The economics of Richard Thaler

Richard Thaler’s work has been particularly influential in finance, helping explain why markets may often overreact to dramatic news. Photo: Reuters

The winner of the Nobel Prize in economics this year, Richard Thaler of Chicago University is widely recognized as one of the chief protagonists of the behavioural economics revolution that has challenged some of the standard assumptions and theories of economic theory.

Along with the 2002 Nobel Prize winner in economics Daniel Kahneman, his co-author Amos Tversky (who would have likely shared the prize with Kahneman had he not died in 1996) and Jack Knetsch, Thaler has pioneered a new way of looking at economics by drawing on insights from psychology and psychological experiments.

Unlike several other geniuses in the field who have gone on to win the ultimate recognition in the profession, Thaler had a rather tame beginning to his academic life. His doctoral thesis was on evaluating the monetary value of a human life—which is often used by regulators to measure the benefits of interventions that prevent deaths, say on highways or from air pollution. Based on his thesis, Thaler published in 1976, a fairly influential research paper on the theory and techniques of valuing a life statistically.

Thaler’s dissertation supervisor, the renowned economist Sherwin Rosen, despite co-authoring the 1976 paper with him, was not quite impressed with the young economist, later telling The New York Times, “We did not expect much of him.”

Perhaps Rosen’s dim view of Thaler sprang from what he saw as Thaler’s diversions away from the core question of his research. In the words of his colleague and collaborator, Cass Sunstein, Thaler had an “unfailingly mischievous mind”.

The “value of a statistical life” that Thaler was estimating was based on ascertaining the amounts that people are actually paid to incur risks in the workplace. When workers face an additional mortality risk of 1 in 100,000, how much more money do employers give them? Even as he was writing a “math-heavy” dissertation to arrive at the answer, he began tweaking the question itself to see if it produced a different response, wrote Sunstein in a 2016 essay on Thaler’s work.

“He started asking people two questions,” wrote Sunstein. “The first: How much would you pay to eliminate a mortality risk of 1 in 100,000? The second: How much would you have to be paid to accept a mortality risk of 1 in 100,000? According to standard economic theory, people’s answers to the two questions should be essentially identical. But they weren’t. Not close. The answers to the second questions were much higher (often in the range of $500,000) than the answers to the first (often in the range of $2000). In fact, some people responded to the second question, ‘there is no amount you could name.’ According to standard economic theory, that’s serious misbehaving.”

Thaler showed his results to Rosen, who told him to stop wasting his time. But it was these results rather than the thesis he ended up writing that paved the way for Thaler’s seminal contributions to behavioural economics. This was not the first time however that a future Nobel laureate’s work had been summarily dismissed by his or her guide. The early writings of the Amartya Sen, for instance, were once dismissed by his thesis supervisor Joan Robinson at Cambridge University as a “heap of ethical rubbish”.

Thaler met much the same fate at Rochester University. But soon after finishing his dissertation, he teamed up with the psychologists Kahneman and Tversky to produce a series of path-breaking research papers that established the quirks of human beings when faced with economic choices. Thaler’s later work showed that the stark differences in responses to the two questions about payments on mortality risk sprang from the “endowment effect”: people value goods that they have more than they value exactly the same goods when they are in the hands of others. As such, they placed a much higher value on accepting a mortality risk than they did on eliminating that same risk.

Thaler along with his pioneering colleagues showed that the mistakes that people made—contrary to what mainstream economists believed—were not random. Instead, some such mistakes were predictable and led to systemic society-wide issues, which could be corrected by correcting incentives, or “nudging” people to slightly modify their behaviour.

For instance, Thaler showed that people are far more likely to opt in for retirement savings plans when opting in was the default option in such schemes. In an influential 1991 paper, Kahneman and Thaler listed several such “anomalies” where the actual outcomes differed starkly from what standard economic theory predicted.

Thaler’s work has been particularly influential in finance, helping explain why markets may often over-react to dramatic news. Along with another recent Nobel laureate, Robert Shiller, Thaler has been one of the pioneers in the area of behavioural finance, helping us understand market phenomena that conventional economics could not explain well.

Thaler made a cameo appearance, alongside the actress and singer Selena Gomez, in the film The Big Short, in which he used behavioural economics to help explain the causes of the financial crisis.

It is not surprising that Thaler is one of the few economists who was not enthused by the “surge pricing” feature of the cab-hailing service Uber. Surge pricing refers to the extra charge that kicks in during peak hours in areas when demand for cabs spikes sharply.

Surge pricing is based on the central tenets of economics, and yet it has faced the ire of customers in several market economies across the world. Many customers who accept surge pricing when they are faced with that option end up complaining about the firm, often on social media. The reaction is even more severe when there is an emergency, such as during the December 2014 hostage crisis in Sydney, when a masked gunman held people captive in a café.

Thaler was an early critic of this model. In his 2015 book Misbehaving: The Making of Behavioral Economics, Thaler argues that temporary spikes in demand, “from blizzards to rock star deaths, are an especially bad time for any business to appear greedy”. He argues that to build long-term relationships with customers, firms must be seen as “fair” and not just efficient, and that this often involves giving up on short-term profits even if customers may be willing to pay more at that point to avail themselves of its product or service.

“I love Uber as a service,” writes Thaler. “But if I were their consultant, or a shareholder, I would suggest that they simply cap surges to something like a multiple of three times the usual fare. You might wonder where the number three came from. That is my vague impression of the range of prices that one normally sees for products such as hotel rooms and plane tickets that have prices dependent on supply and demand. Furthermore, these services sell out at the most popular times, meaning that the owners are intentionally setting the prices too low during the peak season.

“I once asked the owner of a ski lodge why he didn’t charge more during the Christmas week holiday, when demand is at a peak and rooms have to be booked nearly a year in advance. At first, he didn’t understand my question. No one had ever asked why the prices are so low during this period when prices are at their highest. But once I explained that I was an economist, he caught on and answered quickly. ‘If you gouge them at Christmas, they won’t come back in March.’ That remains good advice for any business that is interested in building a loyal clientele.”

Thaler’s insights are based not just on anecdotes, but spring from a long body of research on these issues. In a landmark 1986 study conducted jointly with Kahneman and Knetsch, Thaler showed that community standards of fairness dictated when and how far firms could raise prices.

Markets often failed to clear in the short term because such notions of fairness prevented companies from raising prices when demand rose, they pointed out. The study was based on interviews that elicited the views of people on several scenarios where a firm changed prices or wages. For instance, an overwhelming majority of participants considered it unfair of a hardware store to raise the price of snow shovels when faced with a sudden increase in demand the morning after a snow storm.

After defending surge pricing early on, Uber has tried to tweak this feature in its app. Thaler’s criticism may be prompting a rethink within the company. Even the Indian government in its regulations relating to cab aggregators such as Uber and Ola seems to have stuck to Thaler’s thumb rule of capping prices to three times the base fare (during daytime rides).