Saturday, November 18, 2017
Perspective

Perspective: Richard Thaler won the Nobel Prize for making economics more human — and more real

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In 1996, an Israeli psychologist named Amos Tversky was curiously, but fulsomely, eulogized for having urged economists to put down their formulas and look out the window to see people as they really are.

The first to do so was Richard Thaler, an economist at the University of Chicago Booth School of Business. On Monday, Thaler won the Nobel Prize.

If the only criterion for winning was making the dismal science un-dismal — even fun — Thaler would have won years ago. But because his work, to use an overused phrase that here fits, also revolutionized our understanding, Oslo, finally, could not look the other way.

Let's start with the fun. A basic tenet of modern economics is the law of one price. This means that a person may value a quart of milk to be worth either more, or less, than $1 — but not both. From this simple building block economists built complex formulas describing how humans will (supposedly) behave in their economic lives. Raise the price above $1 and they switch to juice. Lower it and they buy oceans of milk. Notice how orderly and logical it is.

No speculative tidal waves or market busts. Each consumer is making a rational choice — acting according to a fixed idea of the value of milk.

But the economists who built these models never went to the beach with Richard Thaler. He popped the axiom of "one price" with a simple lab experiment. Suppose, he inquired of test subjects, you are indeed on the beach. Someone offers to bring back Budweiser from a convenience store, but it's a long walk (and out of cellphone range), so she asks how much people would be willing to spend. The answer was just a few dollars.

Thaler asked other subjects how much they would be willing to spend if the beer were purchased at a nearby upscale hotel. The latter group said twice as much. This made, to the conventional economist, no sense at all. If you are drinking a beer on the sand, what difference where it was purchased? You either value a Bud at $3 or at $7 — it cannot be both.

But Thaler sensed that people do not, in real life, conform to the models. Their sense of "value" is influenced by subjective factors — among them a sense of "fairness." Although the "utility," as economists say, of drinking the beer is the same, it does not feel right to spend $7 at a grocery store.

This simple experiment, and many others like it, turned what had become the truly dismal science of economics on its head.

It turned out, in myriad ways, that humans are not the bloodless calculating machines that the models supposed. Once Thaler dared to question the economic orthodoxy, the examples multiplied. Suppose you purchased a $100 opera ticket and discovered upon arriving at the opera house you had lost the ticket. Most people would not buy another, reckoning that $200 was too much to spend on Verdi. But that is irrational. The only choice now is whether Verdi is worth $100 — which you resolved when you bought the first ticket.

This is an example of the sunk cost effect, which for some years was virtually Thaler's meal ticket. No "rational" person would go to the gym merely because they had purchased a nonrefundable membership. But real people do precisely that.

And to a rational being, it is either worth spending 30 minutes to save $20 — or it is not. Yet people (pre-Internet) would drive across town to buy a cheaper sweater — yet not think of doing so to save $20 on an automobile. It doesn't seem "worth" it — though the $20 saved is the same.

More subtly, people rationalize their spending decisions in a way no computer could abide. For instance, you scrimp at the supermarket, regularly saving $5 on every trip — but on vacation blow $30 on a fancy wine. Thaler dubbed this "mental accounting."

Some of Thaler's insights were reassuring. That people leave tips in out-of-town restaurants where they will never return means they care about more than, as the model says, maximizing wealth. We are guided, as Adam Smith recognized but economists in the late-20th and 21st centuries routinely forgot, by "moral sentiments" as well.

And some were disturbing. For instance, people are not entirely rational even when they think they are. Their judgments are subtly "anchored" by background noise — even random noise. People were asked in an experiment to write down their phone number and then to guess the year the Huns invaded Europe. People with higher phone numbers guessed higher years for the Huns.

Thaler, as he has always pointed out, built on the work of Tversky and his fellow psychologist, Daniel Kahneman. (Kahneman won a Nobel Prize in 2002.) Tversky and Kahneman were the first to document systematic irrational behaviors. For instance, they realized what pollsters have long known — decisions may be biased by how questions are framed. Thaler took this a step further by showing that people create their own frames. A poker player ahead at the end of the night may play more recklessly because he is playing with "house money." A rational player would play the first and last hand the same.

But Thaler's lasting accomplishment was to pull these realizations out of psychology, where they were regarded as interesting quirks, into economics, where they spawned a new discipline, "behavioral economics." That discipline now has its own rich literature, thanks to Thaler's many talented disciples, whose cumulative effect has been profound. To get there, Thaler had to combat a neoclassical orthodoxy whose view of behavior was as rigidly deterministic, and as universally subscribed to, in the day, as were Marx and Engels in the Kremlin.

Thaler's first paper on the subject was rejected by the leading economic journals. Even his academic adviser worried that he was wasting a promising career. But Thaler persisted because the evidence of his own heart told him the models were wrong. The moment of inspiration occurred in the 1970s when he and a friend in Rochester decided to skip a basketball game because of a blinding snowstorm. "But if we had bought the tickets already, we'd go," said the friend. "True — and interesting," Thaler replied.

The upshot on the profession was seismic. Since people were rational, economists had long maintained — with a straight face — that market prices were always as right as could be, thus "bubbles" could not exist. This thinking prevented Alan Greenspan, as chairman of the Federal Reserve, from acting on reports in the 2000s that housing prices and mortgage policies were out of whack.

Just as bizarrely, economists held that people automatically adjust their spending to accommodate their expected lifetime earnings and the amount they will need to retire. Indeed, according to the models, a person who found $100 on the street would, rationally enough, deposit the bulk in her savings account. Thaler knew that if he ever found that bill, he would splurge on dinner.

Because most people are not good at saving, Thaler and a colleague, Cass Sunstein, have prodded employers to change the default setting on retirement plans, "nudging" employees to save more. This is his biggest practical triumph.

Perhaps his larger feat is rescuing economics, once a humanitarian discipline, from the prison of mathematics. After World War II, the economics profession became so thoroughly mathematized as to be unintelligible to the layperson. Good models are useful, but Thaler reminded their creators to base them not on imagined hyper-rational beings, but on the real people outside the window.

© 2107 Washington Post

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