The imperfect human cogs in the economy
Last week, Richard Thaler was awarded the Nobel Prize in economics for introducing “psychologically realistic assumptions into analyses of economic decision-making”. Often called the father of behavioural economics, Thaler is best known for analysing the mundane and everyday human choices. His work explains everything from fat waistlines to slim savings accounts.
Thaler started his work in what eventually became the field of behavioural economics by challenging the idea of the rational utility maximizing agent in economics models. Thaler distinguishes between the Econ—the abstract homo economicus individual used in rational choice axioms—and the more realistic Human. He argues that economists get into trouble when they make highly specific predictions by assuming the world is inhabited by Econs. Humans frequently violate the predictions by acting human. Over the years, he has detailed a variety of cases where individuals deviate systematically in their behaviour from the agents in models developed by economists.
One way to think about this year’s prize is that the committee recognizes the value in rediscovering the ideas of the old masters. The idea that humans are not Econs as modelled in traditional neoclassical economics had its origins centuries ago, starting with the writings of Adam Smith describing the moral sympathies of individuals in their social interactions. Smith’s construct of the “impartial spectator” (after whom this column is named) is a consequence of the fallible and imperfect nature of human choices and conduct.
Carl Menger, one of the marginalists contributing to the bedrock of modern economics, also conceived of individuals within the market process more as Human than Econ. Menger’s individual has been described as “... A bumbling, erring, ill-informed creature, plagued with uncertainty, forever hovering between alluring hopes and haunting fears, and congenitally incapable of making finely calibrated decisions in pursuit of satisfactions”.
Acknowledged by Nobel Committee 2009, Elinor Ostrom also advocated conducting rational choice analysis as if the choosers were human. Through her work on governing common pool resources, she showed that the bumbling human described by Menger both creates and overcomes problems posed by the commons.
While the idea of describing the economic agent in a more human way is not unique to Thaler, he brought these ideas back and posed his questions in direct challenge to the existing economic orthodoxy. Early in his career, he was at best tolerated for an interesting point of view, or at worst ridiculed for challenging the foundational assumption in neoclassical economics—the rational utility maximizing individual. It took almost three decades for behavioural economics to gain currency, in large part due to the acknowledgement by the Nobel Committee of the work by George Akerlof, Robert Shiller, and Daniel Kahneman. The moment of recognition for Thaler personally came in 2015 when he became the president of the American Economic Association.
Some of Thaler’s most interesting work is in the field of behavioural finance, which studies how cognitive limitations influence financial markets. His work demonstrated the asymmetry between gains and losses experienced by individuals, and the consequences of this asymmetry on financial choices. He also developed the theory of mental accounting, explaining how people simplify financial decision-making by creating separate accounts in their minds, focusing on the narrow impact of each decision rather than its overall effect. Then there is his work on the inconsistent choices made when individuals face costs in the present with benefits arising in the future.
Another aspect that sets Thaler apart from his fellow laureates is his accessible writing and his public involvement in converting these ideas into implementable policy. On the normative side, since individuals deviate from the behaviour predicted in the model due to systematic biases, Thaler (and his co-authors) argue that one could “nudge” individuals into making better choices. His book with Cass Sunstein by the same name highlights the areas where better outcomes could be achieved by designing the appropriate “choice architecture” within which fallible individuals could make better choices losing their freedom. This has inspired a lot of policy programmes, including the UK’s famous Nudge Unit.
It is useful to understand the contradiction between the positive and normative aspects of Thaler’s work. On the one hand, he recognizes that individuals behave more like Humans than Econs. On the other hand, his policy recommendations are to nudge humans so they act more like Econs. Highlighting this contradiction, New York University’s Mario Rizzo points out that Thaler accepts the normative standard emerging from rational choice models while simultaneously criticizing the descriptive accuracy of the very same rational choice models. Which raises the question: If individuals are Human, why must they be nudged into making decisions more aligned with the rational utility-maximizing robotic agent Econ? Is such a nudge even going to work? How often can it be used before the effect vanishes? How quickly do nudges turn into “shoves” when used by a coercive state?
These are just some of the many important policy questions that emerge from Thaler’s work. Resolving these difficult questions may be the winner’s curse Thaler famously described.
Shruti Rajagopalan is an assistant professor of economics at State University of New York, Purchase College and a fellow at the Classical Liberal Institute, NYU School of Law.
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