Thaler Explained Why It Makes Sense That Things Don’t Make Sense

Background

“Big achievements of the behavioural revolution has been to get economists as a whole to back away a bit from grand theorising, and to focus more on empirical work and specific policy questions.” The Economist (R.A.)

As readers of (even just) the popular press will be aware – the topic of behavioral economics recently received still more profile.  Specifically, I am referring to the award (October 9, 2017) of the Nobel Prize for Economics to Richard Thaler.  Worthy of note Thaler is an economist – in contrast with David Kahneman who won the Nobel Prize in Economic Sciences (2002) and is a psychologist. The latter I have referenced many times such as Freaking out about the guy the “Freakonomics” guy freaks out about and in several other articles referenced in the bibliography.

(Before I go further, I must acknowledge Thaler is arguably best known outside academia for his cameo role in “The Big Short”.)

Of note here:

• Thaler and Kahneman (and his deceased partner, Tversky) collaborated – as Thaler describes their time at Stanford “In a way, I taught them economics and they taught me psychology.”
• Slightly more than 5% of all Nobel economics prizes ever awarded have now gone to behavioral economists that worked in the study of economics (and finance) from this non-traditional perspective.
• Thaler’s work was done while at the University of Chicago, the institution most associated with a “rationalist” approach to economics. Arguably, a polar opposite approach but arguably, behavioral economics is an add-on not a substitute.

(You will find a thought provoking insight into the Nobel Prize process at large and Thaler’s selection at Science Advances One Funeral at a Time. The Latest Nobel Proves It.)

Thaler has observed that behavioral economics goes back to Adam Smith (1776) and “The Wealth of Nations,” which dealt with behavioral issues including the need to control impulses and the dangers of emotions.

Mainstream economics was subsequently built on a “universally” accepted principle that people behave rationally. Many Economists understood that this was not literally true but they accepted that it was close enough and proceeded to build mathematical models that would predict the future.

Ignoring as they did that behavior is often irrational – however, fortunately this seems to be in predictable ways.

Clearly, the ongoing contributions (validation) in this area are of paramount importance to the Business Brain Model – and my target audience of business people who recognize contributions from the world of neuroscience and psychology.

Review

Perhaps, the best way to introduce Thaler’s work is with the generalization that human behavior is universally related to economic consequences or as put by the Nobel Prize Foundation:  “In total, Richard Thaler’s contributions have built a bridge between the economic and psychological analyses of individual decision-making.”

In amongst Thaler’s many salient observations:

• The importance of fairness.
  1. People will penalize unfair behavior even if they do not benefit from doing so.
  2. Fundamental notions of fairness can/will shift depending on the situation.
• People are constantly looking for societal and organizational cues as to what the socially acceptable courses of action are.
  1. Behavioural decisions are not made independent of the context.
• Humans tend to focus on instant gratification.
  1. An important observation in deal structure of all types
• People depart from rationality in consistent ways
  1. This behavior lends itself to predictability

The above is nicely summed up further in a note from his citation: “The Academy said his research had harnessed psychologically realistic assumptions in analyses of economic decision-making, exploring the consequences of limited rationality, social preferences, and lack of self-control.” American Richard Thaler Wins Nobel Economics Prize (Reuters)

“Economists understood that individuals didn’t always behave according to those rules, but the idea was that, in aggregate, the rules would allow for a pretty good approximation of reality.”  The Economist (R.A.)

Relevance

Here is a brief (selected) list of places where Thaler’s work would be directly relevant to the readers of the Business Brain Model and clearly illustrates this is not all academic in its context!

Incidentally, “nudges” are designed to capitalize on non-rationale (but predictable) behavior.

• If you find a men’s public washroom floor clean:
  1. The strategy of placing a ‘fly’ on urinal reflects a form of ‘nudge’
• If children can be encouraged to eat healthier based on positioning of healthy food in a cafeteria
  1. Another nudge reflecting the “choice architecture”
• If umbrella prices are not raised in a rain storm
  1. He has illustrated how surge pricing is not well received by public
• “Retirement baskets” facilitate saving
  1. The idea is that retirement savings become the default choice as offered to employees.
• Improved public service and lower energy consumption
  1. Also lend themselves to ‘nudge’ approach
• Identifying the dilemma of workers preference to see others’ jobs cut than lower their wages
  1. Important insight in corporate/industry rationalization

Resources

For the non-economist/non-psychologist amongst our readers – Thaler’s ideas are in the popular press as follows:

• The Winner’s Curse: Paradoxes and Anomalies of Economic Life
• Nudge: Improving Decisions About Health, Wealth, and Happiness
• Misbehaving: The Making of Behavioral Economics

And for the others wanting more meat on the bones:

• Advances in Behavioral Finance
• Quasi Rational Economics
• Advances in Behavioral Finance, Volume II (Roundtable Series in Behavioral Economics)

Conclusion

Perhaps, the best way to tie all this up in a bow is to end with the quote of Richard Thaler on how he will spend his more than a million dollar prize:

• “I will try to spend it as irrationally as possible.”

Bibliography

• A. – Richard Thaler’s work demonstrates why economics is hard
• Binyamin Appelbaum – Nobel in Economics Is Awarded to Richard Thaler
• Peter Coy – Science Advances One Funeral at a Time. The Latest Nobel Proves It
• Heather Long – American professor wins Nobel Prize in economics for trying to understand bad human behavior
• Reuters – American Richard Thaler Wins Nobel Economics Prize
• Robert Shiller – Richard Thaler is a controversial Nobel prize winner – but a deserving one
• Jeff Sommer – Richard Thaler Talks About Silly (but Serious) Things
• Paul Wiseman And Jim Heintz – Nobel goes to Richard Thaler who made economics human again

Relevant Business Brain Model articles

1. Daniel Kahneman Meets Dalai Lama
2. Thinking Errors: Part One – Is your Radar set to Detect Cognitive Traps?
3. Thinking Errors: Part Two – The Ironic Magnitude of Cognitive Biases
4. Hooked on Hedonics: Is Happiness the next Holy Grail of Business?
5. Freaking out about the guy the “Freakonomics” guy freaks out about
6. When is the best time to decide why you failed?

About the Author: W.B. “Bud” Kirchner is a serial entrepreneur and philanthropist with more than 50 years of business success. He is not a scientist or an academic but he does have a diversified exposure to neuroscience, psychology and related cognitive sciences. Generally speaking, the ideas he expresses here are business-angled expansions of other people’s ideas, so when possible, he will link to the original reference.