effective, then the conventional tools ought to be used. Nudges are not inherently superior. The best policy instrument is context dependent.

ENHANCING RATIONAL COST-BENEFIT ANALYSIS WITH BEHAVIOURAL ECONOMICS

Nonetheless, a rational view of behavioural economics requires us to also acknowledge that behavioural effects do have implications on a government's decision-making process.

Unlike an individual, a government does not have inherent preferences for certain goods and services. Instead, a government needs to take society's preferences into account in prioritising which goods and services to provide.

For example, in deciding whether to build a road through a nature reserve, the government needs to have a sense of society's preferences between convenience and greenery. The means of doing so is to conduct a cost-benefit analysis.

Such an exercise puts a dollar value on otherwise non-monetary costs and benefits, allowing a holistic evaluation of the trade-offs that each option entails. And, these dollar values are computed using techniques that measure society's preferences for goods.

Non-market goods, such as fairness and transaction (inconvenience) costs mentioned earlier, and others like national pride and aesthetics can be valued and included in the cost-benefit analysis as well.

However, precisely because cost-benefit analysis uses the subjective values that people place on the costs and benefits at hand, people's susceptibility to behavioural effects would also affect the computation of costs and benefits. The behavioural economics of loss aversion and the endowment effect is an example of this. People tend to value things more if they own them. Consequently, the amount one is willing to pay for gaining something is less than what one is willing to accept for losing it.

Thus, the choice of measure matters. For example, assessing pollution damages with willingness-to-pay to mitigate the pollution - rather than willingness-to-accept compensation for the pollution - would produce a lower value for the cost of pollution.

Additionally, since people value fairness, a cost-benefit analysis that does not explicitly take the impact of equity into account would be incomplete. Cost-benefit analysis should include people's level of pro-social behaviour when evaluating the socio-economic impact of proposed projects.

Behavioural economics has certainly broadened the field of economics and has provided policymakers with another set of tools to use, but reminding ourselves that rationality in these insights and tools is equally important. Prof Thaler thoroughly deserves the Nobel Prize for his pioneering work. The award should be quite gratifying for someone whose thesis adviser once provided the following assessment: "We did not expect much of him."


  • Euston Quah is professor of cost-benefit analysis and head of economics at Nanyang Technological University. He is also president of the Economic Society of Singapore.
    Christabelle Soh is an economics teacher at a local school. Jonathan Tan is associate professor of economics at the University of Nottingham.
    Zach Lee, a research associate at NTU, also contributed to this article.
A version of this article appeared in the print edition of The Straits Times on November 25, 2017, with the headline 'Why Thaler matters: A rational look at behavioural economics'. Print Edition | Subscribe