As an assistant professor, Richard Thaler once faced students who were unhappy about their scores — they complained the average score was only 72 out of 100. Explanations that they would receive a letter grade on the curve irrespective of absolute scores did not help. So, Thaler increased the maximum possible score to 137, a score not easy to compute percentages in the head with, in the next exam. An average of 70% meant students, much to their delight, scored about 95 on average.
Simple, creative interventions such as this have peppered the long academic career of Thaler, winner of the 2017 Nobel Prize in Economic Sciences. The Nobel Committee highlighted his contributions in understanding “the consequences of limited rationality, social preferences, and lack of self-control” in individual decisions and market outcomes.
Classical economics has been built on the foundational assumption of rationality — a term used somewhat differently in economics than in the English language. Rationality assumes people have perfect foresight and are selfish in a material sense. While the assumptions were originally made to simplify complex problems of decisionmaking, with time they came to be regarded as absolute and immutable. Instead of treating such assumptions as useful but simplistic descriptions of reality, they often began to be treated as though they were the reality. A natural consequence was that the predictions of economic models, which rested on the foundational assumption of rationality, such as “markets are efficient”, began to be treated as a commandment. This uncriticality of the dominant paradigm was the historical backdrop against which psychologically nuanced theories of economic decisionmaking started to develop under the stewardship of Daniel Kahneman (2002 Nobel), Amos Tversky and, somewhat later, Richard Thaler. This is now fashionably called Behavioural Economics.
Thaler has had an enormous influence in economics, as well as on psychology, finance and marketing. He is one of the few academics in social science whose conceptual breakthroughs have enormously influenced public policy. One of his early contributions was the idea of ‘endowment effect’, a term he introduced in an influential 1980 paper. The idea is best illustrated in a paper he co-authored with Jack Knetsch and Daniel Kahneman in 1990, which showed people value goods much more when they have it than when they don’t. An experiment in which coffee mugs were randomly distributed to half the students in a class at Cornell, found a substantial difference in the valuation of the mug by students who had it and those who did not. This was in violation of rationality and, in particular, the Coasian prediction that valuations would be roughly equal. Endowment effects have been widely documented in a number of settings, and have been used to explain important empirical departures from rational predictions.
Thaler’s other important idea was mental accounting — people did not treat money as one big pool, but had separate mental accounts for each category. In a seminal 1985 paper, he illustrated the idea: a family saved $ 15,000 to buy their dream vacation home in five years and the savings earned an interest of 10% in a money market. The family bought a car for $ 11,000 through a three-year car loan at 15%. The fact that the family could have saved a substantial amount of money had they financed it out of their savings is irrational in the economic sense. Thaler argued that in this case the family did not simply save $ 15,000, but they saved $ 15,000 for the vacation house. Such narrow bracketing of our accounts have important implications for our savings and choice behaviour.
Thaler has also been one of the early proponents of the notion of “nudge”, or subtle changes in the choice architecture. Thaler and the co-author of their book Nudge: Improving Decisions About Health, Wealth and Happiness, Cass Sunstein, showed that people can be nudged to make healthier choices by strategically placing fruits and salads (good) ahead of fries (bad). They coined the term ‘libertarian paternalism’ to insist on the libertarian roots of the foundation of the tweak in choice architecture — paternalism because someone else decides that salads are healthy but fries are not; libertarian because both salads and fries are still available on the menu.
Nudges have been used in many settings to help people improve their choices. To address the problem of low savings rate in many countries, for example, classical economics will use standard macroeconomic tools as policy instruments. But behavioural economics will say part of the problem is in people’s lack of cognitive bandwidth to arrive at optimal solutions of complex problems such as how much to save. A nudge driven policy intervention may be to change the default: employees may simply uncheck a box and opt out instead of opt in. Such changes in the design of choice architecture have substantially increased the savings rate. Abhijit Banerjee and others have found that a small amount of free lentils — a nudge — more than doubled immunisation rates in rural Rajasthan. Such “medium-sized gains by nano-sized investment”, as Kahneman put it, have led to the development of a Behavioural Insights Team or “Nudge Unit” in the UK, USA, Singapore and Australia. The nudge units have worked to improve tax collection, health decisions, voter turnouts, etc. India is yet to develop a nudge unit of its own and harness returns from such cheap interventions. The Nobel for Thaler’s work points us to the way forward.