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

7 min read . Updated: 09 Oct 2017, 09:21 PM IST Pramit Bhattacharya

Richard Thaler has challenged the way we think about the economy, and has helped revolutionize the field of economics

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.